Financial Accounting Theory and Analysis Text and Cases, 13th Edition Solution Manual by Ace Test Banks

Accounting Theory and Analysis 13th Edition

FASB ASC Tutorial and Solutions Manual By Richard G. Schroeder University of North Carolina at Charlotte

Myrtle W. Clark University of Kentucky

Jack M. Cathey University of North Carolina at Charlotte 1

Using the Codification to Solve the FASB ASC Cases Prior to attempting to use the codification website to solve the FASB ASC cases, it is recommended that you read “Test Driving the Codification,” by Carolyn Ford and C. William Thomas, Journal of Accountancy, December, 2008. Available at http://www.journalofaccountancy.com/Issues/2008/Dec/TestDrivingtheCodification.htm and review the tutorials on the codification website. Overview of the Codification The Financial Accounting Standards Board codification (FASB ASC) is organized into general topics listed on the left-hand side of the home page (General Principles, Presentation, etc.). Clicking on any of the general topics will bring up what the FASB terms a “landing page.” Each landing page contains a list of sub topics for that link. For example, clicking on the general topic Assets brings up list of seven sub topics (Cash and Cash Equivalents, Receivables, etc.). Notice that each of the subtopics is identified by a three-digit number. This allows for access via the go to function that we will discuss later. Clicking on any of the subtopics brings up a second link to what are termed sections and contain the content specific area of the FASB ASC. All Subtopics have a set of standard Sections unless there is nothing to include in a particular standard section, in which case that standard Section is left out of the Subtopic and therefore the FASB ASC. There are sixteen standard Sections for each Subtopic. Sections are indicated by a two-digit number between 00 and 99. Some of the most frequently used sections are: 25 Recognition, 30 Initial Measurement 35 Subsequent Measurement, 50 Disclosure and Implementation Guidance and Instructions. Each Section has Paragraph numbers that start over at the beginning of each Section. Each Paragraph, therefore, has a two-part number. The first number is the Section number, and the second part is the Paragraph number within that Section. The Paragraphs are where “substantive content” of the FASB ASC is found. The rest of the levels only exist to organize the information in the Paragraphs and help navigate to the information contained in them. In order to view the specific content areas, it is necessary to click on the JOIN ALL SECTIONS tab found on each section page. For example, assume we are interested in the authoritative literature on accounting for sales of products when a right to return exists. First, click on the topic Revenue at the lefthand side of the home page, then on the landing page Revenue Recognition. Next, click on the products subsection. Finally click the JOIN ALL SECTIONS tab and all of the paragraph content will appear. Page down through the material and you will find that Paragraph 25-1 contains the authoritative guidance for accounting for sales of products with a right to return. 2

The home page also gives other options for navigating the FASB ASC. Two of these are the SEARCH function and the GO TO option. We have found that using these functions is an easy way to start navigating the FASB ASC. To use the search method of navigating the FASB ASC, first, type the general topic in the search box at the top right of the FASB ASC home page. This will give you some references to specific FASB ASC sections where the topic is discussed. Choose the section that seems most appropriate and type the reference number in the GO TO box at the top left-hand side of the FASB ASC homepage. Once you are redirected to the desired section, click combine sections and all of the information on the topic will be displayed. You can then browse through the material to find the appropriate subsection that addresses the case issue. Let’s use this option to find the authoritative literature on accounting for sales of products with a right to return Type “right to return,” in the search box at the top right of the FASB ASC web page. You will get references to the place where this issue is discussed. Seven possibilities appear, but in reviewing we see that the criteria are contained in 605-15-25-1. Type this number in the box next to the GO TO link at the top left-hand side of the FASB ASC homepage. This will redirect you to the content specific paragraph that discusses accounting for sales of products where a right of return exists. (Note: in some searches you may be redirected to the section outline. If so, click the JOIN ALL SECTIONS tab and all of the paragraph content will appear. If the issue involves accessing a previous specific pronouncement, it is also possible to access the topic through the cross reference function. On the home page, select Cross Reference. This feature allows you to access the relevant FASB ASC section by citing the original source. To use this feature, first access the drop down menu under Standard Type. (Standard Type refers to the authoritative body that originally issued the pronouncement. For example, the Financial Accounting Standards Boards uses the acronym FAS. A discussion of the acronyms for the various standard types is contained through a link in the directions). Next, use the drop down menu under standard number and choose the appropriate number. Then click GENERATE REPORT. When the results appear, click on the first paragraph number at the far right side. Next, click on the 3-digit topic at the top under Table of Contents. When the results appear, click and expand and all of the subtopics will appear. Choose the subtopic you wish to view and then combine sections and the relevant authoritative literature will be displayed. For example, to answer case 9-3, choose FAS from the drop down Standard Type menu. Then choose 143 from the standard number drop down menu. (Please note 3

that the standard number for asset retirement obligations was misidentified in the case. It should be 143 not 144). Click on GENERATE REPORT and when the results appear, click on 05-4 on the first line under paragraph number. When the results appear, click 410 Asset Retirement and Environmental Obligations. When the results appear, the most appropriate section seems to be 20 Asset Retirement Obligations. Select it and then click the JOIN ALL SECTIONS tab and all of the paragraph content will appear. Finding original source material still contained in the Codification Several of the FASB ASC cases ask for EITF pronouncements related to a particular topic. In order to find original source material from the EITF or any other authoritative body use the following steps: 1. Find the relevant topic in the FASB ASC 2. Click expand for the relevant subtopic 3. Click the JOIN ALL SECTIONS tab 4. From the menu select Printer-friendly with ƒ Page/Print functions sources 5. Page through the material to find content originally sourced from the EITF

CHAPTER 1 Case l-1 a.

The FASB had three primary goals in developing the Codification: 1. Simplify user access by codifying all authoritative US GAAP in one spot. 2. Ensure that the codified content accurately represented authoritative US GAAP as of July1, 2009. 3. Create a codification research system that is up to date for the released results of standard-setting activity.

The Codification is expected to improve accounting practice by: 1. Reducing the amount of time and effort required to solve an accounting research issue 2. Mitigating the risk of noncompliance through improved usability of the literature 3. Provide accurate information with real-time updates as Accounting Standards Updates are released 4. Assisting the FASB with the research and convergence efforts.

The FASB ASC is composed of the following literature issued by various standard setters: 1. Financial Accounting Standards Board (FASB) a. Statements (FAS) b. Interpretations (FIN) c. Technical Bulletins (FTB) d. Staff Positions (FSP) e. Staff Implementation Guides (Q&A) f. Statement No. 138 Examples. 2. Emerging Issues Task Force (EITF) a. Abstracts b. Topic D. 3. Derivative Implementation Group (DIG) Issues 4. Accounting Principles Board (APB) Opinions 5. Accounting Research Bulletins (ARB) 6. Accounting Interpretations (AIN) 7. American Institute of Certified Public Accountants (AICPA) a. Statements of Position (SOP) b. Audit and Accounting Guides (AAG)—only incremental accounting guidance 5

c. Practice Bulletins (PB), including the Notices to Practitioners elevated to Practice Bulletin status by Practice Bulletin 1 d. Technical Inquiry Service (TIS)—only for Software Revenue Recognition Additionally, in an effort to increase the utility of the FASB ASC for public companies, relevant portions of authoritative content issued by the SEC and selected SEC staff interpretations and administrative guidance have been included for reference in the Codification, such as: 1. 2. 3. 4.

Regulation S-X (SX) Financial Reporting Releases (FRR)/Accounting Series Releases (ASR) Interpretive Releases (IR) SEC Staff guidance in: a. Staff Accounting Bulletins (SAB) b. EITF Topic D and SEC Staff Observer comments

The FASB ASC contains all current authoritative accounting literature. However, if the guidance for a particular transaction or event is not specified within it, the first source to consider is accounting principles for similar transactions or events within a source of authoritative GAAP. If no similar transactions are discovered, nonauthoritative guidance from other sources may be considered. Accounting and financial reporting practices not included in the Codification are nonauthoritative. Sources of nonauthoritative accounting guidance and literature include, for example, the following: 1. Practices that are widely recognized and prevalent either generally or in the industry 2. FASB Concepts Statements 3. American Institute of Certified Public Accountants (AICPA) Issues Papers 4. International Financial Reporting Standards of the International Accounting Standards Board Pronouncements of professional associations or regulatory agencies 5. Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids 6. Accounting textbooks, handbooks, and articles

Case 1-2 a.

Inclusion or omission of information that materially affects net income harms particular stakeholders. Accountants must recognize that their decision to implement (or delay) reporting requirements will have immediate consequences for some stakeholders. 6

Yes. Because the FASB standard results in a fairer presentation, it should be implemented as soon as possible--regardless of its impact on net income.

The accountant's responsibility is to provide financial statements that present fairly the financial condition of the company. By advocating early implementation, Hoger fulfills this task.

Potential lenders and investors, who read the financial statement and rely on its fair representation of the financial condition of the company, have the most to gain by early implementation. A stockholder who is considering the sale of stock may be harmed by early implementation that lowers net income (and may lower the value of the stock).

Case 1-3 a.

CAP. The Committee on Accounting Procedure, CAP, which was in existence from 1939 to 1959, was a natural outgrowth of AICPA (then AIA) committees, which were in existence during the period 1933 to 1938. The committee was formed in direct response to the criticism received by the accounting profession during the financial crisis of 1929 and the years thereafter. The authorization to issue pronouncements on matters of accounting principles and procedures was based on the belief that the AICPA had the responsibility to establish practices that would become generally accepted by the profession and by corporate management. As a general rule, the CAP directed its attention, almost entirely, to resolving specific accounting problems and topics rather than to the development of generally accepted accounting principles. The committee voted on the acceptance of specific Accounting Research Bulletins published by the committee. A two-thirds majority was required to issue a particular research bulletin. The CAP did not have the authority to require acceptance of the issued bulletins by the general membership of the AICPA, but rather received its authority only upon general acceptance of the pronouncement by the members. That is, the bulletins set forth normative accounting procedures that "should be" followed by the accounting profession but were not "required" to be followed. It was not until well after the demise of the CAP, in 1964, that the Council of the AICPA adopted recommendations that departures from effective CAP Bulletins should be disclosed in financial statements or in audit reports of members of the AICPA. The demise of the CAP could probably be traced by four distinct factors: (1) the narrow nature of the subjects covered by the bulletins issued by the CAP, (2) the lack of any theoretical groundwork in establishing the procedures presented in the bulletins, (3) the lack of any real authority by the CAP in prescribing adherence the procedures described by the bulletins, and (4) the lack of any formal representation on the CAP of 7

interest groups such as corporate managers, governmental agencies, and security analysts. APB. The objectives of the APB were formulated mainly to correct the deficiencies of the CAP as described above. The APB was thus charged with the responsibility of developing written expression of generally accepted accounting principles through consideration of the research done by other members of the AICPA in preparing Accounting Research Studies. The committee was in turn given substantial authoritative standing in that all opinions of the APB were to constitute substantial authoritative support for generally accepted accounting principles. If an individual member of the AICPA decided that a principle of procedure outside of the official pronouncements of the APB had substantial authoritative support, the member had to disclose the departure from the official APB opinion in the financial statements of the firm in question. The membership of the committee comprising the APB was also extended to include representation from industry, government, and academe. The opinions were also designed to include minority dissents by members of the board. Exposure drafts of the proposed opinions were readily distributed. The demise of the APB occurred primarily because the purposes for which it was created were not being accomplished. Broad generally accepted accounting principles were not being developed. The research studies supposedly being undertaken in support of subsequent opinions to be expressed by the APB were often ignored. The committee in essence became a simple extension of the original CAP in that only very specific problem areas were being addressed. Interest groups outside of the accounting profession questioned the appropriateness and desirability of having the AICPA directly responsible for the establishment of GAAP. Politicization of the establishment of GAAP had become a reality because of the far-reaching effects involved in the questions being resolved. FASB. The formal organization of the FASB represents an attempt to vest the responsibility of establishing GAAP in an organization representing the diverse interest groups affected by the use of GAAP. The FASB is independent of the AICPA. It is independent, in fact, of any private or governmental organization. Individual CPAs, firms of CPAs, accounting educators, and representatives of private industry will now have an opportunity to make known their views to the FASB through their membership on the Board. Independence is facilitated through the funding of the organization and payment of the members of the Board. Full-time members are paid by the organization and the organization itself is funded solely through contributions. Thus, no one interest group has a vested interest in the FASB.

Conclusion. The evolution of the current FASB certainly does represent "increasing politicization of accounting standard setting." Many of the efforts extended by the AICPA can be directly attributed to the desire to satisfy the interests of many groups within our society. The FASB represents, perhaps, just another step in this evolutionary process. b.

Arguments for politicization of the accounting rule-making process: 1.

Accounting depends in large part on public confidence for its success. Consequently, the critical issues are not solely technical, so all those having a bona fide interest in the output of accounting should have some influence on that output.

There are numerous conflicts between the various interest groups. In the face of this, compromise is necessary, particularly since the critical issues in accounting are value judgments, not the type which are solvable, as we have traditionally assumed, using deterministic models. Only in this way (reasonable compromise) will the financial community have confidence in the fairness and objectivity of accounting rule making.

Over the years, accountants have been unable to establish, on the basis of technical accounting elements, rules, which would bring about the desired uniformity and acceptability. This inability itself indicates rule setting is primarily consensual in nature.

The public accounting profession, through bodies such as the Accounting Principles Board, made rules which business enterprises and individuals "had" to follow. For many years, these businesses and individuals had little say as to what the rules would be, in spite of the fact that their economic well-being was influenced to a substantial degree by those rules. It is only natural that they would try to influence or control the factors that determine their economic well-being.

Arguments against the politicization of the accounting rule-making process: 1.

Many accountants feel that accounting is primarily technical in nature. Consequently, they feel that substantive, basic research by objective, independent and fair-minded researchers ultimately will result in the best solutions to critical issues, such as the concepts of income and capital, even if it is accepted that there isn't necessarily a single "right" solution.

Even if it is accepted that there are no "absolute truths" as far as critical issues are concerned, many feel that professional accountants, taking into account the 9

diverse interests of the various groups using accounting information, are in the best position, because of their independence, education, training, and objectivity, to decide what generally accepted accounting principles ought to be. 3.

The complex situations that arise in the business world require that trained accountants develop the appropriate accounting principles.

The use of consensus to develop accounting principles would decrease the professional status of the accountant.

This approach would lead to "lobbying" by various parties to influence the establishment of accounting principles.

Case 1-4 a.

The term "accounting principles" in the auditor's report includes not only accounting principles but also\practices and the methods of applying them. Although the term quite naturally emphasizes the primary or fundamental character of some principles, it includes general rules adopted or professed as guides to action in practice. The term does not however, mean rules from which there can be no deviation. In some cases, the question is which of several partially relevant principles has determining applicability. Neither is the term "accounting principles" necessarily synonymous with accounting theory. Accounting theory is the broad area of inquiry devoted to the definition of objectives to be served by accounting, the development and elaboration of relevant concepts, the promotion of consistency through logic, the elimination of faulty reasoning, and the evaluation of accounting practice.

Generally accepted accounting principles are those principles (whether or not they have only limited usage) that have substantial authoritative support. Whether a given principle has authoritative support is a question of fact and a matter of judgment. Since September 15, 2009 the primary source of GAAP has been the FASB’s accounting standards codification. However, if the guidance for a transaction or event is not specified within a source of authoritative GAAP for that entity, an entity shall first consider accounting principles for similar transactions or events within a source of authoritative GAAP for that entity and then consider nonauthoritative guidance from other sources (FASB ASC 105-10-5-2). The CPA is responsible for collecting the available evidence of authoritative support and judging whether it is sufficient to bring the practice within bounds of generally accepted accounting principle.

The auditor’s report states that a company’s financial statements present “fairly,” in all material respects, its financial position, based on his or her judgment as to whether the accounting principles selected and applied have general acceptance and that the accounting principles selected are appropriate given the circumstances. This statement 10

is necessary because there are many areas where companies make choices among and between accounting principles (Depreciation method, inventory cost flow assumptions, etc.). Therefore, it is expected that financial reports are prepared in a manner that reflects the underlying economic events and activities of the reporting entity. This expectation was stressed in SAS No. 90 which stated, "In each SEC engagement, the auditor should discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the entity's accounting principles applied in its financial reporting. The discussion should also include items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements. “As a consequence, the choices of accounting principles made by one company are often different than those made by another company. Case 1-5 A factor that influenced the development of accounting during the 19th century was the evolution of joint ventures into business corporations in England. The fact that many individuals, external to the business, needed information about the corporation's activities created the necessity for periodic reports. Additionally, the emerging existence of corporations created the need to distinguish between capital and income. The statutory establishment of corporations in England in 1845 stimulated the development of accounting standards, and laws were subsequently passed that were designed to safeguard shareholders against improper actions by corporate officers. Dividends were required to be paid from profits, and accounts were required to be kept and audited by persons other than the directors. However, initially anyone could claim to be an accountant, as there were no organized professions or standards of qualifications. The industrial revolution and the succession of Companies Acts in England also served to increase the need for professional standards and accountants. In the later part of the 19th century, the industrial revolution arrived in the United States, and with it came the need for more formal accounting procedures and standards. This period was also characterized by widespread speculation in the securities markets, watered stocks, and large monopolies that controlled segments of the United States economy. In the 19th century the progressive movement was established in the United States, and in 1898 the Industrial Commission was formed to investigate and report on questions relating to immigration, labor, agriculture, manufacturing, and business. Although no accountants were either on the Commission or used by the Commission, a preliminary report issued in 1900 suggested that an independent public accounting profession should be established in order to curtail observed corporate abuses.

Although most accountants did not necessarily subscribe to the desirability of the progressive reforms, the progressive movement conferred specific social obligations on accountants. As a consequence accountants generally came to accept three general levels of progressiveness: (1) a fundamental faith in democracy, a concern for morality and justice and a broad acceptance of the efficiency of education as a major tool in social amelioration; (2) an increased awareness of the social obligation of all segments of society and introduction of the idea of accountability to the public of business and political leaders; and (3) an acceptance of pragmatism as the most relevant operative philosophy of the day. The major concern of accounting during the early 1900s was the development of a theory that could cope with corporate abuses that were occurring at that time, and capital maintenance emerged as a concept. This concept evolved from maintaining invested capital intact, to the maintenance of the physical productive capacity of the firm, to the maintenance of real capital. In essence this last view of capital maintenance was an extension of the economic concept of income (see Chapter 3) that there could be no increase in wealth unless the stockholder or the firm were better off at the end of the period than at the beginning. During the period 1900-1915 the concept of income determination was not well developed. There was, however, a debate over which financial statement should be viewed as most important, the balance sheet or the income statement. Implicit in this debate was the view that either the balance sheet or the income statement must be viewed as fundamental and the other residual, and that relevant values could not be disclosed in both statements. The 1904 International Congress of Accountants marked the initial development of the organized accounting profession in the United States, although there had been earlier attempts to organize and several states had state societies. At this meeting, the American Association of Public Accountants was formed as the professional organization of accountants in the United States. In 1916, after a decade of bitter interfactional disputes, this group was reorganized into the American Institute of Accountants (AIA). The American Association of the University Instructors in Accounting was also formed in 1916. Initially this group focused on matters of curriculum development, and it was not until much later that it attempted to become involved in the development of accounting theory. World War I changed the public's attitude toward the business sector. Many people believed that the successful completion of the war could be, at least partially, attributed to the ingenuity of American businesses. As a consequence, the public perceived that business had reformed, and external regulation was no longer necessary. The accountant's role changed from a protector of third parties to the protector of business interests. Critics of accounting theory during the 1920s suggested that accountants abdicated the stewardship role, placed too much emphasis on the needs of management, and permitted too much flexibility in financial reporting. During this time financial statements were viewed as 12

the representations of management, and accountants did not have the ability to require businesses to use accounting principles they did not wish to employ.

Case 1-6 a.

Historically, accounting has been considered a highly trustworthy profession. Public accounting firms trained new accountants in the audit function with oversight from senior partners who believed that their firm’s integrity rode on every engagement. That is, new auditors were assigned client responsibility after minimal formal audit training. Most of the training of new accountants took place on-site, and the effectiveness of the new auditor depended on the effectiveness of the instructor. CPA firms have always called their customers “clients” and have worked hard to cultivate them. Partners routinely entertained clients at sporting events, country clubs, and restaurants, and many CPA firm employees later moved on to work in their clients’ firms. Any conflicts in these relationships were, at least partially, offset by the CPA firm’s commitment to professional ethics. These relationships changed as information technology advisory services grew in the late 1970s and early ’80s. Also in the mid-1980s, the AICPA lifted its ban on advertising. As a result, revenue generation became more critical to partners’ compensation. Thereafter, the profit structure of CPA firms changed dramatically and in 1999, revenues for management consulting accounted for more than 50 percent of the then Big Five’s revenue. As a result, the audit function evolved into a loss leader that public accounting firms offered in conjunction with vastly more lucrative consulting engagements. But as pubic accounting firms competed more aggressively on price for audit engagements, they were forced by cost considerations to reduce the number of procedures performed for each client engagement. This resulted in increased test of controls and statistical models, and fewer of the basic, time-consuming tests of transactions that increase the likelihood of detecting fraud. In addition, junior auditors were frequently assigned the crucial oversight roles usually filled by senior partners, who were otherwise engaged in marketing activities to prospective clients. This reduced the effectiveness of the instructor–new accountant training process.

1. Arthur Andersen, formerly one the Big Five audit firms, has gone out of business. 2. In July 2002, President George W. Bush signed into law the Sarbanes-Oxley Bill, which imposes a number of corporate governance rules on publicly traded companies 3. Establishment of PCAOB.

Case 1-7 a.

The structure of the FASB is as follows. A board of trustees nominated by organizations whose members have special knowledge and interest in financial reporting is selected. The organizations originally chosen to select the trustees were the American Accounting Association; the AICPA; the Financial Executives Institute; the National Association of Accountants (The NAA’s name was later changed to Institute of Management Accountants in 1991) and the Financial Analysts Federation. In 1997 the Board of Trustees added four members from public interest organizations. The board that governs the FASB is the Financial Accounting Foundation (FAF). The FAF appoints the Financial Accounting Standards Advisory Council (FASAC), which advises the FASB on major policy issues, the selection of task forces, and the agenda of topics. The number of members on the FASAC varies from year to year. The bylaws call for at least twenty members to be appointed. However, the actual number of members has grown to about thirty in recent years to obtain representation from a wider group of interested parties. The FAF appoints the Financial Accounting Standards Advisory Council, which advises the FASB on major policy issues, the selection of task forces, and the agenda of topics. The FAF is also responsible for appointing the seven members of the FASB and raising the funds to operate the FASB. The FAF currently collects in excess of $23 million a year to support the activities of the FASB.

The members of the Financial Accounting Foundation are come from various accounting, business, financial and government organizations and entities that have been invited to nominate FAF Trustees; however, the final authority for all appointments rests solely with the discretion of the Board of Trustees

FASB ASC 1-1 Variable Interest Entities (VIEs) Special purpose entities are accounted for by using the requirements for variable interest entities (VIEs). The information for this question is found by searching the topic “variable interest entities.” 1. The definition of variable interest entities is contained in FASB ASC 810-10- 2520 2. The guidance of the consolidation of VIEs is contained in 810-10-05-8 to 13. FASB ASC 1-2 Status of ARBs First search the glossary for the three terms Revenue recognition topic 605 14

Treasury stock topic 505-30 Comparative financial statements topic 205 Then Search ARB 43 in cross reference Look for topic 605 (revenue) in the results Treasury Stock Search ARB 43 in cross reference Look for topic 505- 30 (treasury stock) in the results Comparative Financial Statements Search ARB 43 in cross reference Look for topic 205 (comparative financial statements ) in the results

205-10-45 Use print function printer friendly with sources

FASB ASC 1-3 Accounting for the Investment Tax Credit Search investment tax credit Found at 740-10-25- 45 7 46 740-10-47-27 & 28 FASB ASC 1-4 SEC Comments 1. Search revenue recognition Found under customer payment and incentives 605-50-S99-1

Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings 2. Search debt with conversions and other options 15

Found under 470-20 -S99 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings 3. Search software cost of sales and services Found under 985-705-S99 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings FASB ASC 1-5 GAAP Guidelines Search “generally accepted accounting principles.” Found under 105-10 Room for Debate Debate 1-1 Which Body Should Set Accounting Standards in the United States? This question has no one correct answer. It is meant to get students talking about something that they probably haven’t thought about before. Students in favor of the SEC being the rule making body could argue that the FASB has failed to ensure that financial statements fairly present the results of operations. They could then cite the recent scandals. They could argue that the SEC has the power to regulate and they don’t see why the profession should then need to be self-regulated. They could also argue that under the FASB there is too much flexibility and too much reliance on managerial intent, thereby allowing management to manage earnings and otherwise manipulate its financial statements. Moreover, lack of exercise of government direct oversight could result in diminishing the effectiveness of accountants to audit due to a potential erosion of independence. They could point to Sarbanes-Oxley. Students in favor of the FASB making the rules could argue against big government. They could point out that government sets accounting standards in countries that are not capitalistic. The result in those countries is a cookie cutter approach to financial statements and lack of flexibility that leaves no room for professional judgment. Whereas, the standards provided by the FASB are aimed to provide financial statements that fairly present financial statements, taking into consideration the circumstances in which a company operates. They could also argue 16

that accountants, not government officials, best understand their role and how best to measure and report financial information. Debate 1-2 Should the scope of accounting standards be narrowed further? Team 1. This question should prompt the student to investigate how management might benefit from alternative accounting choices. They can go to the web and find out that accounting choices provide managerial incentives that are either income increasing or income decreasing. They may also find instances that management can choose methods of presenting financial information that make the company appear less risky. Income-increasing choices afford management the ability to paint a better picture of company performance. Management may be inclined to select income increasing policies because • They believe the stock market will react favorably and their own personal wealth and position in the firm may be more secure. • Their bonus may be tied to the bottom line. • The company may appear better able to pay suppliers and thus may be in a better position to negotiate favorable terms with suppliers • The company may appear better able to repay debt and thus look good to a lender. • Students can cite real-world examples, e.g., World Com capitalized expenses Income-decreasing choices may be selected by companies that • Are highly regulated, such as utility companies. Poor performance can support the notion that the company deserves a rate increase • If a company is having a bad year, it may choose to load up the income statement with expenses and losses so that it will appear better off in future years. • Have labor unions hope to fare better in negotiations for labor contracts Companies have used off-balance sheet financing to improve the perception of a company’s riskiness. Enron is a prime example. Enron used special purpose entities to hide debt from investors. The student can also argue that accounting choice can be used to provide more relevant financial statements. For example, SFAS 115 provides choices that are intended to result in financials that better disclose the results of management investment choices. Team 2. 17

All of the above can be used as arguments against the proliferation of accounting choices. Narrowing accounting choices has been a goal of accounting professionals for many years. For example, one of the objectives of the APB was to narrow areas of difference in GAAP. Critics maintain that management is allowed too much leeway in the selection of the accounting procedures used in corporate financial reports. These criticisms revolve around two issues (1) Executive compensation is frequently tied to reported earnings, so management is inclined to adopt accounting principles that increase current revenues and decrease current expenses and (2) the value of a firm in the marketplace is determined by its stock price. This value is highly influenced by financial analysts’ quarterly earnings estimates. Managers are fearful that failing to meet these earnings estimates will trigger a sell-off of the company’s stock and a resultant decline in the market value of the firm. The large number of accounting frauds that were evident during recent years provide examples of the ways that management has manipulated financial statement in order to fool the public. Many of these cases might not have occurred if management were not afforded the discretion to choose accounting procedures and practices. In short, accounting choice can result in earnings management, fraudulent financial reporting, a lack of financial statement transparency, financial statements that are not reliable, and financial statements that are biased. WWW Case 1-8 a.

The ultimate authority to issue accounting pronouncements rests with the Securities and Exchange Commission (SEC) which was created by the Securities Act of 1933 and the Securities Exchange Act of 1934, The SEC was created to administer various securities acts. Under powers provided by Congress, the SEC was given the authority to prescribe accounting principles and reporting practices. Nevertheless, because the SEC has generally acted as an overseer and allowed the private sector to develop accounting principles, and this authority has seldom been used. However, the SEC has exerted pressure on the accounting profession and has been especially interested in narrowing areas of difference in accounting practice. In 1936 the AICPA’s Committee on Accounting Procedure (CAP) was formed. This committee had the authority to issue pronouncements on matters of accounting practice and procedure in order to establish generally accepted practices. The works of the CAP were originally published in the form of Accounting Research Bulletins (ARBs); however, these pronouncements did not dictate mandatory practice and received authority only from their general acceptance. The ARBs were consolidated in 1953 into Accounting Terminology Bulletin No. 1, “Review and Resume,” and 18

ARB No. 43. ARBs No. 44 through No. 51 were published from 1953 until 1959. The recommendations of these bulletins that have not been superseded are contained in the FASB Accounting Standards Codification (FASB ASC; discussed below) and referenced throughout this text where the specific topics covered by the ARBs are discussed. By 1959 the methods of formulating accounting principles were being questioned as not arising from research or based on theory. The AICPA responded to the alleged shortcomings of the CAP by forming the Accounting Principles Board (APB). The objectives of this body were to advance the written expression of generally accepted accounting principles (GAAP), to narrow areas of difference in appropriate practice, to narrow areas of difference in appropriate practice and to discuss unsettled controversial issues. The pronouncements of this body were termed “APB Opinions.” In 1974 the APB was replaced with the Financial Accounting Standards Board. The pronouncements of this organization were originally terms Statements of Financial Accounting Standards. Subsequently, after the publication of the Accounting Standards Codification, they have been termed Accounting Standards Updates. b.

This term, initially proposed by Carman Blough, the first chief accountant of the SEC, is meant to mean authority of 'substantial weight' or importance, and not necessarily a majority view. Thus there might be three authoritative positions all of which are appropriate at a point in time before some standard is established. The majority may have gone in one direction, but the minority who were also considered 'authoritative' and could be used.

The SEC and the AICPA have been the sources of authority for compliance with accounting standards. The SEC has indicated that financial statements conforming to standards set by the FASB will be presumed to have authoritative support. The AICPA, in Rule 203 of the Code of Professional Ethics, requires that members prepare financial statements in accordance with GAAP. Failure to follow Rule 203 can lead to the loss of a CPA’s license to practice.

Case 1-9 a.

This controversy was over the proper method to use in accounting for the investment tax credit. In the early 1960s the country was suffering from the effects of a recession. After President John F. Kennedy took office, his advisors suggested an innovative fiscal economic policy that involved a direct income tax credit (as opposed to a tax deduction) based on a percentage of the cost of a qualified investment. Congress passed legislation creating the investment tax credit in 1961. The APB was then faced with deciding how companies should record and report the effects of the investment tax credit. It considered two alternative approaches: 19

1. The flow-through method, which treated the tax credit as a decrease in income tax expense in the year it occurred. 2. The deferred method, which treated the tax credit as a reduction in the cost of the asset and therefore was reflected over the life of the asset through reduced depreciation charges. The APB decided that the tax credit should be accounted for by the deferred method and issued APB Opinion No. 2. This pronouncement stated that the tax reduction amounted to a cost reduction, the effects of which should be amortized over the useful life of the asset acquired. The reaction to this decision was quite negative on several fronts. Members of the Kennedy administration considered the flow-through method more consistent with the goals of the legislation, and three of the then–Big Eight accounting firms advised their clients not to follow the recommendations of APB Opinion No. 2. In 1963, the SEC issued Accounting Series Release No. 96, allowing firms to use either the flow-through or deferred method in their SEC filings. The fact that the SEC had the authority to issue accounting pronouncements, and the lack of general acceptance of APB Opinion No. 2, resulted in the APB’s partially retreating from its previous position. Though reaffirming the previous decision as being the proper and most appropriate treatment, APB Opinion No. 4 approved the use of either of the two methods. b.

The lack of support for some of the APB’s pronouncements and concern over the formulation and acceptance of U. S. GAAP caused the Council of the AICPA to adopt Rule 203 of the Code of Professional Ethics. This rule requires departures from accounting principles published in APB Opinions or Accounting Research Bulletins (or subsequently FASB Statements and now the FASB ASC) to be disclosed in footnotes to financial statements or in independent auditors’ reports when the effects of such departures are material. This action has had the effect of requiring companies and public accountants who deviate from authoritative pronouncements to justify such departures.

Case 1-10 Originally, the FASB issued two types of pronouncements, Statements of Financial Accounting Standards (SFASs) and Interpretations. Subsequently, the FASB established two new series of releases: Statements of Financial Accounting Concepts (SFACs) and Technical Bulletins. The SFASs constitute the FASBs conceptual Framework (discussed in Chapter 2). SFASs convey required accounting methods and procedures for specific accounting issues and officially created U. S. GAAP. 20

Interpretations were modifications or extensions of issues pronouncements. SFACs constitute the FASBs conceptual framework (discussed in Chapter 2 and are intended to establish the objectives and concepts that the FASB will use in developing standards of financial accounting and reporting. To date, the FASB has issued eight SFACs, which are discussed in depth in Chapters 2, 6, 7, 14 and 17. SFACs differ from SFASs in that they do not establish U. S. GAAP. Similarly, they are not intended to invoke Rule 203 of the Rules of Conduct of the Code of Professional Ethics. It is anticipated that the major beneficiary of these SFACs will be the FASB itself. However, knowledge of the objectives and concepts the Board uses should enable users of financial statements to better understand the content and limitations of financial accounting information. Technical Bulletins were strictly interpretive in nature and did not establish new standards or amend existing standards. They were intended to provide guidance on financial accounting and reporting problems on a timely basis. Case 1-11 a.

The FASB had three primary goals in developing the codification: 1. Simplify user access by codifying all authoritative U.S. U. S. GAAPs in one spot. 2. Ensure that the codified content accurately represented authoritative U.S. U. S. GAAPs as of July 1, 2009. 3. Create a codification research system that is up to date for the released results of standard-setting activity.

The FASB ASC was expected to impact accounting practice by: 1. Reduce the amount of time and effort required to solve an accounting research issue 2. Mitigate the risk of noncompliance through improved usability of the literature 3. Provide accurate information with real-time updates as Accounting Standards Updates are released 4. Assist the FASB with the research and convergence efforts

The FASB no longer issues Statements of Financial Accounting Standards. Changes to authoritative U.S. GAAP, the FASB ASC, are publicized through an Accounting Standards Update (ASU). Each ASU 1. Summarizes the key provisions of the project that led to the ASU 2. Details the specific amendments to the FASB Codification 3. Explains the basis for the Board’s decisions

Case 1-12

Those who contend that there is a standards overload problem base their arguments on two allegations: Not all U. S. GAAP requirements are relevant to small business financial reporting needs, and even when U. S. GAAP requirements are relevant, they often violate the pervasive cost–-benefit constraint. Critics of the standard-setting process for small businesses also assert that U. S. GAAP were developed primarily to serve the needs of the securities market. Many small businesses do not raise capital in these markets; therefore, it is contended that U. S. GAAP were not developed with small business needs in mind. The standards overload problem has several consequences for small business: 1. If a small business omits a U. S. GAAP requirement from audited financial statements, a qualified or adverse opinion may be rendered. 2. The cost of complying with U. S. GAAP requirements can cause a small business to forgo the development of other, more relevant information. 3. Small CPA firms that audit smaller companies must keep up to date on all the same requirements as large international firms, but they cannot afford the specialists who are available on a centralized basis in the large firms. Many accountants have argued for differential disclosure standards as a solution to the standards overload problem. That is, standards might be divided into two groups. One group would apply to businesses regardless of size. The second group would apply only to large businesses, small businesses, or particular industries. For example, the disclosure of significant accounting policies would pertain to all businesses, whereas a differential disclosure such as earnings per share would apply only to large businesses. The FASB and various other organizations have studied but have not reached a consensus. A special committee of the AICPA favored differential reporting standards. The FASB had historically taken the position that financial statement users might be confused when two different methods are used to describe or disclose the same economic event, but in 2009 the International Accounting Standards Board (IASB) issued a pronouncement that omits or simplifies the applicability of its standards and disclosure requirements for small and mediumsized companies (see Chapter 3). The attempt to harmonize U.S. and international U. S. GAAP can result in the adoption of a similar FASB standard; however, bankers (a major source of capital for small businesses) and financial analysts have fairly consistently criticized differential reporting requirements as a solution to the standards overload problem. Case 1-13 a.

The term economic consequences refers to the impact of accounting reports on various segments of our economic society. This concept holds that the accounting practices a company adopts affect its security price and value. Consequently, the choice of 22

accounting methods influences decision making rather than just reflecting the results of these decisions. One example of the economic consequences of an accounting standard was the release of the FASB’s pronouncement on other postretirement benefits (OPRBs), FASB Statement No. 106, “Other Post Retirement Benefits”. The accounting guidelines for OPRBs required companies to change from a pay-as-you-go basis to an accrual basis for health care and other benefits that companies provide to retirees and their dependents. The accrual basis requires companies to measure the obligation to provide future services and accrue these costs during the years employees provide service. This change in accounting caused a large increase in recorded expenses for many companies. Consequently, a number of companies simply ceased providing such benefits to their employees, at a large social cost. There are many more examples.

Case 1-14 The answer to this case requires a visit to the Microsoft Corporation’s homepage at the time it is assigned. Financial Analysis Case The solutions to the financial analysis case depend upon the company and year selected.

CHAPTER 2 Case 2-1 a.

The FASB's conceptual framework study should provide benefits to the accounting community such as: 1. Guiding the FASB in establishing accounting standards on a consistent basis. 2. Determining bounds for judgment in preparing financial statements by prescribing the nature, functions, and limits of financial accounting and reporting. 3. Increasing users understanding of and confidence in financial reporting.

The two fundamental qualities that make accounting information useful for decision making are relevance and faithful representation. Relevant financial information is capable of making a difference in the decisions made by users. Financial information is capable of making a difference in decisions if it has predictive value and confirmatory value and is material. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information has confirmatory value if it provides feedback (confirms or changes) about previous evaluations. Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the FASB was not able to specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena but also must faithfully represent the phenomena that it purports to represent. A perfectly faithful representation has three characteristics: completeness, neutrality, and free from error. Although perfection is difficult or even impossible to achieve, the objective is to maximize those qualities to the extent possible. A complete depiction should include all information necessary for a user to understand the phenomenon being depicted. For some items, a complete depiction also might entail explanations of significant facts about the quality and nature of the items, factors, and circumstances that might affect their quality and nature and the 24

process used to determine the numerical depiction. A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. Neutral information does not mean information with no purpose or no influence on behavior. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. Information that is free from error will result in a more faithful representation of financial results. Comparability, verifiability, timeliness, and understandability are the qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal. Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities also can be verified. Timeliness means having information available to decision makers in time to be capable of influencing their decisions. Generally, the older the information is, the less useful it is. However, some information can continue to be timely long after the end of a reporting period because, for example, some users might need to identify and assess trends. Understandability involves classifying, characterizing, and presenting information clearly and concisely. Case 2-2. a.

The Conceptual Framework Project is an attempt by the FASB to develop concepts useful in guiding the board in establishing standards and in providing a frame of reference for resolving accounting issues. Over the years this project first attempted to develop principles or broad qualitative standards to permit the making of systematic rational choices among alternative methods of financial reporting. Subsequently the project focused on how well these overall objectives could be achieved. The FASB has stated that it intends the Conceptual Framework Project 25

to be viewed not as a package of solutions to problems but rather as a common basis for identifying and discussing issues, for asking relevant questions, and for suggesting avenues for research. The Conceptual Framework Project has resulted in the issuance of eight statements of Financial Accounting Concepts that impact upon financial accounting: No.1-Objectives of Financial Reporting by Business Enterprises (superseded); No.2-Qualitative Characteristics of Accounting Information (Superseded); No.3-Elements of Financial Statements of Business Enterprises (Superseded); No.5-Recognition and Measurement in Financial Statements of Business Enterprises; No.6-Elements of Financial Statements;” No. 7-“Using Cash Flow Information and Present Value in Accounting Measurements” and No. 8 “Conceptual Framework for Financial Reporting (Chapters 1 & 3). ii. The FASB has been criticized for failing to provide timely guidance on emerging implementation and practice problems. During 1984 the FASB attempted to respond to this criticism by (1) establishing a task force to assist in identifying issues and problems that might require action, the Emerging Issues Task Force, and (2) expanding the scope of the FASB Technical Bulletins in an effort to offer quicker guidance on a wider variety of issues. Emerging issues arise because of new types of transactions, variations in accounting for existing types of transactions, new types of securities, and new products and services. They frequently involve the company's desire to achieve "off balance sheet" financing or "off income statement" accounting. The Emerging Issues Task Force was formed to assist the FASB in issuing timely guidance on these emerging issues. That is, the task force's responsibility is to identify emerging issues as they develop, investigate and review them, and finally to advise the board whether the issue merits its attention. The members of the task force all occupy positions that make them aware of emerging issues. The current members include the directors of accounting and auditing from 11 public accounting firms (including all of the "Big Four"), two representatives from the Financial Executives Institute, one from the National Association of Accountants and the Business Roundtable, and the FASB's Director of Research who serves as Chairman. b.

The Financial Accounting Standards Board, the Securities and Exchange Commission, and the American Institute of Certified Public Accountants have been criticized for imposing too many accounting standards on the business community. The Standards overload problem has been particularly burdensome on small businesses that do not have the necessary economic resources to research and apply all of the pronouncements issued by these sources. Those who contend that there is a standards overload problem base their arguments on two allegations. 26

Not all GAAP requirements arc relevant to small business financial reporting needs.

2. Even when they are relevant, they frequently violate the pervasive cost benefit constraint. Critics of the standard-setting process for small business also assert that GAAP were developed primary to serve the needs of the securities market. Many small businesses do not raise capital in these markets therefore, it is contended that GAAP were not developed with small business needs in mind. Some of the consequences of the standards overload problem to small business are as follows. 1. If a small business omits a GAAP requirement from audited financial statements, a qualified or adverse opinion may be rendered. 2. The cost of complying with GAAP requirements may cause a small business to forgo the development of other, more relevant information. 3. Small CPA firms that audit smaller companies must keep up to date on all of the same requirements as large international firms, but cannot afford the specialists that are available on a centralized basis in the large firms. Many accountants have argued for differential disclosure standards as a solution to the standards overload problem. That is, standards might be divided into two groups. One group would apply to business regardless of size. The second group would be applied selectively only to large businesses, small businesses, or particular industries. For example, the disclosure of significant accounting policies would pertain to all businesses, whereas a differential disclosure such as earnings per share would be applicable only to large businesses. Case 2-3 a.

Quantitative data are helpful in making rational economic decisions. Stated differently, quantitative data aid the decision maker in making choices among alternatives, so that the actions are correctly related to consequences. i.

ASOBAT defined accounting as “the process of identifying, measuring, and communicating economic information to permit informed judgments and decision by users of the information.” Both this definition and Sprouse and Moonitz believe that communicating information is helpful for users to make rational decisions and informed judgments. 27

ii.

Similarly, SFAC No. 8 states that accounting information should be useful for investment decision-making. The user should be able to use accounting information to make decisions about investing in a company.

Case 2-4 a.

In describing continuity, Sprouse and Moonitz stated that in the absence of evidence to the contrary, the entity should be viewed as remaining in operation indefinitely. In the presence of evidence that the entity has a limited life, it should not be viewed as remaining in operation indefinitely.

No. Since a business is presumed to continue indefinitely, the value relevant to a purchaser is fair market value. This value measures the present value of future cash flows to the buyer. It is relevant for the buyer because the buyer presumes that the business will continue and thus will generate those future cash flows.

No. A bankruptcy provides evidence that the business is not expected to remain in operation indefinitely. In this case, the assets that are reported in the company’s balance sheet should be measured at net realizable value.

Case 2-5 a.

SFAC No. 6 defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” If your company is using a building to produce automobiles, the probable future economic benefit is the expected inflow of resources from the sales of automobiles. This benefit accrues to the company who may then use them, if it wishes, to make more automobiles. The prior transaction that caused the asset to exist is the acquisition of the building.

In this case, the probable future economic benefit is the net realizable value that the company will receive when it sells the building. Again, the acquisition of the building is the result of a prior transaction or event.

In this case, the probable future economic benefit is the inflow of resources that will eventually flow into the company when it produces the automobiles. The transaction that caused the asset to exist was the acquisition of the building.

Case 2-6 In general, SFAC No. 5 attempts to set forth recognition criteria and guidance on what information should be incorporated into financial statements, and when this information should be reported. According to this Statement, a full set of financial statements for a period shows: 28

1. 2. 3. 4. 5.

Financial position at the end of the period. Earnings for the period. Comprehensive income for the period. Cash flows during the period. Investments by and distributions to owners during the period.

The statement of financial position should provide information about an entity's assets, liabilities, and equity and their relationship to each other at a moment in time. It should also delineate the entity's resource structure major classes and amounts of assets and its financing structure-major classes and amounts of liabilities and equity. The statement of financial position is not intended to show the value of a business, but it should provide information to users wishing to make their own estimates of the enterprise's value. The pronouncement then indicates that the building blocks to full disclosure are: 1. The scope of recognition and measurement 2. Basic financial statements 3. Areas directly affected by existing FASB standards 4. Financial reporting 5. All information useful for investment, credit, and similar decisions Earnings is defined a measure of entity performance during a period. It measures the extent to which asset inflows (revenues and gains) exceed asset outflows. The concept of earning provided in SFAC No. 5 is similar to net income for a period in the then current practice. However, it excluded certain adjustments from earlier periods that are now recognized in the current period. It was expected that the concept of earnings would continue to be subject to the process of gradual change that has characterized its development. In SFAC No. 5, the FASB attempted to broaden the scope of the measurements of the operating results of business enterprises by introducing the definition of comprehensive income as follows: Comprehensive income is the change in equity (net assets) of an entity during a period from transactions and events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. The relationship between earnings and comprehensive income was illustrated: Revenues Less: Expenses Plus: Gains Less: Losses = Earnings

Earnings Plus or minus cumulative accounting adjustments Plus or minus other nonowner changes in equity = Comprehensive income 29

SFAC No. 5 then proceeded to the discussion measurement and recognition. It defined measurement as the process of identifying the proper attribute of an event or transaction and of choosing the proper measurement scale. SFAC No 5 defined recognition as the process of formally recording an item into the financial statements of an entity as an element and indicated that an item and information about it should meet four recognition criteria and be recognized at the time these criteria are met (subject to the cost–benefit and materiality constraints). 1. Definitions. The item meets the definition of an element contained in SFAC No. 6 (Previously SFAC No. 3 at the time SFAC No. 5 was published). 2. Measurability. It has a relevant attribute, measurable with sufficient reliability. 3. Relevance. The information about the item is capable of making a difference in user decisions. 4. Faithful representation. Financial reports represent economic phenomena in words and numbers Case 2-7 a.

Employees meet the definition of an asset. An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others' access to it, and (c) the transaction or other event giving rise to the entity's right to or control of the benefit has already occurred. Employees embody a probable future benefit that will contribute to future net cash flows. They will work so that the company can have revenues. The company will benefit because they control what the employees do on the job. Employment of the employees gave rise to the entity’s right to control the benefit.

No. According to SFAC No. 5, to report an asset in the balance sheet, it not only must meet the definition of an asset, but it must be capable of being measured.

c. i.

The value would be more relevant because it would measure the expected future cash flows that the employees would be expected to generate. It would be less reliable because there is no precise method to measure the value of human capital. It can only be estimated. Therefore, two measurements made by two different measurers are unlikely to be the same.

ii. Yes. Representational faithfulness means that the items in the balance reflect what they purport to be. If human capital is an asset, then reporting its estimated value would reflect the value of that asset and would as a result provide representational faithfulness. Case 2-8 30

According to SFAC No. 7 the bonds are distinguished by the uncertainty of their future cash flows. The bonds would sell at the present value of their future cash flows, discounted at the market rate of interest. The company with the better credit rating would yield a lower market rate, assuming that the stated rates for both companies are the same. So, if the stated rates are the same, Company A’s bond might be more valuable it its credit rating were better than Company B’s.

If both companies have the same credit rating, then the one reason that Company A’s bond would have a higher market value than would Company B’s bond would be that Company A’s bond has a shorter term than Company B’s bond. If they both have the same term, then Company A’s bond would sell for more than Company B’s bond if Company A were offering a higher stated interest rate.

FASB ASC FASB ASC 2-1 Use of Present Value The information on present value is contained in the FASB ASC at FASB ASC 82010-55. It can be accessed through the glossary. FASB ASC 2-2 Conceptual Framework Search conceptual framework Found under 605 Revenue Recognition 10 Overall S99 SEC Materials FASB ASC 2-3 Decision-Maker Concept Search decision maker 10 hits FASB ASC 2-4 Understandability Concept Search understandability Found under 715 compensation—Retirement Benefits > 10 Overall > 10 Objectives

FASB ASC 2-5 Relevance Concept 31

Search relevance – 15 hits FASB ASC 2-6 Recognition and Measurement Guidance Search recognition and measurement-over 70 hits FASB ASC 2-7 Reporting Comprehensive Income is contained in sections FASB ASC 220-10. It is found by searching comprehensive income. FASB ASC 2-8 Using Present Value Search present value-over 100 hits

Room for Debate Debate 2-1 A Question of Materiality Team 1: Arguments for capitalization of boxes. 1.

Objectives of financial reporting Decision usefulness requires that companies report the status of enterprise resources. The boxes provide future service potential. As such, they meet the definition of an asset found in SFAC No. 6. Hence, they are a resource that should be reported.

Definition of assets SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. The boxes are assets. They will provide future economic benefits for a particular entity (Roper Co). The company will use them for at least 10 years. They result from past transaction - a purchase.

Qualitative Characteristics Relevance Capitalization is relevant because it provides information about outcomes of past transactions or events. The user is informed that the boxes are assets. They were 32

purchased by the company, and the company intends to use them over an extended period of time. Hence their cost is not a current period expense. Faithfull Representation Capitalization provides reliability. Because the boxes will be used over an extended period of time, they meet the definition of an asset found in SFAC No. 6. Hence, capitalization presents the economic facts and provides information that is representationally faithful. If they are assets, they should be reported as such, rather than expensed, a representation that would not report them as they purport to be. Also, capitalization of the cost would be neutral because it would provide an unbiased representation of the economic substance of the purchase transaction. Team 2 Arguments against the capitalization of the boxes. 1.

Materiality

Materiality was defined in SFAC No 2 as the threshold for recognition. When the dollar amount is small, the particular accounting treatment will not affect the decisions of an informed user. In this case, the cost of boxes is clearly immaterial, implying that they need not be capitalized as assets. 2.

Cost Constraint

The benefits derived from capitalization should exceed the cost of capitalization. Since the cost of the boxes is not material, capitalization would not provide sufficient benefit, in terms of decision usefulness, to warrant this accounting treatment. Capitalization would require depreciation over the useful life of the boxes. This would require adjusting entries for a ten-year period. The amount of depreciation reported each period would be trivial and would have essentially no effect on earnings. Hence, the cost of the bookkeeping effort would be greater than the benefits, if any, derived. 3.

Objectives of financial reporting

The primary objective of financial reporting is decision usefulness. Accounting information should provide information that is useful to investors, creditors and other users in making decisions regarding investing, lending, etc. This implies that accounting information is relevant to the decision-maker. Even though the boxes will last 10 years, the cost is immaterial and hence irrelevant. 4.

Qualitative Characteristics of accounting information Relevance

As stated above, relevance means that the information provided will make a difference in the decisions of investors, creditors and other users. The expenditure is immaterial and as such, the accounting treatment is irrelevant, and capitalization is irrelevant. Debate 2-2 The Need for A Universally Accepted Theory of Accounting Team 1: A universally accepted theory of accounting is needed for the development of internally consistent accounting principles. Accounting practices have developed in response to changing economic conditions and, in some cases, in response to what are perceived as crises. For example, SFAS No. 114, was prompted to inconsistent practices of reporting impaired loans, and SFAS No. 94 was prompted by off-balance sheet recognition of lease liabilities. This piece-meal, reactionary approach to accounting has resulted in standards that are not only internally inconsistent, but are also inconsistent with international standards. A theory of accounting would provide a common basis for identifying and discussing issues. This is the goal of the FASB’s conceptual framework project. Such a theory could be used to help narrow the number of accounting choices currently available to management, thereby reducing management’s ability to manipulate financial statements to suit their personal, or company goals. As such, it could help guide the development of neutral standards, which aids in the allocation of scarce resources and the efficient functioning of capital markets In addition to helping reduce managerial bias in reporting results of operations and financial position, a universally accepted theory of accounting could serve to reduce personal biases in the standard setting process itself. Reliance on such a theory could result in the development of those standards that are consistent with the theory itself. A universal theory of accounting would be consistent with the concepts-based approach to accounting standards described by the American Accounting Association. A universally accepted accounting theory could provide a basis for standard setting that would satisfy the following. 1. Economic substance, not the form, of a given transaction should guide its financial reporting. 2. The mapping between economic substance of a transaction and its financial statement representation could be supported by a common theoretical basis, thereby providing understandability and a common basis of comparison across companies and over time. Team 2: 34

To date, no standard setting body has developed a universally accepted theory of accounting. An argument against a universal theory of accounting can be based on the complexity of the phenomena that financial statements purport to represent. According to SATTA, while there has been general agreement that the purpose of financial accounting is to provide economic data about accounting entities, divergent theories have emerged because of the way different theorists specified users of accounting data and the environment. For example, users might be defined either as the owners of the accounting entity or more broadly to include creditors, employees, regulatory agencies, and the general public. Similarly, the environment might be specified as a single source of information or as one of several sources of financial information. SATTA discussed why none of the approaches to theory had gained general acceptance, SATTA raised six issues. 1. The problem with relating theory to practice. The real world is much more complex than the world specified in most accounting theories. For example, most theory descriptions begin with unrealistic assumptions such as holding several variables constant. 2. Allocation problem. Allocation is an arbitrary process. For example, the definition of depreciation as a rational and systematic method of allocation has led to a variety of interpretations of these terms. 3. The difficulty with normative standards. Normative standards are desired states; however, different users of accounting information have different desired states. As a result, no set of standards can satisfy all users. 4. The difficulties in interpreting security price behavior research. Market studies (such as the efficient market studies discussed in Chapter 4) attempt to determine how users employ accounting numbers. These studies have attempted to control for all variables except the one of interest, but there have been disagreements over whether their research designs have actually accomplished this goal. 5. The problem cost-benefit considerations accounting theories. A basic assumption of accounting is that the benefits derived from adopting a particular accounting alternative exceed its costs. However, most existing theories do no indicate how to measure benefits and costs. 6. Limitations of data expansion. At the time SATTA was published, a view was emerging that more information is preferable than less. Subsequent research has indicated that users have a limited ability to process accounting information. (The issue of information processing is discussed in Chapter 4.)

The FASB’s conceptual framework project (CPF) cannot be viewed as a universally accepted theory of accounting, nor does the FASB purport that it is. The FASB intends the CFP to be viewed not as a package of solutions to problems but rather as a common basis for identifying and discussing issues. For example, SFAC No. 8 can be described as the goal to guide practice. It does not even directly affect practice. Rather, the SFACs affect practice only by means of their influence on the development of new accounting standards. So, rather than a universally accepted theory of accounting, we have settled for the CFP, which does not provide all the answers, but has been relied upon to aid the standard-setting process. And, it has provided a basis to narrow alternatives and to eliminate those that are inconsistent with it. It also is used to guide the development of neutral standards, which aids in the allocation of scarce resources and the efficient function of capital markets In other words, we can operate with concept-based accounting standards by relying upon the CFP rather than a universally accepted theory of accounting. The CFP has been criticized and will evolve to address criticism from the SEC that the objectives of the standards that are derived from it need to be more clearly defined, implementation guidance needs to be improved, scope exceptions need to be reduced and the asset-liability approach to standard setting should be retained WWW Case 2-9 a. An example of the way Veblen influenced Scott is contained in Lawrence and Stewart: “Veblen believed men acquired habits of thought unconsciously and the thoughts men get are shaped by their daily activities. Any change in daily activities, such as that occasioned by the Industrial Revolution, would be expected to lead to a major shift in previous habits of thought. Scott saw the scientific method as the new habit of thought coming to dominance.” b. Scott’s hierarchy of postulates and principles were: Orientation Postulate. Accounting is based on a broad consideration of the current social, political, and economic environment. The Pervasive Principle of Justice. The second level in Scott’s conceptual framework was justice, which was seen as developing accounting rules that offer equitable treatment to all users of financial statements. The Principles of Truth and Fairness. Scott’s third level contained the principles of truth and fairness. Truth was seen as an accurate portrayal of the information presented. Fairness was viewed as containing the attributes of objectivity, freedom from bias, and 36

impartiality. The Principles of Adaptability and Consistency. The fourth level of the hierarchy contained two subordinate principles, adaptability and consistency. Adaptability was viewed as necessary because society and economic conditions change; consequently, accounting must also change. However, Scott indicated a need to balance adaptability with consistency by stating that accounting rules should not be changed to serve the temporary purposes of management. Case 2-10 a. The project 1. Focused on changes in the environment since the original frameworks were issued, as well as omissions in the original frameworks, in order to efficiently and effectively improve, complete, and converge the existing frameworks. 2. Gave priority to addressing and deliberating those issues within each phase that were likely to yield benefits to the Boards in the short term—that is, cross‐cutting issues that affect a number of their projects for new or revised standards. Consequently, work on several phases of the project was to be conducted simultaneously, and the Boards expected to benefit from work being conducted on other projects. 3. Initially considered concepts applicable to private‐sector business entities. Later, the Boards were to jointly consider the applicability of those concepts to private‐sector not‐for‐profit organizations. b. The eight phases of the CFP, are: A. Objectives and qualitative characteristics B. Definitions of elements, recognition, and derecognition C. Measurement D. Reporting entity concept E. Boundaries of financial reporting, and presentation and disclosure F. Purpose and status of the framework G. Application of the framework to not‐for‐profit entities Case 2-11 Qualitative Characteristics The qualitative characteristics are described in Chapter 3 of SFAC No. 8 and distinguish between better (more useful) information and inferior (less useful) information. These qualitative characteristics are either fundamental or enhancing characteristics, depending on how they affect the decision usefulness of information. The two fundamental qualities that

make accounting information useful for decision making are relevance and faithful representation. Case 2-12 37

The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-13 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-14 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-15 During the early 2000s, the FASB noted that concerns were being expressed about the quality and transparency of accounting information. One of the main concerns was the increasing complexity of FASB standards. The Board concluded that much of the detail and complexity associated with accounting standards was the result of rule-driven implementation guidance, which allows “accounting engineering” to get around the rules thereby allowing companies to circumvent the intent and spirit of the standards. Additionally, the FASB noted that its Conceptual Framework has not provided all of the necessary tools for resolving accounting problems. This deficiency was attributed to the fact the certain aspects of the Conceptual Framework are internally inconsistent and incomplete. As a result, the Board is considering the need to develop an overall reporting framework similar to International Accounting Standard No. 1. Such a framework would provide guidance on issues such as materiality assessments, going concern assessments, professional judgment, consistency and comparability. It would also allow few, if any, exceptions and fewer implementation guidelines. To illustrate the difference between rules based and principles based standards, the standard setting process can be viewed as a continuum ranging from highly rigid standards on one end to general definitions of economics-based concepts on the other end. For example, consider accounting for the intangible asset goodwill. An example of the extremely rigid end of the continuum is the previously acceptable practice: Goodwill is to be amortized over a 40-year life until it is fully amortized. This requirement leaves no room for judgment or disagreement about the amount of amortization expense to be recognized. Comparability and consistency across firms and through time is virtually assured under such a rule. However, the requirement lacks relevance because it does not reflect the underlying economics of the reporting entity, which differ across firms and through time. At the opposite end of the continuum is the FASB’s new rule: 38

Goodwill is not amortized. Any recorded goodwill is to be tested for impairment and if impaired, written down to its current fair value on an annual basis. This requirement necessitates the application of judgment and expertise by both managers and auditors. The goal is to record the economic deterioration of the asset, goodwill Case 2-16 At a joint meeting in Norwalk, Connecticut, on September 18, 2002, the FASB and the IASB both acknowledged their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting (the Norwalk Agreement). The two boards pledged to use their best efforts to (1) make their existing financial reporting standards fully compatible as soon as is practicable and (2) coordinate their future work programs to ensure that once it is achieved, compatibility is maintained. The international convergence project has three major aspects: (1) the Financial Statement Presentation Project, (2) the Conceptual Framework Project, and (3) the Standards Update Project. Case 2-17 a.

FASB’s Conceptual Framework should provide benefits to the accounting community such as: 1. Guiding the FASB in establishing accounting standards on a consistent basis. 2. Determining bounds for judgment in preparing financial statements by prescribing the nature, functions and limits of financial accounting and reporting. 3. Increasing users’ understanding of and confidence in financial reporting.

The most important quality for accounting information as usefulness for decision making. Relevance and faithful representation are the primary qualities leading to this decision usefulness. Usefulness is the most important quality because, without usefulness, there would be no benefits from information to set against its costs.

There are several key characteristics or qualities that make accounting information desirable. The importance of three of these characteristics or qualities is discussed below. Understandability—information provided by financial reporting should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it, or who misuse it.

Relevance—the accounting information is capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations (including is material). Faithful representation—the faithful representation of a measure rests on whether the numbers and descriptions matched what really existed or happened, including completeness, neutrality, and free from error. (Note to instructor: Other qualities might be discussed by the student, such as enhancing qualities. All these qualities are defined in the textbook). Financial Analysis Case The solutions to the financial analysis depend upon the company and year selected.

CHAPTER 3 Case 3-1 The greatest advantage attributed by advocates of the harmonization of accounting standards is that international financial information would be comparable. Consequently, the concerns about the reliability of foreign financial statements would be alleviated; and the free flow of international investments would be enhanced. Harmonization is also seen as resulting in improved risk analysis which would result in the lowering of interest rates. Another advantage is that the time and money now spent to consolidate divergent financial information would be saved. Presently, many adjustments, often arbitrary and sometimes base on faulty assumptions are needed. A third advantage would be the tendency for accounting standards to be raised to the highest level to be consistent with local economic, legal and social conditions. This is seen as overcoming the presently deficient accounting information presently supplied by developing economies. Critics of harmonization hold that it is neither practical nor perhaps even valuable. They point to the spotty record of domestic standard setters in the United States where they are well-funded and widely supported. They also argue that a well-developed global capital market already exists and has evolved without uniform accounting standards; consequently, there is no compelling need to harmonize standards. Other critics indicate that widespread cultural differences, especially language, make harmonization an almost impossible goal. Finally, some individuals feel that the issue of legal enforcement of standards may be an insurmountable problem Case 3-2 a.

A company may take different approaches in preparing financial statements for users in foreign companies. These are as follows: 1. Send the same set of financial statements to all users (domestic or foreign). This is, in essence, a do-nothing approach, and puts the entire burden of understanding the financial reports on the user. On the other hand, if a company raises very little capital outside its home country, the added expense of taking another approach may not be worthwhile. Also, some companies using foreign investment may sell directly to sophisticated users who are able to use the unadjusted financial statements such as pension funds. 41

Translate the financial statements sent to foreign users into the language of the foreign nation's users. This is termed convenience translation and is a relatively inexpensive method of accommodation of foreign users. The user is saved the inconvenience of dealing with a foreign language, but still must understand another country's accounting practices and monetary unit. This is a low-cost alternative to the do-nothing approach.

Translate the financial statements sent to foreign users into the foreign nation's language and currency. This is termed preparing convenience statements. Although this process makes the statements easy for foreign users to read, it may mislead them into believing that the statements were prepared using the foreign country's accounting principles.

Prepare two sets of financial statements, one using the home country language, currency and accounting principles, the second using the language, currency and accounting principles of the foreign country’s users. This is a large step in the direction of accommodating foreign users and should only be considered when the perceived benefits exceed the costs.

Prepare one set of financial statements based on worldwide accepted accounting principles. This is a utopian approach. At the present time there are no worldwide accepted accounting standards. This approach can only be taken if international accounting standards are harmonized.

No correct answer. Asks for an opinion.

Case 3-3 a. The IASB was formed to develop worldwide accounting standards. In 2001 it was replaced by the International Accounting Standards Board. Its purpose was to develop worldwide accounting standards. b. The IASC attempts to achieve its objectives through the formulation and publication of accounting standards to be observed in the presentation of financial statements. The IASC also attempts to use its membership in achieving its objectives. It attempts to promote the worldwide acceptance and observance of the accounting standards that it publishes. The members of the IASC agree to support the standards and to use their best endeavors to ensure that published financial statements comply with the standards, to ensure that auditors enforce the standards, and to persuade governments, stock exchanges and other bodies to support the standards. However, the IASC has no enforcement authority and must rely on the "best endeavors" of its members. 42

Case 3-4 a.

The IASB has noted that its standards may be used 1. As national requirements 2. As the basis for some or all national requirements 3. As an international benchmark for countries that develop their own requirements 4. By regulatory authorities for domestic and foreign companies 5. By companies themselves

The IASB has no enforcement authority and must rely on the best endeavors of its members

The globalization of business and finance has led more than 12,000 companies in approximately 166 jurisdictions to adopt IFRS.

Case 3-5 a.

In 1989, the IASC issued its initial conceptual framework titled “Framework for the Preparation and Presentation of Financial Statements.” In 2010, the IASB and FASB issued a joint revision to their conceptual frameworks titled by the IASB The Conceptual Framework for Financial Reporting. However, changed priorities and the slow progress of the project led to it being abandoned in 2010 after only Phase A of the joint project had been finalized and introduced into the existing IASB and FASB frameworks as Chapters 1 and 3 in 2010. Subsequently, in 2011 the IASB implemented an agenda consultation initiative (Discussed earlier). Many of the participants in this initiative suggested reactivating the conceptual framework project due to the large number of conceptual issues associated with many of its current projects. As a result, the IASB added the conceptual framework project back to its agenda in 2012, as an IASB-only project. This project is no longer aimed at a substantial revision of the framework but rather is focused on those topics that are not yet covered. The current project focuses on the following five topics: • • • • •

Reporting entity Presentation (including OCI) Disclosure Elements Measurement

A Discussion Paper covering all aspects of the project was published in 2013, followed by two Exposure Drafts one covering the Conceptual Framework itself, and one covering references to the Conceptual Framework in other IASB pronouncements. The IASB’s goal ass to make significant improvements to the Conceptual Framework as soon as possible. 43

b. A revised Conceptual Framework (CF) was issued in 2018. It contains an introduction and eight chapters as follows: Chapter 1 - The objective of general-purpose financial reporting. Chapter 2 - Qualitative characteristics of useful financial information. Chapter 3 - Financial Statements and the reporting entity. Chapter 4 - The elements of financial statements. Chapter 5 - Recognition and Derecognition. Chapter 6 - Measurement. Chapter 7 - Presentation and disclosure. Chapter 8 - Concepts of capital and capital maintenance. Case 3-6 The IASC’s revised Framework for the Preparation of Financial Statements describes qualitative characteristics as the attributes that make the information provided in financial statements useful. The following four principal qualitative characteristics were defined.

•

Comparability - Information about a reporting entity is more useful if it can be compared with a similar in-formation about other entities and with similar information about the same entity for another period or an-other date. Verifiability - Verifiability helps to assure users that information represents faithfully the economic phenomena it purports to represent. Timeliness - Information is available to decision-makers in time to be capable of influencing their decisions. Understandability - Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyze the information with diligence.

• • •

The qualitative characteristics identified by the FASB Conceptual Framework in SFAC No. 8 were described as a hierarchy of accounting qualities. As such they were more specific than those identified by the IASC.

Case 3-7 a.

SFAC 8 defines comparability as the qualitative characteristic that enables users to identify and understand similarities in, and differences among items. Making comparisons is normally a quantitative assessment of those characteristics. Such comparisons are valid only if the measurements used reliably represent the characteristic that is being compared. Moreover, comparability cannot be achieved without consistency of inputs and classification. 44

Comparability can refer to comparisons across time or between or among business entities. The usefulness of accounting information of an enterprise is greatly enhanced when it can be compared to similar information of another enterprise or to similar information of the same enterprise for some other reporting period. The purpose of making such comparisons is to detect and explain similarities or differences. The financial statements of a U.S. company’s operating in a foreign country, which allowed fixed assets to be valued on balance sheets at current value, would not be comparable to the financial statement of companies in those countries. Comparability implies that measurements of two companies being compared to each other be made in the same way. It would be difficult to directly compare the fixed assets of a company that measures the assets at historical cost with one that measures fixed assets at current value. b.

The user should be able to rely upon accounting information. Accounting information is reliable when users can depend on it to represent the economic conditions and circumstances it purports to represent. Reliability implies that the accounting information is representationally faithful, verifiable, and neutral. According to SFAC No. 8, faithful representation is correspondence or agreement between a measure or description and the phenomenon it purports to represent. Accounting phenomena to be represented and reported are economic resources and obligations and the transactions and events that change those economic resources and obligations. Verifiability means that several measurers are likely to obtain the same measure. This quality contributes to the usefulness of accounting information because verification should provide a significant degree of assurance that accounting measures represent what they purport to represent. It is successful in minimizing measurer bias, but not necessarily measurement bias. As a result, verifiability does not guarantee that amounts reported are in fact representationally faithful because verification cannot guarantee the appropriateness of the accounting method selected. It can only guarantee consensus among different measurers. Neutrality means that in either formulating or implementing accounting standards, the primary concern should be the relevance and reliability of the information being provided, not the effect that the accounting standards will have on a particular interested party. That is, accounting information should be free from bias toward a predetermined result. Neutrality implies that accounting information reports economic activity and financial position as faithfully as possible without attempting to influence behavior in some particular direction. Accounting information that is not neutral loses credibility. 45

Amounts reported for property plant and equipment would be more reliable. Current cost requires estimates and some educated guesswork, particularly with regard to fixed assets which do not have a ready resale market. Historical cost-based amounts rely on historical transactions which provide objective balance sheet measures. Although some discrepancies may still occur between different measurers due to estimating useful life or salvage value, and even different accounting approaches to cost allocation, the historical cost-based amounts have greater reliability because they are verifiable and objectively determined. c.

Relevant accounting information is capable of making a difference in a decision by facilitating user predictions about outcomes of past, present, and future events or by confirming or correcting expectations. Hence, relevant information has predictive and feedback value. Moreover, to be relevant to the decision at hand, the information must be timely. It must be provided when it is needed. Thus, timeliness is an ancillary aspect of relevance because information needs to be available to the decision-maker before it loses its capacity to influence decisions. The student could argue for either approach as being relevant. Current cost would be relevant in evaluating a company from a physical capital maintenance perspective. It would provide a measure of what it would cost to replace the physical capacity of existing assets. Alternatively, the student could argue that historical information is more objective and reliable and provides information consistent with the stewardship function of accounting and the financial capital maintenance concept of income.

Case 3-8 a.

Under IFRS No. 1, entities must explain how the transition to IASB standards affects their reported financial position, financial performance, and cash flows. IFRS No. 1 requires an entity to comply with each IFRS that has become effective at the reporting date of its first financial statements issued under IASB standards. The following principles apply: 1. Recognize all assets and liabilities whose recognition is required under existing IFRSs. 2. Do not recognize items as assets or liabilities when existing IFRSs do not allow such recognition. 3. Reclassify assets, liabilities, and equity as necessary to comply with existing IFRSs. 4. Apply existing IFRSs in measuring all recognized assets and liabilities.

The amendments to IAS No. 1 contained in the 2014 Disclosure Initiative encourage companies to apply professional judgment in determining what information to disclose and how to structure it in their financial statements. The key provisions of the amendments include: 1.

Materiality — Clarifies that entities should not obscure information by aggregating or providing immaterial information and that materiality considerations apply to all parts of the financial statements, even when a standard requires a specific disclosure. Statement of financial position and statement of profit or loss and other comprehensive income — Explains that the list of line items to be presented in these statements can be disaggregated and aggregated as relevant and that an entity’s share of other comprehensive income of equity-accounted associates and joint ventures should be presented in the aggregate as a single line item according to whether the share will subsequently be reclassified as profit or loss. Notes — Add examples of possible ways to arrange the notes to clarify that entities should consider understandability and comparability when determining the order of the notes and to demonstrate that the notes need not be presented in the order listed in paragraph 114 of IAS No. 1. The IASB also removed guidance and examples related to the identification of significant accounting policies that were perceived as potentially unhelpful.

Case 3-9 a.

Since General Motors and Ford use LIFO, inventory in their balance sheets will reflect old costs. These costs will not represent recent costs and could be many years old. As a result, it could be argued that these balance sheet figures in no way purport to reflect the status of these resources at the balance sheet date and hence are useless for investor decision-making. On the other hand, Honda and Daimler-Benz use FIFO. Their inventory balances would reflect recent purchase prices which would more closely reflect the current value of the inventory at the balance sheet date. Although these values would be based on cost, they would be closer to replacement cost than what would be reported under LIFO and hence more relevant to decisions regarding the financial status of the enterprise.

If two estimates of an amount that is to be received or paid in the future are about equally likely, conservatism dictates using the less optimistic estimate. As a result, accountants tend to recognize losses more often than gains. Under the assumption that price rise rather than fall, General Motors, Chrysler, and Ford provide more conservative accounting information as it relates to inventory. Each of these companies uses LIFO. LIFO matches recent, higher costs with revenues, 47

resulting in lower reported profits and lower asset values that Honda and DaimlerBenz. However, in recent years this conclusion is tempered by the incidence of relatively low inflation. FASB ASC 3-1 IASB and GAAP Search “Generally accepted accounting standards” 105-10-05 Indicates that IASB standards are not presently considered GAAP FASB ASC 3-2 FASB ASC 3-2 Share-Based Payments Information on stock compensation is contained in FASB ASC 718-10-S99. It is accessed through the share-based payment topic

Room for Debate Debate 3-1 Principles of Consolidation Team 1 According to the conceptual framework, financial statements should be relevant, reliable, comparable, and understandable. Investors should be able to understand the financial information of companies that operate in foreign countries. They should be able to compare the financial results across international boundaries. If companies throughout the world prepare financial statements using the same, or at least similar accounting principles and practices, comparability will be among companies would be greatly enhanced. Moreover, the investor would better understand financial results if companies use similar, and internally consistent accounting approaches. Both US GAAP and the IASB define assets as having probable future benefit and as resources that are controlled by the entity. Even though we don’t agree that the assets of one entity should be reported by another entity if we cannot control through our voting rights, consolidation of those assets of controlled entity would provide comparability internationally. Improved decision making would occur because it would no longer be necessary to interpret foreign financial statements and because comparability would be improved. Also, if the US were to increase harmonization of their accounting standards with the IASB, due to its status as a world leader, economically and otherwise, it would aid in the IASB’s efforts to promote worldwide acceptance and observance of international accounting standards. The result would be an enhanced general acceptability of international accounting standards. If general acceptance and use of international accounting standards is increased in other countries, the result would be not only 48

enhanced comparability, but increased transparency of financial reporting worldwide. Moreover, the increase transparency would provide more relevant information for user decision making. Reliability would also be enhanced because more preparers would conform to accounting practices, based on acceptable, unbiased measurement methods. Team 2 We do not believe that harmonization of accounting standards should be the paramount consideration when setting accounting standards. Accounting standards should be based on the U.S. conceptual framework. According to the conceptual framework, financial statements should be understandable, reliable, relevant, and as a result, aid investors to make better decisions. If an international accounting standard does not meet those criteria, it should not be adopted by the US. In other words, harmonization should not be our primary goal, providing relevant, transparent financial statements should be. We do not believe that a company should report assets that it does not control by exercise of voting rights. An investee company is a separate legal entity. Even though its decision making may be influenced by a large minority stockholder, that stockholder can be over-ruled by the majority. If so, the stockholder does not, in fact, maintain control over the assets of the investee company and those assets do not meet the definition of providing future benefit to the minority investor because their use may not benefit the minority investor. If so, those assets not only will not meet the conceptual framework’s definition of an asset, consolidating those assets on the parent company balance sheet would result in reporting items that are not representationally faithful. Thus, the resulting consolidated balance sheet could not be viewed as containing items, all of which are relevant to users. WWW Case 3-10 a.

The SEC’s rationale for this decision was to foster the adoption of a set of globally accepted accounting standards.

An American Accounting Association committee concluded that eliminating the reconciliation requirement was premature. The committee noted that the decision to eliminate the 20-F reconciliation requirement for a subset of foreign-private issuers must be based on at least one of the following premises: 1. U.S. GAAP and IFRS are, at a minimum, informationally equivalent sets of accounting principles, or 2. Investors can reconstruct consistent and comparable U.S.-GAAP-based summary accounting measures from IFRS financial statements. 49

The committee noted the following points in support of its conclusion: 1. Material reconciling items exist between U.S. GAAP and IFRS and the reconciliation currently reflects information that participants in U.S. stock markets appear to impound into stock prices. 2. In international contexts, U.S. GAAP and IAS/IFRS appear to possess information attributes of high-quality accounting standards _e.g., value relevance or mitigation of information asymmetry; however, U.S. GAAP appears to be preferred by U.S. investors. 3. Cross-country institutional differences will likely result in differences in the implementation of any single set of standards. Thus, IFRS may be a high-quality set of reporting standards pre-implementation but the resulting, published financial statement information could be of low quality, given inconsistent crossborder implementation practices. 4. Legal and institutional obstacles inhibit private litigation against foreign firms in the United States, and the SEC rarely undertakes enforcement actions against cross-listed firms. In the absence of a reliable enforcement mechanism, even high-quality accounting standards can yield low-quality financial reporting. 5. Differential implementation of standards across countries and differential enforcement efforts directed toward domestic and cross-listed firms creates differences in financial reporting even with converged standards. Whether the required reconciliation mitigates differences in implementation or improves compliance is an open issue; however, the SEC should understand the role of the reconciliation in mitigating differences in implementation and compliance before it is eliminated. 6. Despite the cost associated with preparing the reconciliation and satisfying the other listing requirements, evidence suggests that non-U.S. firms garner financial benefits from listing on U.S. exchanges and that the net benefits of a U.S. listing have not been eroded in recent years. 7. Harmonization of accounting standards could be beneficial to U.S. investors if it yields greater comparability and if IFRS provides information U.S. investors prefer for their investment decisions. Harmonization appears to be occurring via the joint standard-setting activities of the FASB and the IASB; thus, special, statutory intervention by the SEC appears to be unnecessary. Case 3-11 Some of the factors that influence the development of a country’s accounting practices are: 1.

Level of Education - There tends to be a direct correlation between the level of education obtained by a country’s citizens and the development of the financial accounting reporting practices in that country. Political System- The type of political system (socialist, democratic, totalitarian, 50

3. 4.

etc.) can influence the development of accounting standards and procedures. Legal System - The extent to which a country’s laws determine accounting practice influences the strengths of that country’s accounting profession. Economic Development - The level of a country’s economic development influences both the development and application of its financial reporting practices

Case 3-12 The IASB trustees’ duties include the following: 1.

Appointing the members of the Board, including those who will serve in liaison capacities with national standard setters, and establishing their contracts of service and performance criteria

Appointing the members of the Standing Interpretations Committee and the Standards Advisory Council

Reviewing annually the strategy of the IASB and its effectiveness

Approving annually the budget of the IASB and determining the basis for funding

Reviewing broad strategic issues affecting accounting standards, promoting IASB and its work, and promoting the objective of rigorous application of IASs, provided that the trustees shall be excluded from involvement in technical matters relating to accounting standards

Establishing and amending operating procedures for the Board, the Standing Interpretations Committee, and the Standards Advisory Council (SAC)

Approving amendments to this constitution after following a due process, including consultation with the SAC and publication of an exposure draft for public comment.

Case 3-13 a.

The objectives of the IFRS Foundation are: 1. To develop, in the public interest, a single set of high-quality, understandable, enforceable, and globally accepted financial reporting standards based upon clearly articulated principles. These standards should require high-quality, transparent, and comparable information in financial statements and other financial reporting to help investors, other participants in the world’s capital markets, and other users of financial information make economic decisions. 2. To promote the use and rigorous application of those standards. 3. In fulfilling the objectives associated with the first two objectives, to take account of, as appropriate, the needs of a range of sizes and types of entities in diverse economic settings. 4. To promote and facilitate adoption of IFRSs, being the standards and interpretations issued by the IASB, through the convergence of national accounting standards and IFRSs. 51

Some other issues addressed in the IASB constitution are: 1. 2. 3. 4. 5.

How the organization is governed The duties of the trustees, and their selection process The responsibilities of the Monitoring Board The composition, qualifications, and duties of the IASB The composition, qualifications, and duties of the IFRS Interpretations Committee 6. The composition, qualifications and duties of the IFRS Advisory Council Case 3-14 The ASAF was established to: •

Support the IFRS Foundation in its objectives, and contribute towards the development, in the public interest, of a single set of high quality understandable, enforceable and globally accepted financial reporting standards to serve investors and other market participants in making informed resource allocations and other economic decisions;

•

Formalize and streamline the IASB’s collective engagement with the global community of national standard-setters and regional bodies in its standard setting process to ensure that a broad range of national and regional input on major technical issues related to the IASB’s standard setting activities are discussed and considered; and

•

Facilitate effective technical discussions on standard-setting issues, primarily on the IASB’s work plan, but which may include other issues that have major implications for the IASB’s work, in sufficient depth, with representatives at a high level of professional capability and with a good knowledge of their jurisdictions/regions

Case 3-15 The structure of the IASB is as follows:

Case 3-16 The solution for this case requires a review of the IASC’s webpage at the time it is assigned. Financial Analysis Case The answer to this case depends on the company selected.

___________________________________________________________________________

CHAPTER 4

Case 4-1 Investors wish to use accounting information to minimize risk and to maximize returns. The capital asset pricing model (CAPM) is an attempt to deal with both risks and return. The rate of return to an investor from buying a common stock and holding it for a period of time is calculated by adding the dividends to the increase (or decrease) in value of the security during the holding period and dividing this amount by the purchase price of the security or dividends + increase (or - decrease) in value purchase price Some risk is peculiar to the common stock of a particular company. For example, a company's stock may decline in value because of the loss of a major customer such as the loss of Hertz as a purchaser of rental cars by the Ford Motor Company. On the other hand, overall environmental forces cause fluctuations in the stock market that impact on all stock prices such as the oil crisis in 1974. These two types of risk are termed unsystematic risk and systematic risk. Unsystematic risk is that portion of risk peculiar to a company that can be diversified away. Systematic risk is the nondiversifiable portion which is related to overall movements in the stock market and is consequently unavoidable. As securities are added to a portfolio unsystematic risk is reduced. Empirical research has demonstrated that unsystematic risk is virtually eliminated in portfolios of 30-40 randomly selected stocks. However, if a portfolio contains many common stocks in the same or related industries, a much larger number of stocks must be acquired. An additional assumption of the CAPM is that investors are risk averse; consequently, investors will demand additional returns for taking additional risks. As a result, high risk securities must be priced to yield higher expected returns than lower risk securities in the marketplace. A simple equation can be illustrated to express the relationship between risk and return. This equation uses the risk free return (the Treasury Bill rate) as its foundation and is stated: Rs = Rf + Rp Where: 54

Rs = The expected return on a given risky security Rf = The risk free rate Rp = The risk premium Since investors can eliminate the risk associated with acquiring a particular company's common stock by acquiring diversified portfolios, they are not compensated for bearing unsystematic risk. And, since well diversified investors are only exposed to systematic risk, investors using the CAPM as the basis for acquiring their portfolios will only be subject to systematic risk. Consequently, the only relevant risk is systematic risk and investors will be rewarded with higher expected returns for bearing market-related risk that will not be affected by company specific risk. The measure of the parallel relationship of a particular common stock with the overall trend in the stock market is termed Beta (β). β may be viewed as a gauge of a particular stock's volatility to the volatility of the total stock market. A stock with a β of 1.00 has a perfect relationship to the performance of the overall market as measured by a market index such as Dow-Jones Industrials or the Standard and Poor's 500 stock index. Stocks with a β of greater than 1.00 tend to rise and fall by a greater percentage than the market; whereas, stocks with a β of less than 1.00 are less likely to rise and fall than is the general market index. Therefore, β can be viewed as a particular stock's sensitivity to market changes, and as a measure of systematic risk. Case 4-2 a.

In the supply and demand model, price is determined by (1) the availability of the product (price) and (2) the desire to possess that product (demand). The assumptions of this model are: 1. 2. 3. 4.

All economic units possess complete knowledge of the economy. All goods and services in the economy are completely mobile and can be easily shifted within the economy. Each buyer and seller must be so small in relation to the total supply and demand that neither has an influence on the price or demand in total. There are no artificial restrictions placed on demand, supply, or prices of goods and services.

The securities market is considered the best example of the supply and demand model because stock exchanges provide a relatively efficient distribution system and information concerning securities is available through many different outlets.

The efficient markets hypothesis holds that the price of a security is determined by the purchaser's knowledge of available relevant information about that security. 55

According to this theory, the market for securities can be described as efficient if it reflects all available information and reacts instantaneously to new information. The three forms of the efficient market hypothesis differ in their definitions of all available information as follows: Weak form - Available information consists of past price history of the security. Semi-strong form - Available information includes past price history and all other publicly available information. Strong form - Past price history, all publicly available information and insider information.

Case 4-3 a.

Calendar anomalies are related with particular time periods i.e. movement in stock prices from day to day, month to month, year to year etc. Following are examples of calendar anomalies: Calendar anomalies 1. Weekend Effect:

Description Stock prices are likely to fall on Monday; consequently, the Monday closing price is less than the closing price of previous Friday. The prices of stocks are likely to increase on the last trading day of the month, and the first three days of next month. The prices of stocks are likely to increase during the last week of December and the first half month of January Small-company stocks tend to generate greater returns than other asset classes and the overall market in the first two to three weeks of January.

Turn-of-the-Month Effect:

3. Turn-of-the-Year Effect

4. January Effect:

For many years, it has been argued that value strategies outperform the market. Value strategies consist of buying stocks that have low prices relative to earnings, dividends, the book value of assets or other measures of value. Following are examples of value anomalies: Value anomalies 1. Low Price to Book

Description Stocks with low market price to book value ratios generate greater returns than stocks 56

having high book value to market value ratios. Stocks with high dividend yields tend to outperform low dividend yield stocks. Stocks with low price to earnings ratios are likely to generate higher returns and outperform the overall market, while the stocks with high market price to earnings ratios tend to underperform the overall market. Prior neglected stocks tend to generate higher returns than the overall market in subsequent periods of time. While the prior best performers tend to underperform the overall market.

2. High Dividend Yield 3. Low Price to Earnings (P/E)

4. Neglected Stocks

Technical analysis is a general term for a number of investing techniques that attempt to forecast security prices by studying past prices and other related statistics. Common technical analysis techniques include strategies based on relative strength, moving averages, as well as support and resistance. Following are examples of technical anomalies Technical anomaly 1. Moving Average

Description A trading strategy which involves buying stocks when short-term averages are higher than long-term averages and selling stocks when short-term averages fall below their long-term averages. A trading strategy which is based upon resistance and support levels. A buy signal is created when the prices reaches a resistance level. A selling signal is created when prices reach the support level.

2. Trading Range Break

There are also several other types of anomalies that cannot be easily categorized. Examples of these anomalies are:

Other Anomalies 1. The Size Effect

Description Small firms tend to outperform larger firms. Price changes tend to persist after initial announcements. Stocks with positive surprises tend to drift upward, those with negative surprises tend to drift downward. Stocks associated with initial public offerings (IPOs) in tend to underperform the market and there is also evidence that secondary offerings also underperform. Whereas, stocks of firms announcing stock repurchases outperform the overall market in the following years. There is a relationship between transactions by executives and directors in their firm's stock and the stock's performance. These stocks tend to outperform the overall market. Stocks rise immediately after being added to S&P 500

2. Announcement Based Effects and Post-earnings Announcement Drift

3. IPO's, Seasoned Equity Offerings, and Stock Buybacks

4. Insider Transactions

5. The S&P Game

Behavioral finance explores the proposition that investors are often driven by emotion and cognitive psychology rather than rationale economic behavior. It suggests that investors use imperfect rules of thumb, preconceived notions, biasinduced beliefs and behave irrationally. Consequently, behavioral finance theories attempt to blend cognitive psychology with the tenets of finance and economics to provide a logical and empirically verifiable explanation for the often-observed irrational behavior exhibited by investors. The fundamental tenet of behavioral finance is that psychological factors, or cognitive biases, affect investors, which limits and distorts their information and may cause them to reach incorrect conclusions even if the information is correct.

Some of the most the most common cognitive biases in finance are: Mental accounting - The majority of people perceive a dividend dollar differently from a capital gains dollar. Dividends are perceived as an addition to disposable income; capital gains usually are not.

Biased expectations - People tend to be overconfident in their predictions of the future. If security analysts believe with an 80% confidence that a certain stock will go up, they are right about 40% of the time. Between 1973 and 1990, earnings forecast errors have been anywhere between 25% and 65% of actual earnings. Reference dependence - Investment decisions seem to be affected by an investor’s reference point. If a certain stock was once trading for $20, then dropped to $5 and finally recovered to $10, the investor’s propensity to increase holdings of this stock will depend on whether the previous purchase was made at $20 or $5 Representativeness heuristic. In cognitive psychology this term means simply that people tend to judge “Event A” to be more probable than “Event B” when A appears more representative than B. In finance, the most common instance of representativeness heuristic is that investors mistake good companies for good stocks. Good companies are well-known and, in most cases, fairly valued. Their stocks, therefore, may not have a significant upside potential. Case 4-4 The deductive approach to the development of a theory begins with the establishment of certain objectives. Once the objectives have been identified, key definitions and assumptions are stated. the researcher then develops a logical structure for accomplishing the objectives, based on the definitions and assumptions. Political economy theory is an example of deductive theory formation in that it stresses that the objective of accounting should not be the benefit of one group over another and recommends viewing market and socio-economic forces in the development of accounting theory. Agency theory is also a normative theory in that it attempts to explain behavior. The inductive approach to the development of a theory emphasizes making observations and drawing conclusions from those observations. It is going from the specific to the general. Under this approach the researcher generalizes about the universe based upon a number of observations of specific situations. APB Statement No. 4 was an example of inductive research in that it described GAAP on the basis of observations about current practice. The pragmatic approach to theory development is based on the concept of utility or usefulness. That is, once a problem has been identified, the researcher attempts to find a utilitarian but not necessarily a optimum solution. A Statement of Accounting Theory by Sanders, Hatfield and Moore was an example of the pragmatic approach to theory development in that it essentially recommended to accountants "do what you think best." This study was used by some accountants as an authoritative source that justified current practice. Case 4-5 59

The basic assumption of agency theory is that individuals maximize their own expected utilities. It attempts to explain behavior in terms of the benefit to be derived from a particular course of action. Inherent in agency theory is the assumption that there is a conflict of interest between the owners of a firm (shareholders) and the managers because managers are maximizing their own utilities which does not result in a maximization of shareholder wealth. An agency is defined as a relationship by consent between two parties whereby one party (agent) agrees to act on behalf of the other party (principal). According to agency theory, the political process has an impact on agency relationships because political officials frequently believe that inefficient markets can only be remedied by government intervention. Agency theory may help to explain the absence of a comprehensive theory of accounting because of the diverse interests involved in financial reporting; however, it will not help to identify the correct accounting procedures because it only attempts to explain the state of current practice not the best methods of practice. Case 4-6 Studies attempting to assess an individual's ability to use information are termed human information processing research. In general, this research has indicated that individuals have a limited ability to process large amounts of information. The main consequences of this finding are: 1.

An individual's perception of information is selective. That is, since individuals are capable of comprehending only a small part of their environment, their anticipation of what they expect to perceive about a particular situation will determine to a large extent what they do perceive.

Since individuals make decisions on the basis of a small part of the total information available, they do not have the ability to make optimal decisions.

Since individuals are incapable of integrating a great deal of information, they process information sequentially.

If these conclusions are correct, the current focus on disclosure by the FASB may have an effect opposite to what is intended. That is, the annual reports may already contain more information than can be processed by individuals. Case 4-7 a.

Critical perspective research rejects the view that knowledge of accounting is grounded in objective principles. Rather researchers adopting this viewpoint share a belief in the indeterminacy of knowledge claims. This indeterminacy view rejects the notion that knowledge is externally grounded and is only revealed through systems of rules that are superior over other ways of understanding phenomena. These researchers attempt 60

to interpret the history of accounting as a complex web of economic, political and accidental co-occurrences. They have also argued that accountants have been unduly influenced by one particular viewpoint in economics (utility based, marginalist economics). This economic viewpoint holds that business organizations trade in markets that form a part of a society's economy. Profit is the result of these activities and is indicative of the organization's efficiency in using society's scarce resources. In addition, these researchers maintain that accountants have also taken as given the current institutional framework of government, markets, prices and organizational forms with the result that accounting serves to aid certain interest groups in society to the detriment of other interest groups. b.

Critical perspective research views mainstream accounting research as being based upon the view that there is a world of objective reality that exists independently of human beings which has a determinable nature that can be observed and known through research. Consequently, individuals are not seen as makers of their social reality, instead they are viewed as possessing attributes that can be objectively described (i.e. leadership styles or personalities). The critical perspectivists maintain that mainstream accounting research equates normative and positive theory. That is, what is and what ought to be are the same. It is also maintained that mainstream accounting research theories are put forth as attempts to discover an objective reality, and there is an expressed or implied belief that the observed phenomena are not impacted by the research methodology. In summary, mainstream accounting research is based upon a belief in empirical testability.

In contrast, critical perspective research is concerned with the ways societies, and the institutions that make them up, have emerged and can be understood. Research from this viewpoint has been claimed to be based on three assumptions: 1. Society has the potential to be what it is not. 2. Conscious human action is capable of molding the social world to be something different or better. 3. No. 2 can be promoted by using critical theory.

Case 4-8 a.

No. Financial reporting should be neutral. According to SFAC No. 5, neutrality means that in either formulating or implementing accounting standards, the primary concern should be the relevance and reliability of the information being provided, not the effect that the accounting standards will have on a particular interested party. That is, accounting information should be free from bias toward a predetermined result. Neutrality implies that accounting information reports economic activity and financial position as faithfully as possible without attempting to influence behavior in some particular direction. Accounting information that is not neutral loses credibility. 61

Employers who provide postretirement and postemployment benefits presumably do so because the employees earned these benefits while they worked. If so, these costs accrue during the employment period. When they are accounted for, accrual or payas-you-go, does not affect the amount and timing of the future payments. Management decisions should be based on how they affect cash flows, i.e., their economic impact, not on how accountants report economic events. b.

Arguably, there are social costs associated with the accounting for postemployment and postretirement benefits. If management reacts to the accounting change be curtailing benefits, the cost is real and obvious. Employees will not receive benefits as they did before. Other possible costs might include agency costs such as management compensation or debt covenant agreements. If management’s compensation is based on net income, expensing the cost of providing these benefits early will reduce net income and management’s bonus. Reporting previously unreported liabilities for future benefit payments would negatively affect debt-toequity ratios that may be perceived by the stock market as increased risk and may violate existing debt covenant agreements.

Critical perspective proponents would argue that the social costs (see b.) outweigh the benefits, if any, of reporting postemployment benefits and postretirement benefits in accordance with the new pronouncements.

Mainstream accounting proponents would argue that the role of accounting is to report unbiased information. Accounting should report economic circumstances and events as they are and should not present information to achieve a particular result. They would argue that not to report the information required because of potential social costs would be to present financial information that was biased and thus not neutral, thereby violating the neutrality concept. They would also argue that the user needs to know the potential cost of these benefits and therefore reporting them in accordance with the new pronouncements is relevant to user decision making.

Case 4-9 a.

Liabilities are defined as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Capital leases meet this definition; hence they represent claims to resources. Liabilities are to be measured at the present value of future cash flows discounted at the effective rate of interest. This measurement requirement is consistent with the accounting of capital leases. Investors, creditors and other users recognize liabilities as requiring the use of cash in the future, hence, reporting liabilities at the present value 62

of future cash flows provides information for user predictions of future cash outflows. While it is true that reporting the anticipated future cash flows in footnotes would also provide users with information to predict future cash flows, simultaneous reporting of the present value of those future cash flows as a liability on the balance sheet underscores the fact that there is a present claim to company resources. Also, lease capitalization reports an asset that was essentially purchased. This treatment is consistent with that of other purchased assets. The leased asset provides the same services as a purchased asset. It will provide future benefit over its useful life or the lease term and hence meets the definition of an asset. Reporting its value as an asset meets the conceptual framework’s objective of providing information regarding a company’s resources. Simply listing the expected future lease payments in a footnote tends to obscure the fact that there is an asset and that the asset provides future benefit which presumably will be associated with future cash inflows. b.

The semi-strong form of the EMH implies that all publicly available information is impounded in security prices. Since the cash flows are the same whether the lease is capitalized or not, and those cash flows would be public information regardless of whether the lease were capitalized or described in the footnotes, the market would instantaneously impound the information into the stock prices in the same way under either accounting approach as soon as the information became public.

Agency theory would predict that managers would choose accounting procedures that would increase assets, increase earnings, or decrease debt. The higher debt is to equity the more likely the company will breach existing debt covenants. Management is expected to act in a manner that would reduce associated agency costs. Lease capitalization would increase assets, but it would also increase debt. Hence, agency theory would predict that management would have a tendency to structure lease agreements so that the debt would not be reported on the balance sheet - i.e., management would not want to capitalize leases.

Case 4-10 a. ROA – Policy 1 ROA – Policy 2 b.

2014 17.0% 18.5%

2015 18.4% 19.1%

2016 14.2% 14.4%

2017 12.9% 12.9%

For the first three years ROA computed under policy #2 is higher than ROA computed under policy #1. In the last two years the amounts are the same. ROA – Policy 1 is computed by taking the Net Income as provided in the problem divided by the Total Assets as provided in the problem. 63

2018 16.3% 16.3%

ROA – Policy 2 is computed by dividing the adjusted net income by the adjusted assets. Here are the adjusted amounts for each year

Adjusted Assets Adjusted NI

2014 $ 231,839

2015 $ 290,345

2016 $ 321,686

2017 $ 375,319

2018 $ 365,725

$ 39,510

$ 53,394

$ 45,687

$ 48,351

$ 59,531

Adjusted assets are computed by adding Net Capitalized R&D to Total Assets each year. Net Capitalized R&D is total Cumulative R&D less Accumulated Amortization. Adjusted Net Income is Net Income plus R&D less Amortization Expense. Amortization Expense is computed based on a three-year life. c.

There is no correct answer to this question – both approaches have a rational basis. Agree – Company’s would not spend money on R&D activities if they did not think the expenditure will produce increase revenues (and/or decreased costs) and income in future periods. By capitalizing R&D net income will be a better performance measure as the increased net income arising from R&D will be offset by the cost of the activity in the form of amortization expense. The revenues and costs will be matched in the correct period. Disagree – At the time that a company incurs R&D costs they are not sure that the expenditure will create any future benefit. Some R&D projects create new profitable products and some never make it out of the lab. Accounting standards do not permit the recognition of contingent assets – assets that may or may not have future value depending on an event that has yet to occur. Capitalizing R&D, due to the inherent uncertainty violates this principle. Both financial statement preparers and auditors would face a host of challenging judgements including: (1) What is the proper amortization period for R&D expenditures and (2) How could impairment analysis for capitalized R&D amounts be conducted?

FASB ASC 4-1 Employee Stock Options Information on stock compensation is contained in FASB ASC 718-10. It can be accessed through the expense topic field or by searching share-based payments. Room for Debate Debate 4-1 The Efficient Market Hypothesis and Accounting Information 64

Team 1 Given the EMH, argue that accounting is relevant The three forms of the efficient market hypothesis (EMH) are the weak form, the semistrong form, and the strong form. According to the weak form, the historical price of a stock provides an unbiased estimate of the future price of the stock. Hence, an investor cannot make excess gains by knowledge of prior prices. But, an investor could gain if he/she has other knowledge regarding expected future performance of a company, e.g., accounting information. Under this form of the EMH, accounting information is definitely relevant. According to the semi-strong form of the EMH, all publicly available information is instantaneously impounded into security prices. Hence, publicly available information, such as publicly released accounting information is already reflected in the price of a share of stock, and knowledge of this information would not provide an advantage to any potential investor. In this case only insider information, e.g., accounting information which is not released to the public, would benefit the potential investor. Yet there are restrictions on insider trading of stocks. Nevertheless, insider information is still useful for other purposes. It is used for planning and strategy for the corporation. It is used in labor negotiations. It is used for the preparation of income tax returns. Many users use the information According to the strong form of the EMH, all information is impounded into security prices. Under this theory, even insiders could not benefit from knowledge of nonpublic information. But accounting information would still be useful to lenders, and a host of other users. Team 2 Given the EMH, argue that accounting information is irrelevant The three forms of the efficient market hypothesis (EMH) are the weak form, the semistrong form, and the strong form. According to the weak form, the historical price of a stock provides an unbiased estimate of the future price of the stock. Hence, an investor cannot make excess gains by knowledge of prior prices. Under this form of the EMH it is not possible to argue that accounting information is irrelevant. An investor could gain if he/she has other knowledge regarding expected future performance of a company, e.g., accounting information. Under this form of the EMH, accounting information is definitely relevant. According to the semi-strong form of the EMH, all publicly available information is instantaneously impounded into security prices. Hence, publicly available information, such as publicly released accounting information is already reflected in the price of a share of stock, and knowledge of this information would not provide an advantage to any potential investor. If this is so, investors would not have information 65

that is not publicly available and accounting information would be irrelevant. They could do just as well picking stock randomly. According to the strong form of the EMH, all information is impounded into security prices. No information, even accounting information which is not available to the public, would provide an advantage to any investor over other investors. Hence, accounting information would not be relevant. Debate 4-2 Critical perspective versus mainstream accounting Team 1 Present arguments supporting critical perspectives research. Critical perspectives proponents argue that accounting is not objective. Rather, the accounting procedures and standards resulted from a complex web of economic, political, and accidental co-occurrences. For example, the recent pronouncements related to accounting for fair value and accounting for stock options created pressure on Congress to interfere in the standard setting process. Similarly, the pronouncement on loan impairments created outside pressures for the FASB to promulgate accounting rules taking the present value of future cash flows into consideration. The result is that debtors and creditors of impaired loans, in particular troubled debt restructures, account for the same economic event in different ways. It is difficult to explain how this kind of accounting asymmetry provides information that is representationally faithful and therefore objective. Critical perspectives proponents also argue that accounting has been unduly influenced by utility based, marginalist economics. That is, the profit motive is all that matters. This viewpoint overlooks many other goals of business organizations, such as social goals. In addition, they argue that accountants aid profit-oriented groups to the detriment of others. Critical perspectives proponents view organizations in both a historic and a societal context. Accordingly, accounting should serve the good of society as well as business organizations. It should concern itself with the powerful multinational corporation and how these corporations affect the benefits received by and the costs to society. For example, accounting reports should provide information regarding the social costs of polluting the environment. Team 2 Arguments supporting traditional mainstream accounting research Traditional mainstream accounting research is concerned with unbiased, objective reporting of results of economic transactions and events. Accounting serves a stewardship function for investors, creditors and other users. Because the modern corporation is characterized by separation of management and ownership, accounting 66

has a responsibility to owners to report how management has utilized the resources entrusted to it and how the company has actually performed during the accounting period. Accounting does have a duty to society. But, that duty is not to try to cause corporations to provide benefit to the society at large. Rather, in a free market economy, business serves society by providing goods and services to the public. In return, business provides a return to owners, jobs for societies people, and profits to other businesses by buying goods and services from them. It is the accountant's job to report on these activities so that users of accounting information can assess the value of the company. It is not the accountant’s job to pass judgment on the activities themselves or to bias reporting so that a societal goal can be reached. Debate 4-3 Positive versus normative accounting theory Team 1 Support reliance on positive theory to develop a general theory of accounting Proponents of the positive theory of accounting maintain that it provides a description of existing accounting practice. In fact, this theory has arisen because existing theoretical constructs do not fully explain accounting practice. Stated differently, positive theory explains what is, rather than what should be. Thus, it can be used to explain why companies make the accounting choices that they do. Positive accounting can be associated with the contractual view of the firm in which accounting practices have evolved to mitigate contracting costs by establishing agreement among varying parties. For example, a positivist would say that conservatism has origins in the contract markets, including managerial compensation contracts and lender debt contracts. To prove their point, one would argue that, absent conservatism, managerial compensation agreements may reward managers based on current performance that may later prove unwarranted. According to Watts and Zimmerman, positive accounting theory should help us to better understand the sources of pressures that drive the accounting standard-setting process and how accounting standards affect individuals and individual behavior and thus the allocation of resources. According to the theory, managers of firms make accounting choices because of their own self interests. If we can better understand how accounting standards affect management, then we can do a better job of writing standards to help bring about appropriate, rather than dysfunctional management behavior. If we don’t know how accounting standards will be used, then it is unlikely that the goals of transparency and better reporting will be achieved. Positive, not normative accounting theory explains observed accounting practice. Unlike normative accounting theory it does not rely on consensus of accounting 67

professionals. Because there is no set of goals that is universally accepted by accountants, normative accounting theory development may not provide appropriate, practical accounting standards. Thus, since normative accounting theories rely upon acceptability, the resulting theoretical development may be suspect. Team 2 Support reliance on normative theory to develop a general theory of accounting Normative accounting theory is based on sets of goals which prescribe the way financial reporting should be, not just how it is. If we do not know what we should be reporting, how can we expect to develop accounting standards whose use will produce financial reports that can be relied upon to present the true financial picture of the reporting entity? Accountants typically agree with the Conceptual Framework’s goal of providing decision-relevant financial information to users. Decision-relevant financial reports provide the user with information which they can use to predict future performance and to compare companies. Only accounting standards that are based on what ought to be are likely provide management with a consistent choice and application of accounting policies so that reported results are unbiased and transparent. Accounting standards derived from normative theory can result in financial statements that are consistent across time and among companies. Knowledge of how managers can use accounting information to bias financial results is useful but does not provide accountants with what they need to prepare decision-relevant financials. Accounting standards should be based on clearly stated objectives that can be used to derive logical and consistent principles and practices. Just because there is no universally accepted set of objectives, does not mean that there should not be. There is, at least, a relatively wide acceptance of the underlying objectives and assumptions outlined in the FASB’s Conceptual Framework. These assumptions can certainly be relied upon to aid in the development of logical and consistent accounting standards. We can use these objectives and assumptions to logically derive accounting standards using a deductive approach. In other words, deduction, based on agreed upon assumptions, is an appropriate approach to accounting theory development. This is the normative approach. WWW Case 4-11 a.

Agency relationships involve costs to principals. Agency costs have been defined as the sum of (1) monitoring expenditures incurred by principals to control the behavior of agents, (2) bonding expenditures incurred by the agent, and (3) the residual loss. Monitoring expenditures include such costs as costs of measuring and observing the 68

agent’s behavior and the costs of establishing compensation schemes that would tend to provide incentives to the agent to realign personal goals to be closer to those of principals. Bonding expenditures are incurred by the agent to guarantee that he will not take certain actions to harm principal’s interest or that he will compensate the principal if he does. The wealth effect caused by a difference between actions taken by the agent and what the principal would have the agent take. Because individuals are expected to take actions to maximize their own utility, managers and shareholders are expected to incur monitoring and bonding costs as long as these costs are less than the residual loss. b.

An increase in debt would increase agency costs. An increase in debt would increase interest expense and lower income to stockholders. It would also increase the debt-toequity ratio and thus would be perceived as increasing risk. Increase in risk may increase the cost of debt via increased interest rate.

To reduce risk, debt-holders often restrict the amount of debt a company can issue, by putting a limit on the company’s debt-to-equity ratio. The debt covenants are a bonding cost that reduce the cost of debt.

Case 4-12 The primary goal of accounting information is to provide investors with information that is relevant and faithfully represents economic phenomena, so they can make informed investment decisions. Individual investors make the following investment decisions: • • •

Buy—a potential investor decides to purchase a particular security on the basis of available information. Hold—an actual investor decides to retain a particular security on the basis of available information. Sell—an actual investor decides to dispose of a particular security on the basis of available information.

Individual investors use all available financial information to assist in acquiring or disposing of the securities contained in their investment portfolios that are consistent with their risk preferences and the expected returns offered by their investments. One of the methods available to investors to make these decisions is fundamental analysis. Fundamental analysis is an attempt to identify individual securities that are mispriced by reviewing all available financial information. These data are then used to estimate the amount and timing of future cash flows offered by investment opportunities and to incorporate the associated degree of risk to arrive at an expected share price for a security. This discounted share price is then compared to the current market price of the security, thereby allowing the investor to make buy–hold–sell decisions. 69

Case 4-13 The EMH has several implications for the development of accounting theory. Some critics of accounting have argued that the lack of uniformity in accounting principles has allowed corporate managers to manipulate earnings and mislead investors. This argument is based on the assumption that accounting reports are a primary source of information on a business organization. The results of EMH research suggest that stock prices are not determined solely by accounting reports. This conclusion has led researchers to investigate how accounting earnings are related to stock prices. The results of these investigations imply that accounting earnings are correlated with securities returns. Other accounting research relies on research findings that support the EMH to test market perceptions of accounting numbers and financial disclosures. This research is based on the premise that an efficient market implies that the market price of a firm’s shares reflects the consensus of investors regarding the value of the firm. Thus, if accounting information or other financial disclosures incorporate items that affect a firm’s value, they should be reflected in the firm’s security price. An additional issue is the relationship between EMH and the economic consequences argument introduced in Chapter 1. The EMH holds that stock prices will not be influenced by accounting practices that do not affect profitability or cash flows. However, history indicates that various stakeholders have attempted to lobby the FASB over such changes. Examples of these efforts include accounting for the investment tax credit and accounting for foreign currency translation. Some accountants claim that this is an example of existing theory failing to fully explain current practice and is consistent with steps 3 and 4 of the Kuhnian approach to scientific progress discussed by SATTA. If so, an existing paradigm is found to be deficient and the search for a new paradigm begins. These accountants generally maintain that the positive theory of accounting provides a better description of existing accounting practice. Case 4-14 Prospect theory is characterized by the following: •

Certainty: People have a strong preference for certainty and are willing to sacrifice income to achieve more certainty. For example, if option A is a guaranteed win of $1,000, and option B is an 80 percent chance of winning $1,400 but a 20 percent chance of winning nothing, people tend to prefer option A.

•

Loss aversion: People tend to give losses more weight than gains: They’re loss‐averse. So, if you gain $100 and lose $80, it may be considered a net loss in terms of satisfaction, even though you came out $20 ahead, because you tend to focus on how much you lost, not on how much you gained.

•

Relative positioning: People tend to be most interested in their relative gains and losses as opposed to their final income and wealth. If your relative position doesn’t improve, you won’t feel any better off, even if your income increases dramatically. In other words, if you get a 10 percent raise and your neighbor gets a 10 percent raise, you won’t feel better off. But if you get a 10 percent raise and your neighbor doesn’t get a raise at all, you’ll feel rich.

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Small probabilities: People tend to underreact to low‐probability events. For example, you might completely discount the probability of losing all your wealth if the probability is very small. This tendency can result in people making very risky choices.

Case 4-15 The students will have different answers to this case depending on the companies selected and the time period chosen. Case 4-16 The costs in agency relationships are: Monitoring expenditures are defined as expenditures by the principal to control the agent’s behavior. Examples of monitoring costs are external and internal auditors, the SEC, capital markets including underwriters and lenders, boards of directors, and dividend payments. Bonding costs are defined as expenditures to guarantee that the agent will not take certain actions to harm the principal’s interest. Examples of bonding costs include managerial compensation, including stock options and bonuses and the threat of a takeover if mismanagement causes a reduction in stock prices. Even with monitoring and bonding expenditures, the actions taken by the agent will differ from the actions the principal would take, and the wealth effect of this divergence inaction is defined as residual loss. Residual losses are the extent to which returns to the owners fall below what they would be if the principals and the owners exercised direct control of the corporation. Case 4-17 Examples of some of the new reporting measures that have been developed that arguably could address this criticism are: 1.

Key Performance Indicator (KPI) – A measurable value that demonstrates how effectively a company is achieving key business objectives. For example, zero defects 71

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in a manufacturing process. Businesses currently use KPIs to evaluate their success at reaching targets. Value Reporting Revolution – Investors want to know more about what companies actually do to create value to be able to make sound, long-term investment decisions. They need information about market dynamics, corporate strategy, and nonfinancial value drivers that are leading indicators of a company’s future financial performance and stock price. Advocates of this concept point out that many companies focus on short-term earnings rather than future stock price performance. They suggest instead that to make sound, long-term investment decisions, investors want to know more about market dynamics, corporate strategy, and nonfinancial value drivers that are leading indicators of a company's future financial performance and stock price. Intellectual Capital Reports - The world has moved from an industrial economy, in which economic growth was considered to be mostly determined by the employment of material resources, towards a knowledge-based economy in which wealth creation is associated with the development and maintenance of competitive advantages based on intangible elements that are frequently grouped under the generic term knowledge. Traditional financial statements do not provide the relevant information for managers or investors to understand how these resources – many of which are intangible – create value in the future. Intellectual capital statements bridge this gap by providing information about how intellectual resources create future value. Enhanced Business Reporting Model – Focuses on shifting the reporting model from one that is based primarily on historical or lagging financial information to a model that incorporates relevant value drivers, financial and non-financial performance measures, and qualitative information around management’s strategy, plans, opportunities, and risks. Proponents believe that this improved business reporting model would deliver a broader view of current performance and provide greater understanding of an entity’s future. Integrated Reporting – A process that would provide a periodic report about value creation over time. This report would communicate information about how an organization’s strategy, governance, performance and prospects lead to the creation of value over the short, medium and long term. Proponents believe that an Integrated Reporting financial accounting model would provide greater context for performance data, clarify how value relevant information fits into operations or a business. When utilized by businesses, Integrated Reporting helps management to make company decision making more long-term and adds value to financial and sustainability reports including the following; i. Natural capital: such as natural resources ii. Social and relationship capital: such as ties to the community and government relations iii. Intellectual capital: such as patents and copyrights. iv. Human capital: such as the skills and know-how of an organization’s professionals as well as their commitment and motivation and their ability to lead, cooperate or innovate 72

Financial capital: is the traditional yardstick of an organization’s performance. The capitals available to the organization are increased, decreased or transformed as a result of its value-adding activities.

Case 4-18

The reasons Lev and Gu (L & G) identify as the causing accounting reports to have lost relevance are: 1.

The treatment of intangible assets. In the past few decades, the major corporate value drivers have shifted from property, plant, machinery, and inventories, to patents, brands, information technology, and human resources. That is, studies have shown that since the 1990s companies spend more on intangible assets and other strategic assets such as: brand development, advertising and marketing and unique personal talents; than on physical assets. However, GAAP has failed to adapt to this change and has continued to treat the cost of internally developed intangibles as ordinary expenses. L&G documented that investment in physical assets declined by 35 percent; whereas, investment in intangible assets has increased by almost 60 percent since 1977. Accounting has become less about facts and more and more about manager’s subjective judgments, estimates, and projections. That is, there has been a move away from strictly reporting items at their historical cost. Accounting regulations have increasingly required financial statement items to be revalued by using estimates such as fair value. L&G found a fivefold increase in the use of estimates during the 19952015 period. The increase in unrecorded business events that affect corporate value (competitor moves, regulatory changes, restructurings, alliances, etc.). These events are reported to the SEC on form 8-K but are not formally entered in the accounting records. L&G found a threefold increase in these events during the 1994-2013 period.

Financial Analysis Case The students will have different answers to this case depending on the companies selected.

CHAPTER 5

Case 5-1 a.

Earnings management is the attempt by corporate officers to influence short-term reported income. It is believed that managers may attempt to manage earnings because they believe investors are influenced by reported earnings. The methods of earnings management include the use of production and investment decisions, and the strategic choice of accounting techniques (including the early adoption of new accounting standards). In most cases, earnings management techniques are designed to improve reported income effects; however, such is not always the case. An alternate explanation is the "Big Bath" theory which suggests that management may take the opportunity to report more bad news in periods when performance is low to increase future profits. An argument has also been made that management may choose to take large write-offs in periods when their performance is otherwise extremely positive.

Some methods that may be used by management to smooth earnings are: postponing end-of-the-year inventory replacement expenditures for merchandising companies, postponing the production of products for manufacturing companies, and the early adoption of new FASB accounting standards such as SFAS No. 109 when it has a positive effect on reported net income due to the recording of deferred tax benefits. Arthur Levitt, the former chair of the SEC, has outlined five earnings management techniques that he believes threaten the integrity of financial reporting 1. Taking a bath The one-time overstatement of restructuring charges to reduce assets, which reduces future expenses. The expectation is that the one-time loss is discounted in the marketplace by analysts and investors who will focus on future earnings. 2. Creative acquisition accounting Avoiding future expenses by one-time charges for in-process research and development. 3. “Cookie jar” reserves Overstating sales returns or warranty costs in good times and using these overstatements in bad times to reduce similar charges. 4. Abusing the materiality concept 74

Deliberately recording errors or ignoring mistakes in the financial statements under the assumption that their impact is not significant. 5. Improper revenue recognition Recording revenue before it is earned. It was noted that over half of the SEC’s enforcement cases filed in 1999 and 2000 involved improper revenue recognition issues. Case 5-2 a.

A major purpose of income reporting is to allow investors to predict future cash flows. Despite the evidence that accounting earnings are good indicators of stock returns, the use of the transactions approach to income determination along with the principle of conservatism, and the materiality constraint; have led security analysts to the conclusion that economic income, rather than accounting income is a better predictor of future cash flows. Consequently, these individuals have suggested assessing the quality of earnings to predict future cash flows. Earnings quality is defined as the degree of correlation between a company's accounting income and its economic income. Several techniques have been developed to use in assessing earnings quality including: 1.

Compare the accounting principles employed by the company with those generally used in the industry and by competitions. Do the principles used by the company inflate earnings?

Review recent changes in accounting principles and changes in estimates to determine if they inflate earnings.

Determine if discretionary expenditures, such as advertising, have been postponed by comparing them to previous periods.

Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income statement.

Determine the replacement cost of inventories and other assets. Is the company generating sufficient cash flow to replace their assets?

Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings and cash flows.

Review the relationship between sales and receivables to determine if receivables are increasing more rapidly than sales.

Review the management discussion and analysis section of the annual report and the auditor's opinion to determine management's opinion of the company's future and to identify any major accounting issues.

The answer to this part of the case is dependent upon the company selected. The students should be able to address all, or, at least, most of the above issues and reference the section of the annual report that contained the relevant information.

Case 5-3 Step 1: Identify the contract(s) with a customer A contract is an agreement between two parties that creates enforceable rights and obligations. In his case Airbus has agreed to sell airplanes to Emirates. Step 2: Identify the Performance Obligations in the Contract According to the terms of the agreement, Airbus has only one performance obligation, deliver 50 A380s to Emirates. Step 3: Determine the Transaction Price The transaction price is the amount of consideration (for example, payment) to which a company expects to be entitled in exchange for transferring promised goods or services to a customer, which in this case is $20 billion. Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract In this case, Airbus has only one performance obligation-to deliver 20 A380s to Emirates. Step 5: Recognize Revenue When (or as) the company Satisfies a Performance Obligation Airbus recognizes the $20 billion of revenue as it delivers the A380s to Emirates. In this case the obligation will be satisfied over time as the A380s are delivered. Airbus should use the output method and directly measure the value of theA380s as they are delivered Case 5-4 Step 1: Identify the contract(s) with the customer A contract exists as a student is exchanging consideration for education and housing services to be provided by the university. The university requires a student to pay a non-refundable deposit to hold a spot for the upcoming semester. This is, in essence, a prepayment for the educational and housing services to be provided at a later date. As a result, when the 76

university receives the deposit, it will record a contract liability (deferred revenue). When the student begins taking class and moves into the dorm, this contract liability will be included in the transaction price.

Step 2: Identify the performance obligations The university has the obligation to provide classroom instruction and a room in a residence hall. Tuition and housing are distinct services, as a student can benefit from educational services without the need for housing. As a result, there are two performance obligations tuition and housing. Step 3: Determine the transaction price The university has published fees for different educational levels and programs offered, so the transaction price is different based on different classes of students. Also, the university offers aid packages to students including scholarships and discounts. If a student is does nothing in return for a particular scholarship, the amount of that scholarship is recorded as a reduction in revenue when revenue is recognized. If a student performs a service in exchange for a reduction of tuition, the value of that service is recorded as an expense. The university has an add/drop period during which a student can receive a refund. The university should estimate the percentage of students who will be due a refund based on historical experience. This percentage is then used to reduce the amount of revenue recognized. If a student has paid the remaining of their bill prior to the start of the semester, this amount will be reclassified from contract liability (deferred revenue) to refund liability. After the two-week add/drop period ends, the university should make adjustments to the estimated amount based on actual results. Alternately, since the add/drop period is relatively short, the university could choose to wait until the end of the add/drop period and record only the actual results. Step 4: Allocate the transaction price The university concluded (in step 2) that tuition and housing are separate performance obligations. As a result, the total amount received is allocated to these separate contracts based on their respective published rates. The university also concluded that financial aid applies both to tuition and housing and so the two transaction prices should be reduced accordingly. Step 5: Recognize revenue Revenue for tuition and housing should be recognized ratably over the course of the semester as the related services are performed. Case 5-5 Skippers Landing should allocate the transaction price of $65,000 to the boat and the mooring services based on their relative standalone selling prices as follows: Boat: $55,714 ($65.000 × ($60,000 / $70,000)) Mooring services: $9,286 ($65,000 × ($10,000 / $70,000)) 77

The allocation results in the $5,000 discount being allocated proportionately to the two performance obligations. Case 5—6 The contract price for the boat ($62,000) falls within the range Skippers Landing established for standalone selling prices; therefore, Skippers Landing could use the stated contract price for the boat as the standalone selling price in the allocation: Boat: $55,972 ($65,000 × ($62,000 / $72,000)) Mooring services: $9,028 ($65,000 × ($10,000 / $72,000)) If the contract price for the boat did not fall within the range (for example, the boat was priced at $56,000), Skippers Landing would need to determine a price within the range to use as the standalone selling price of the boat in the allocation, such as the midpoint. Skippers Landing should apply a consistent method for determining the price within the range to use as the standalone selling price. Case 5-7 This arrangement includes the following goods or services: (1) the smart phone; (2) product warranty; and (3) repair and replacement service. The product warranty against manufacturing defects is an assurance warranty and should be accounted by recording an expense and liability for the expected repair or replacement costs related to this obligation. Bellcom should account for the repair and replacement service related to customer-inflicted damages as a service‐type warranty. Therefore, it is recorded as a separate performance obligation and revenue allocated to the warranty is recognized over the warranty period. If Bellcom cannot reasonably separate the product warranty and repair and replacement service, it should account for the two warranties together as a single performance Case 5-8 a.

No amount of variable consideration should be included in the transaction price. It is not probable that a significant reversal of cumulative revenue recognized will not occur resulting from a change in estimate of the consideration Henderson Farms Inc. will receive upon future sale of the land. The transaction price at contract inception is therefore $2,000,000. Henderson Farms Inc. will update its estimate, including application of the constraint, at each reporting date until the uncertainty is resolved. This includes considering whether any minimum amount should be recorded.

Henderson Farms Inc. should adjust the transaction price to include $150,000 of variable consideration for which it is probable a significant reversal of cumulative revenue recognized will not occur. Henderson Farms Inc. will update its estimate, either upward or downward, at each reporting date until the uncertainty is resolved.

Case 5-9 a.

The matching concept associates efforts (costs) with accomplishments (revenues). Expenses are generally recognized when economic benefits are used up in delivering goods or producing services - i.e., revenues are earned. Expenses are defined in SFAC No. 6 as outflows or other using up as assets or incurrences of liabilities from producing goods or providing services or rendering other activities that constitute the entity’s ongoing or central operations. This definition is consistent with the matching concept. The matching concept is important to income reporting because of the going concern assumption. Since business entities are presumed to be going concerns, enterprise performance must be assessed at intervals. That is, accountants must report periodically to investors, creditors and other users. Periodic reporting requires that accountants report on the performance of the entity during an accounting period so that users can assess enterprise how well the enterprise is utilizing resources to generate future cash flows for operations, reinvestment in operations, and dividends for investors.

Expenses, such as cost of goods sold, are directly linked to the production of revenue. These costs are matched directly to the revenue generated during the accounting period. Many expenses are associated with the period in which the revenue was generated. These costs include such items as administrative salaries or electricity for the sales office. Other expenses are systematically allocated to the periods benefited by their use. For example, the cost of fixed assets is typically allocated to periods based on useful life.

According to SFAC No. 5, earnings and comprehensive income combined reflect the extent to which and the ways in which the equity (net assets) of an entity increased or decreased from all sources other than transactions with owners during the accounting period. Users need information about the causes of changes in net assets and how these changes affected ongoing operations. Direct measures of asset and liability balances at the end of the accounting period are linked to expense and revenue measurement because financial statements are articulated. The measurement of earnings using a balance sheet approach is consistent with the financial capital maintenance concept of income determination. This concept is critical to determining the return on invested capital. A return on capital occurs only if there has been an increase in net assets during the period exclusive of investments by and 79

distributions to owners. Hence, financial capital maintenance and thus a balance sheet approach to income measurement is relevant to investor decision making. d.

The measurement of deferred income taxes uses the asset/liability approach. Under this approach the deferred tax asset and liability balances are determined. Income tax expense is equal to the current provision for income tax plus the change in the deferred tax asset and or liability balance. Aging of accounts receivable provides balance sheet measure of net realizable value. The resulting balance in the allowance account is used to measure the amount of bad debt expense in the income statement. Measures of cost of goods sold utilize a balance sheet approach. Typically, the cost of inventory is determined, then cost of goods sold is computed as a residual amount.

Case 5-10 a.

1. Cost is the amount measured by the current monetary value of economic resources given up or to be given up in obtaining goods and services. Economic resources may be given up by transferring cash or other property, issuing capital stock, performing services, or incurring liabilities. Costs are classified as unexpired or expired. Unexpired costs are assets and apply to the production of future revenues. Examples of unexpired costs are inventories, prepaid expenses, plant and equipment, and investments. Expired costs, which most costs become eventually, are those that are not applicable to the production of future revenues and are deducted from current revenues or charged against retained earnings. 2. Expense in its broadest sense includes all expired costs, i.e., costs which do not have any potential future economic benefit. A more precise definition limits the use of the term expense to the expired costs arising from using or consuming goods and services in the process of obtaining revenues, e.g., cost of goods sold and selling and administrative expenses. 3. A loss is an unplanned cost expiration and for this reason is often included in the broad definition of expenses. A more precise definition restricts the use of the term loss to cost expirations which do not benefit the revenue-producing activities of the firm. Examples include the unrecovered book value on the sale of fixed assets and the write-off of goodwill due to unusual events within an accounting period. The term loss is also used to refer to the amount by which expenses and exceed revenues during an accounting period. 80

i. Cost of goods sold is an expired cost and may be referred to as an expense in the broad sense of the term. On the income statement it is most often identified as a cost. Inventory held for sale which is destroyed by an abnormal casualty should be classified as a loss. ii. Bad debts expense is usually classified as an expense. However, some authorities believe that it is more desirable to classify bad debts as a direct reduction of sales revenue (an offset to revenue). A material bad debt which was not provided for in the annual adjustment, such as bankruptcy of a major debtor, may be classified as a loss. iii. Depreciation expense for plant machinery is a component of factory overhead and represents the reclassification of a portion of the machinery cost to product cost (inventory). When the product is sold, the depreciation becomes a part of the cost of goods sold which is an expense. Depreciation of plant machinery during an unplanned and unproductive period of idleness, such as during a strike, should be classified as a loss. The term expense should preferably be avoided when making reference to production costs. iv. Organization costs are those costs that benefit the firm for its entire period of existence and are most appropriately classified as a non-current asset. When there is initial evidence that a firm's life is limited the organizational costs should be allocated over the firm's life as an expense or amortized as a loss when going concern foresees termination. In practice, however, organization costs are often written off in early years of a firm's existence. v. Spoiled goods resulting from normal manufacturing processing should be treated as a cost of the product manufactured. When the product is sold the cost becomes an expense. Spoiled goods resulting from an abnormal occurrence should be classified as a loss.

Period costs and product costs are usually differentiated under one of two major concepts. One concept identifies a cost as a period or product cost according to whether the cost expires primarily with the passage of time or directly for the production of revenue. The other concept identifies a cost as a product or a period cost according to whether or not the cost is included in inventory. Under the first concept period costs are all costs which expire within the accounting period and are only indirectly related to the production of revenue within the period and product costs are those costs associated with the manufacture of a firm's product and that generate revenue in the period of its sale. Some costs are easily associated with the production of revenue, such as the manufacturing or purchase cost of a product 81

sold and are designated as product costs. Other costs may be incurred as costs of doing business and are more difficult to relate to the production of revenue, such as general and administrative costs, and are classified as period costs. Costs which cannot be readily identified with the production of revenue in any particular period, such as the company president's salary which may produce revenue in many distant future accounting periods, are also classified as period costs because they cannot be specifically identified with any future accounting period. Under the second concept product costs include only the costs which are carried forward to future accounting periods in inventory and all expired costs are period costs. Case 5-11 a.

If two estimates of an amount that is to be received or paid in the future are about equally likely, the concept of conservatism dictates using the less optimistic estimate.

Conservatism has affected financial reporting because there is a tendency for accountants to recognize losses, but not gains. For example, loss contingencies are accrued when they are probable, and the amount of the potential loss is reasonably estimable. Similar gain contingencies are not accrued. In accounting for saleleasebacks where more than a minor portion is leased back, losses on sales are recognized; whereas, gains are deferred. Lower-of-cost-or-market is used for inventory whereby the carrying value of inventory is written down to market if it is lower, but not up to market if market is higher. It should be noted that The FASB has recently moved to lessen the impact of conservatism in financial reporting. That is, while conservatism appeared in SFAC No. 2 it was removed in SFAC No. 8. In SFAC No. 8 the FASB, uses the term faithful representation instead of the term reliability as a fundamental quality that make accounting information useful for decision making. Prudence (conservatism) which was an aspect of reliability in SFAC No. 2 is not considered an aspect of faithful representation. The FASB’s rationale for this decision was that including it as an aspect of faithful representation would be inconsistent with the characteristic of neutrality. That is, if financial information is biased in a way that encourages users to take or avoid predetermined actions, that information is not neutral.

No. If an economic loss has occurred, it should be reported. There is no reason that a similar occurrence for a gain should not also be reported. Accountants should report what has happened during the accounting period in an unbiased objective way. Gains happen as well as losses. If they are not also reported, the reporting of gains and losses in the income statement will not be what it purports to be.

No. Physical capital maintenance implies that earnings occur when the physical capacity exclusive of owner transactions increases during the accounting period. Physical capital is the replacement cost of a company’s net assets. Replacement cost can increase or decrease. Such a concept of earnings would recognize increases and decreases in current value (gains and losses) during the accounting. However, these changes would be considered capital maintenance adjustments, rather than earnings adjustments. Physical capital maintenance matches current cost with current period revenues. Holding gains and losses would be excluded from the income statement.

Yes, and no. Financial capital maintenance basically accommodates any measure of asset value, whether or not conservative. Whatever measurements are used, changes in assets and liabilities would flow through the income statement. Nevertheless, an argument could be made that financial capital is maintained only if the measurements reflect the purchasing power of dollars invested in the company. If so, measures based on price level changes, specific or general could arguably be preferred to historical cost. If so, gains and losses should both be recognized.

Case 5-12 a.

Some common non-GAAP metrics include free cash flow, funds from operations, adjusted revenues, adjusted earnings, adjusted earnings per share, adjusted earnings before interest, taxes, depreciation, and amortization (known as adjusted EBITDA), and net debt.

Regulation G includes the following requirements related to the use of non-GAAP financial measures. •

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Non-GAAP financial measure cannot be misleading. A non-GAAP financial measure is considered to be misleading when, taken together with the information or discussion accompanying that measure, and in light of the circumstances under which it is presented, it contains an untrue statement of a material fact or omits to state a material fact. A presentation of the most directly comparable GAAP measure. To identify the most directly comparable GAAP measure, a registrant first determines the purpose of the non-GAAP financial measure and whether it is intended to be used as a measure of the registrant’s liquidity or its performance. It is expected that users of the financial statements will rely on the income statement for information about the registrant’s performance and the statement of cash flows for information about the registrant’s liquidity. Therefore, a non-GAAP financial measure that is a performance measure should generally be reconciled to a line item in the registrant’s income statement while a non-GAAP financial measure that is a liquidity measure should generally be reconciled to a line item in the registrant’s statement of cash flows A reconciliation to most directly comparable GAAP measure. The reconciliation should generally be presented in schedule format, beginning with the most directly 83

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comparable GAAP measure, with quantitative adjustments reconciling to the nonGAAP financial measure The presentation cannot be more prominent than the most directly comparable GAAP measure. In light of the lack of formal guidance on the topic, the SEC staff provided examples of the types of non-GAAP financial measure disclosures the SEC staff believed would fail to meet the equal or greater prominence requirement. These include omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures and presenting a nonGAAP measure using a style of presentation (e.g. bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure. A statement disclosing reasons management believes the measure is useful to investors and a statement disclosing any additional purpose, to the extent material, for which management uses the measure. Those statements should not be boilerplate; they should be substantive and specific to: the measure used, the nature of the registrant, the registrant's business and industry; and the manner in which management assesses and applies the measure. For example, it is not sufficient to say only that the measure is useful to analysts as that is not substantive. A prohibition on excluding items that require cash settlement from liquidity measures. This prohibition emphasizes the importance of management’s initial classification of a non-GAAP financial measure as either a liquidity or performance measure. A prohibition on adjustments to GAAP earnings for nonrecurring, infrequent or unusual items. A registrant may not present in an SEC filing a non-GAAP performance measure that eliminates or smooths items identified as nonrecurring, infrequent or unusual when the nature of the charge or gain makes it reasonably likely to recur within two years; or there was a similar charge or gain within the prior two years. A prohibition related to placement of non-GAAP financial measures. A registrant may not present a non-GAAP financial measure: on the face of the financial statements, in the accompanying notes or on the face of any pro forma financial information provided to comply with the reporting regulations for smaller reporting companies. A prohibition related to use of titles or descriptions. A registrant may not use titles or descriptions of non-GAAP financial measures that are the same as, or

confusingly similar to, titles or descriptions used for GAAP financial measures. FASB ASC 5-1 Revenue Recognition A search for revenue recognition resulted in over 90 different places in the FASB ASC where revenue recognition is discussed. FASB ASC 5-2 Recognition of Franchise Fee Revenue Accounting for franchise fee revenue is found at FASB ASC 952-605-25. It is found by searching franchise fee revenue. 84

FASB ASC 5-3 Real Estate Sales The answer is found at FASB ASC 360-20-40-3 and FASB ASC 360-20-40-27 and can be found by searching for real estate sales.

FASB ASC 5-4 Current Value Search current value 274 Personal Financial Statements 10 Overall 05 Background FASB ASC 5-5 Accounting for Inflation Search inflation 255 Changing Prices 10 Overall FASB ASC 5-6 Revenue and Gains Use revenue link FASB ASC 5-7 Accounting for Long-term Construction Contracts Search long term construction 606 Revenue Recognition 35 Construction-Type and Production-Type Contracts\

FASB ASC 5-8 Use of the Installment and Cost Recovery Methods Search installment method. 605-10-25-3 FASB ASC 5-9 Matching

Search matching – over 30 hits FASB ASC 5-10 Conservatism 85

Search conservatism

FASB ASC 5-11 Materiality

Search materiality - 18 hits Room for Debate Debate 5-1 Concepts of Capital Maintenance Team 1 Arguments in favor of the physical capital maintenance concept 1.

The concept of physical capital maintenance is concerned with maintaining productive capacity. Productive capacity is provided by the company’s assets, and capital is defined as the operating assets of the entity. Assets must eventually be replaced in order to maintain the current level of productive capacity. Hence, measurement of assets at their replacement cost is consistent with this theory.

Under the physical capital maintenance concept current period revenues are matched with the current cost of the assets used to generate the revenue. The resulting periodic income is referred to as distributable or sustainable income because as a result of calculating depreciation and cost of goods sold based on their replacement cost, net income reflects the amount that can be distributed to stockholders without impairing the productive capacity of the entity. Thus, income is not recognized until provision has been made to replace these assets. Most going concerns expect to operate in the future at a rate of physical activity equal to the current level. Hence, periodic income should not be recognized until provision has been made to maintain the physical plant at the current level.

The major strength of the physical capital maintenance concept is based on the notion that an increase in enterprise wealth as a result of price changes is excluded from income. According to SFAC No. 5, holding gains and losses are treated as adjustments to equity rather than income. Thus, the concept recognizes that long-run survival of the entity is dependent upon its ability to generate enough income to replace the productive capacity of its existing assets.

Another strength of the physical capital maintenance concept is that it provides insight regarding the amount of dividends that may be paid to investors without impairing the entity’s ability to replace existing assets.

The concept recognizes that fact that enterprises attempt to maintain share prices by maintaining operating flows. Presumably by maintaining a given level of operating capacity, the ability to maintain operating flows is greatly enhanced.

Team 2 Arguments in favor of the financial capital maintenance concept. 1.

Capital, under the financial capital maintenance concept is defined as the monetary values of assets contributed by owners at the time they were contributed. This is the traditional, dominant view of capital maintenance in accounting. The primary emphasis of the financial capital maintenance concept is on the exchange transaction and events that affect the operations and status of the business entity. Hence, most of the information that would be provided under this concept is derived from actual experiences and is thus historical in nature.

Under the financial capital maintenance concept, income results from matching revenues with the cost of generating revenues. Revenues are recognized by applying the realization principle. Accordingly, they are recognized when the earnings process is complete or virtually complete and when an exchange (transactions with customers) has taken place. Costs are matched directly with revenues (e.g., cost of goods sold), directly with the period in which revenues occurred (e.g., utility bills), and allocated to periods in which revenue is generated (e.g., depreciation).

The financial capital maintenance concept presumes that historical cost is the significant and relevant measurement approach. The major strength of this concept is that it is generally understood by users. According to SFAC No. 8, understandability is a desirable of useful accounting information.

Historical cost is objective and provides neutral, unbiased measures of the results of financial transactions and events. Because it is transactions based, the measurements are verifiable and the approach is relatively easy to apply in practice. Moreover, since revenues are not recognized until realized, the financial capital maintenance concept is conservative.

Because adjustments are not made to historical cost for changes in the price level, financial transactions are reported in terms of dollars invested by stockholders. Hence, the concept of financial capital maintenance enables accountants to fulfill their stewardship role to owners.

Debate 5-2 Economic versus Accounting Income Team 1 Argue in favor of the economist’s view of income

Economists generally agree that the objective of measuring income is to determine how much better off a company has become during the accounting period. This view of income is consistent with the notion of “real income”, or increases in economic wealth. Under this view, a company has income if it is better off at the end of the accounting period than at the beginning of the period and the increase is wealth is not due to investments by owners or distributions to owners. The amount of income during the period is equal to the maximum amount that could be distributed to owners and still leave the company as well off as it was in the beginning of the period. This notion is consistent with accounting for assets at current value. Economic income would take preservation of the physical plant into consideration, but would also adjust for changes in price levels. The difference between economic income and that derived from the physical capital maintenance concept is that economic income would include holding gains and losses, while physical capital maintenance income would not. According to SFAC No. 8, relevant information about an entity should provide predictive ability. Because current values represent the market’s assessment of the value of assets and hence take into consideration the future cash flows that they would generate, income measurement utilizing current values should provide information relevant to predict future cash flows. The economic view of income is consistent with recognition of income during production. It is not based on the sale of the asset to customers. Instead it is presumed that the enterprise is in business to realize cash from the production of goods and the provision of services, but that the production process itself is earning the eventual cash inflow. Hence, revenue recognition is based on expectations regarding future events rather than on the transactions as they occur. By the same token, costs would be recognized as they are incurred, rather than be matched against revenue that is recognized in accordance with the realization principle. Team 2 Argue in favor of the accountant’s concept of income Accountants feel that the elements of financial statements should be reported when there is evidence of an exchange. Revenue should be recognized only when it is earned. Accountants should not record revenue that is anticipated. Instead, the existence of revenue should be verified with evidence that an exchange has taken place. Income measurement should be based on matching efforts (costs) with accomplishments (revenues) that have actually occurred. The accountant’s concept of income is anchored on the historical cost model and is consistent with the concept of financial capital maintenance. See, Team 2 under Issue 1 for arguments favoring these concepts. 88

Debate 5-3 Current value measures Team 1 The definition of an asset implies that assets are held to provide future benefits. A company’s future benefits are derived from its use of assets held by it. Future benefit to a company would logically be related to expected future profits and the resultant future cash inflows. Thus, it is reasonable to assume that the measurement of assets should reflect those expectations. We argue that this goal is best met by reporting assets at current value, measured using exit prices. Current value embodies expectations regarding future earning power of net assets. Since assets are held because they provide future benefit, their measurement should be based on their current value in use – that is, by entry values. An entry value is the current estimated fair market price of the asset. It is the cost that a company would incur to replace an existing asset (its replacement cost). According to Edwards and Bell, current entry prices allow the assessment of managerial decisions to hold assets by segregating current value income (holding gains and losses) from current operating income. Under the assumption that operations will continue, this dichotomy allows the long-run profitability of the enterprise to be assessed. The recurring and relatively controllable profits can be evaluated vis-à-vis those factors that affect operations over time but are beyond the control of management. Replacement cost provides a measure of the cost to replace the current operating capacity and, hence, a means of evaluating how much the firm can distribute to stockholders and still maintain its productive capacity. We do not believe that exit values provide appropriate asset measures because they measure what a company could receive if they sell the asset, not what the asset is worth to company while they keep it. Team 2 Since the company already owns the assets, it will not have to replace them. Hence, replacement cost is not relevant. We agree that the value of the asset should be tied to its expected benefit to the company. However, we believe that companies benefit by future cash flows that will result from the asset, not on cash flows to purchase assets already owned. According to Sterling, entry value is irrelevant to what could be realized upon sale of those assets and to their current purchase since they are already owned. Moreover, replacement cost does not measure the capacity to make decisions to buy, hold, or sell in the marketplace. 89

Chambers and Sterling contend that exit prices have decision relevance. Accordingly, during each accounting period, management decides whether to hold, sell, or replace the assets. It is argued that exit prices provide users with better information to evaluate liquidity and thus the ability of the enterprise to adapt to changing economic stimuli. Because management has the option of selling the asset, exit price provides a means of assessing downside risk. It measures the current sacrifice of holding the asset and thereby provides a guide for evaluating management’s stewardship function. A recent FASB pronouncement agrees with Chambers and Sterling. SFAS No. 157 defines fair value as exit price. According to the pronouncement, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This definition emphasizes that fair value is market based rather than entity specific. To summarize, we believe that exit value captures the reasons why management buys, holds, and sells assets. It thus discloses the value of those assets to the entity, and thus is decision-relevant to financial statement users. WWW Case 5-13 Repo 105 is an accounting maneuver where a short-term loan is classified as a sale. In a Repo 105 transaction, the company sells assets (generally securities) and the cash obtained through this sale is then used to pay down debt. This allows the company to appear to reduce its leverage by temporarily paying down liabilities—just long enough to be reflected on the company’s published balance sheet. Subsequently, after the company’s annual report is released, the company borrows cash and repurchases its original assets. Case 5-14 There are four performance obligations: (1) software license, (2) installation services, (3) future upgrades, and (4) telephone support. The customer can benefit from the software (delivered first) because it is functional without the installation services, unspecified future upgrades, or the telephone support. The customer can benefit from the subsequent installation services, unspecified future upgrades, and telephone support together with the software, which it has already obtained. Maxey Inc. concludes that each good and service is separately identifiable because the software license, installation services, unspecified future upgrades, and telephone support are not inputs into a combined item the customer has contracted to receive. Maxey Inc. can fulfill 90

its promise to transfer each of the goods or services separately and does not provide any significant integration, modification, or customization services. Case 5-15 There are three performance obligations: (1) license to customized software, (2) future upgrades, and (3) telephone support. Maxey Inc. determines that the promise to the customer is to provide a customized software solution. The software and customization services are inputs into the combined item for which customer has contracted and, as a result, the software license and installation services are not separately identifiable and should be combined into a single performance obligation. This conclusion is further supported by the fact that Maxey Inc. is performing a significant service of integrating the licensed software with the customer’s other computer systems. The nature of the installation services also results in the software being significantly modified and customized by the service. Case 5-16 a.

Some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. This presumed direct association has been identified both as “associating cause and effect” and as “matching (expense recognition principle).” Direct cause-and-effect relationships can seldom be conclusively demonstrated, but many costs appear to be related to particular revenue and recognizing them as expenses accompanies recognition of the revenue. Generally, the expense recognition principle requires that the revenue recognized, and the expenses incurred to produce the revenue be given concurrent periodic recognition in the accounting records. Only if effort is properly related to accomplishment will the results, called earnings, have useful significance concerning the efficient utilization of business resources. Thus, applying the expense recognition principle is a recognition of the cause-and-effect relationship that exists between expense and revenue. Examples of expenses that are usually recognized by associating cause and effect are sales commissions, freight-out on merchandise sold, and cost of goods sold or services provided.

Some costs are assigned as expenses to the current accounting period because 1. Their incurrence during the period provides no discernible future benefits; 2. They are measures of assets recorded in previous periods from which no future benefits are expected or can be discerned; 3. They must be incurred each accounting year, and no build-up of expected future benefits occurs; 4. By their nature they relate to current revenues even though they cannot be directly associated with any specific revenues; 91

5. 6.

The amount of cost to be deferred can be measured only in an arbitrary manner or great uncertainty exists regarding the realization of future benefits, or both; Uncertainty exists regarding whether allocating them to current and future periods will serve any useful purpose. Thus, many costs are called “period costs” and are treated as expenses in the period incurred because they have neither a direct relationship with revenue earned nor can their occurrence be directly shown to give rise to an asset. The application of this principle of expense recognition results in charging many costs to expense in the period in which they are paid or accrued for payment. Examples of costs treated as period expenses would include officers’ salaries, advertising, research and development, and auditors’ fees.

A cost should be capitalized, that is, treated as a measure of an asset when it is expected that the asset will produce benefits in future periods. The important concept here is that the incurrence of the cost has resulted in the acquisition of an asset, a future service potential. If a cost is incurred that resulted in the acquisition of an asset from which benefits are not expected beyond the current period, the cost may be expensed as a measure of the service potential that expired in producing the current period’s revenues. Not only should the incurrence of the cost result in the acquisition of an asset from which future benefits are expected, but also the cost should be measurable with a reasonable degree of objectivity, and there should be reasonable grounds for associating it with the asset acquired. Examples of costs that should be treated as measures of assets are the costs of merchandise on hand at the end of an accounting period, costs of insurance coverage relating to future periods, and the cost of selfconstructed plant or equipment.

In the absence of a direct basis for associating asset cost with revenue and if the asset provides benefits for two or more accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner. Thus, when it is impractical, or impossible, to find a close cause-and-effect relationship between revenue and cost, this relationship is often assumed to exist. Therefore, the asset cost is allocated to the accounting periods by some method. The allocation method used should appear reasonable to an unbiased observer and should be followed consistently from period to period. Examples of systematic and rational allocation of asset cost would include depreciation of fixed assets, amortization of intangibles, and allocation of rent and insurance.

A cost should be treated as a loss when no revenue results. The matching of losses to specific revenue should not be attempted because, by definition, they are expired service potentials not related to revenue produced. That is, losses result from events that are not anticipated as necessary in the process of producing revenue.

There is no simple way of identifying a loss because ascertaining whether a cost should be a loss is often a matter of judgment. The accounting distinction between an asset, expense, loss, and prior period adjustment is not clear-cut. For example, an expense is usually voluntary, planned, and expected as necessary in the generation of revenue. But a loss is a measure of the service potential expired that is considered abnormal, unnecessary, unanticipated, and possibly nonrecurring and is usually not taken into direct consideration in planning the size of the revenue stream. Case 5-17 a.

Accounting for the penalty as a charge to the current period is justified if the penalty is considered the result of an unusual event (the assessment) occurring within the period. Installation of the air pollution control equipment should prevent the assessment of further penalties.

Accounting for the penalty as a correction of prior periods is justified if the penalty is considered a result of the business activities of prior periods, rather than a result of an event of the current and future periods. The penalty is assessed to correct damage which occurred as a result of production of prior periods and thus represents a cost of production which was omitted from the reported results of those prior periods. Further justification is provided by the fact that determination of the amount of the penalty was presumably made by someone other than management (the Pollution Control Agency) and could not be reasonably estimated before determination. A prior period adjustment should be reported as an adjustment of the current year’s beginning balance of retained earnings, as previously reported. If statements of prior periods are presented, they should be restated to include the portion of the penalty allocable to each period, with appropriate adjustments to other items affected, such as retained earnings, liabilities, and earnings per share. Accounting for the penalty as a capitalizable item to be amortized over future periods is justified if the penalty is viewed as a payment made to benefit future periods. If the penalty is not paid, Global Warming Company will not be allowed to operate in future periods; thus, the penalty is similar to a license to do business. Since the amortized expense will recur from period to period, it should be included in income from continuing operations. Amortization should be computed in a rational and systematic manner.

Financial Analysis Case a.

The students’ answers will vary depending on the company selected. To assess their company’s quality of earnings, they should use the eight techniques outlined in the chapter

Answers will vary 93

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CHAPTER 6

Case 6-1 a.

The basic markets available to Warmen Brothers are (1) domestic screening, (2) foreign screening, (3) video rentals, (4) cable broadcasting (5) network television stations and (6) independent television stations.

The entry order should be as specified in Part a because any other order would jeopardize the maximization of revenue from each source. For example, if a film were sold to independent television stations prior to distribution to cable and network stations, the viewership levels of cable and network stations would decrease.

Revenues should be recognized from each market as they are earned according to the guidelines outlined in FASB ASC 606.

The matching of costs with revenues for the motion picture industry is a difficult process. The amount of revenue available from secondary markets is highly dependent upon the success of the film in the domestic screening market. Consequently, holding production costs to match against secondary markets may result in distorted net income figures. Additionally, many top film stars contracts are based upon a percentage of total profits. A conservative method of recognizing costs is to charge all production costs against domestic and foreign screenings, and to charge other secondary markets only incremental costs. This is somewhat similar to the sunk cost method of income recognition. Although this method is generally not appropriate for most situations, the highly speculative nature of the secondary film markets make it an acceptable practice. During the past several years some film making companies have experienced bankruptcy partially due to faulty revenue recognition methods. Attempting to allocate production costs across all of the secondary markets will require estimates of the total revenues to be received from each of those markets prior to the distribution of the film. This is a very risky process and could lead to distorted financial statements

Recognizing all production costs in the period of domestic and foreign screenings will result in conservative income figures until the secondary market revenues are realized. This procedure might also be criticized as distorting future net income amounts because all production costs have been recognized prior to the recognition of some 94

revenues. Never-the-less, holding production cost and matching them with secondary market revenues is a less favorable option. Note to the instructor: This solution may, or may not, be chosen by the students. It is a good example of a situation needing critical thinking skills where no clear-cut solution is available. The development of the issues is of more importance than the final decision. Case 6-2 The company’s primary financial statements provide information about the earnings of a company and its present cash flows. The primary financial statements also provide information about financial position, including assets and debt, and can use this information to evaluate risk, such as liquidity risk. Investors can use this information to project the amount and timing of future cash flows. These projections are then used to value the company. Hence, the primary financial statements meet the objectives of financial reporting found in SFAS No. 8. According to SFAS No. 8 financial statements provide information useful for investors, creditors and other users. They provide information useful in projecting the amount and timing of future cash flows. They provide information about resources and claims to resources (provided by balance sheet.) They provide information about how those resources are used and about company performance.

Case 6-3 a.

The important distinction between revenues and gains and expenses and losses is whether or not they are associated with ongoing operations. Over the years, this distinction has generated questions concerning the nature of income reporting desired by various financial-statement users. Historically, two viewpoints have dominated this dialogue and have been termed the current operating performance concept and the allinclusive concept of income reporting. The proponents of the current operating performance concept base their arguments on the belief that normal and recurring items should constitute the principal measure of enterprise performance. That is, net income should reflect the day-to-day, profitdirected activities of the enterprise, and the inclusion of other items of profit or loss distort the meaning of the term net income. On the other hand, the advocates of the all-inclusive view believe that net income should reflect all items that affected the net increase or decrease in stockholders’ equity during the period, with the exception of capital transactions. Specifically, these 95

individuals believe that the total net income for the life of an enterprise should be determinable by summing the periods’ net income figures. The underlying assumption behind this controversy is that the method of presentation of financial information is important. That is both viewpoints agree on the information to be presented but disagree on where to disclose different types of revenues, expenses, gains, and losses. b.

Cost of goods sold is considered an expense under both the current operating performance and all-inclusive concepts of income.

ii. Selling expenses are considered expenses under both the current operating performance and all-inclusive concepts. iii. Prior period adjustments are considered gains and losses under a strict interpretation of the current operating performance concept. However, they have been defined as nonowner changes in equity under Statement of Financial Accounting Concepts No.5. Prior period adjustments are considered revenues and expenses under a strict interpretation of the all-inclusive concept. Case 6-4 a.

A change from the sum-of-the-years-digits depreciation method to the straight-line method for fixed assets is a change in accounting principle. The concept of consistency presumes that an accounting principle, once adopted, should not be changed in accounting for events and transactions of a similar type. A change is permissible only if the enterprise justifies the preferability of an alternative acceptable accounting principle. Under the provisions of FASB ASC 250, this accounting change requires retrospective application to prior periods as if it had always been used.

If a public company obtained additional information about the service lives of some of its fixed assets showing that the service lives previously used should be shortened, such a change would be a change in accounting estimate. The change in accounting estimate should be accounted for in the year of change and future years since the change affects both. Specifically, the operating item, depreciation expense, would be increased. In addition, the effect on net income, and related per-share amounts of the current period should be disclosed.

Changing specific subsidiaries comprising the group of companies for which consolidated financial statements are presented is an example of a change in the reporting entity. Such a change requires that the consolidated income statements be restated to reflect the different reporting entity. 96

Case 6-5 a.

Earnings per share, as it applies to a corporation with a capitalization structure composed of only one class of common stock, is the amount of earnings applicable to each share of common stock outstanding during the period for which the earnings are reported. The computation of earnings per share should be based on a weighted average of the number of shares outstanding during the period with retroactive recognition given to stock splits or reverse splits and to stock dividends, except relatively small nonrecurring stock dividends may be ignored.

Meanings of terms often used in discussing earnings per share and the types of items to which they apply follow:

Senior securities are securities which have preference to before earnings are allocated to common stock. Cumulative preferred dividends whether or not earned should be deducted from net income except "if earned" dividends should be deducted only to the extent earned. Preferred stock is a senior security if it has a preference on dividends. Bonds are a senior security and interest expense on the bonds enters into the determination of net income.

For purposes of computing earnings per share residual securities are those securities deriving a major portion of their value from their right to be converted into common stock through the exercise of an option or conversion privilege by the owner of the security. Convertible preferred stock, convertible debt, common stock options and common stock warrants are examples of such securities.

Treatments to be given to the listed items in computing earnings per share are: i.

Dividends on preferred stock should be deducted from net income before computing earnings per share applicable to the common stock and other residual securities. If the preferred stock is cumulative this adjustment is appropriate whether or not the amounts of the dividends are declared or earned.

ii.

Minor reacquisitions of outstanding common stock which are placed in the treasury may be excluded in the computation of earnings per share. However, in determining earnings per share during the period when a major acquisition of treasury common stock was made, the computation should be based on the weighted average number of shares outstanding during the period.

iii.

When the number of common shares outstanding increases as a result of a stock split during the year, the computation should be based on shares outstanding at year end and retroactive recognition should be given for an appropriate number of prior years.

iv.

The existence of a provision for a contingent liability on a possible lawsuit created out of retained earnings will not affect the computation of earnings per share since the appropriation of retained earnings does not affect net income or the number of shares of stock outstanding.

Outstanding preferred stock with a par value liquidation right issued at a premium, although affecting the determination of book value, will not affect the computation of earnings per share for common stock except with respect to the dividends as discussed in c.i. above.

vi.

The exercise of a common stock option which results only in a minor increase in the number of shares outstanding during the period may be disregarded in the computation of earnings per share. If, however, the exercise of a common stock option results in a major increase in the number of shares outstanding, the computation of earnings per share should be based on the weighted average number of shares outstanding during the period. The exercise of a stock option by the grantee does not affect earnings, but any compensation to the officers from the granting of the options would reduce net income and earnings per share.

vii.

The replacement of a machine immediately prior to the close of the current fiscal year will not affect the computation of earnings per share for the year in which the machine is replaced. The number of shares remains unchanged and since the old machine was sold for its book value, earnings are unaffected

Case 6-6 a.

The term accounting change means a change in (1) an accounting principle, (2) an accounting estimate or (3) the reporting entity. A change in accounting principle results from adoption of a generally accepted accounting principle different from the one used previously fry reporting purposes. The term accounting principle includes not only accounting principles and practices but also the methods of applying them. A characteristic of a change in accounting principle is that it concerns a choice from among two or more generally accepted accounting principles. But neither (1) 98

initial adoption of an accounting principle in recognition of events or transactions occurring for the first time or that previously were immaterial in their effect nor (2) adoption or modification of an accounting principle necessitated by transactions or events that are clearly different in substance from those previously occurring is a change in accounting principle. Changes in accounting principle are numerous and varied. They include, for example, a change in the method of inventory pricing, such as from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method; a change in depreciation method for previously recorded assets, such as from the doubledeclining balance method to the straight-line method (other than a change to the straight-line method at a specific point in the service life of an asset that was planned at the time the accelerated method was adopted to fully depreciate the cost of the asset over its estimated life); and a change in the method of accounting for long-term construction-type contracts, such as from the completed contract method to the percentage-of-completion method. Changes in accounting estimates are necessary consequences of periodic presentations of financial statements. Preparing financial statements requires estimating the effects of future events. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, warranty costs, periods benefited by a deferred cost and recoverable mineral reserves. Future events and their effects cannot be perceived with certainty; estimating requires the exercise of judgment. Thus, accounting estimates change as new events occur, as more experience is acquired, or as additional information is obtained. Distinguishing between a change in accounting principle and a change in an accounting estimate sometimes is difficult. For example, a company may change from deferring and amortizing cost to recording it as an expense when incurred because future benefits from the cost have become doubtful. The new accounting method is adopted, therefore, in partial or complete recognition of the change in estimated future benefits. The effect of the change in accounting principle is inseparable from the effect of the change in accounting estimate. Changes of this type often are related to the continuing process of obtaining additional information and revising estimates and are therefore considered as changes in estimates. Changes in the reporting entity are limited mainly to (1) presenting consolidated or combined statements in place of statements of individual companies, (2) changing specific subsidiaries comprising the group of companies for which consolidated financial statements are presented and (3) changing the companies 99

included in combined financial statements. A different group of companies comprises the reporting entity after each change. ii. A correction of an error in previously issued financial statements concerns factors similar to those relating to an accounting change. Errors in financial statements result from mathematical mistakes, mistakes in the application of accounting principles or oversight or misuse of facts that existed at the time the financial statements were prepared. In contrast a change in accounting estimate results from new information or subsequent developments and accordingly from better insight or improved judgment. Thus an error is distinguishable from a change in estimate. A change from an accounting principle that is not generally accepted to one that is generally accepted to one that is generally accepted is considered to be a correction of an error. b.

There is a presumption that an accounting principle once adopted should not be changed in accounting for events and transactions of a similar type. Consistent use of accounting principles from one accounting period to another enhances the utility of financial statements to users by facilitating analysis and understanding of comparative accounting data. The presumption that an entity should not change an accounting principle may be overcome only if the enterprise justifies the use of an alternative acceptable accounting principle on the basis that it is preferable. But a method of accounting that was previously adopted for a type of transaction or event that is being terminated or that was a single, nonrecurring event in the past should not be changed. For example, the method of accounting should not be changed for a tax or tax credit that is being discontinued or for preoperating costs relating to a specific plant. But this does not imply that a change in the estimated period to be benefited for a deferred cost (if justified by the facts) should not be recognized as a change in accounting estimate. The issuance of an Accounting Standards Update by the FASB that creates a new accounting principle that expresses a preference for an accounting principle is sufficient support for a change in accounting principle. The burden of justifying other change rests with the entity proposing the change. The nature of and justification for a change in the method of inventory pricing should be disclosed in the financial statements for the period the change was adopted; the change should be justified on the basis that the new method is more appropriate than the old. In addition, the effect of the change on net income and the related per share amounts should be disclosed for all periods presented. This disclosure may be on the face of the income statement or in the notes. Financial statements of subsequent periods need not repeat the disclosures.

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In one specific situation the application of these provisions may result in financial statement presentations of results of operations that are not of maximum usefulness to intended users. For example, a company owned by a few individuals may decide to change from one acceptable inventory method to another in connection with a forthcoming public offering of shares of its equity securities. The potential investors may be better served by the statements of income for a period of years reflecting the use of the newly adopted accounting principle because it will be the same as that expected to be used in future periods. In recognition of this situation, financial statements for all prior periods presented may be restated retroactively when a company first issues its financial statements for any one of the following purposes: (1) obtaining additional capital from investors, (2) effecting a business combination or (3) registering securities. This exemption is available only once for changes made at the time a company's financial statements are first used for any of the purposes and is not available to companies whose securities currently are widely held. Under these specific circumstances the company should disclose in financial statements issued the nature of the change in accounting principle and the justification for it. c & d. The general conclusion of APB Opinion No. 20 was that previously issued financial statements need not be revised for changes in accounting principles. However, the FASB revisited this issue and in May 2005 issued SFAS No. 154, “Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3,” now contained at FASB ASC 250-10. This pronouncement required retrospective application to prior periods’ financial statements of changes in accounting principles. Retrospective application is defined at FASB ASC 250-10-20 as: “The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years.” When it is impracticable to determine the period-specific effects of an accounting change on one or more prior periods presented, or the cumulative effect FASBASC 250-10, requires that the new accounting principle be applied to the balances of the appropriate assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period rather than being reported in an income statement. Finally, FASB ASC 250-10 requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate (discussed below) effected by a change in accounting principle. 101

Case 6-7 Situation 1 a. A change in the depreciable lives of fixed assets is a change in accounting estimate. b. In accordance with generally accepted accounting principles, the change in estimate should be reflected in the current period and in future periods. c. This change in accounting estimate will affect the statement of financial position in that the accumulated depreciation in the current and future years will increase at a different rate than previously reported, and this will also be reflected in depreciation expense in the earnings statement in the current and future years. d. A footnote should disclose the effect of the change in accounting estimate on net income and related per-share amounts for the current period. Situation 2 a. The change from reporting the investment in Allen using the cost method to using a consolidated financial statement basis is a change in reporting entity. The change in reporting entity is actually a change in accounting principle, but the APB Opinion No. 20 excluded this change from the general category to give it special reporting procedures. b. A change in reporting entity is effected and disclosed by restating all prior-period financial statements in accordance with the method of presenting the current financial statements of the new reporting entity. In the initial set of financial statements occurring after the change, the nature of and reason for the change must be disclosed by footnote, but subsequent financial statements need not repeat the disclosures. c. The statement of financial position will be affected by this change in that the investment account of the parent and the equity section of the subsidiary will be eliminated, intercompany accounts will be eliminated, and a goodwill account as well as a minority interest account may arise. The income statement will be affected in that intercompany transactions will be eliminated and a minority interest in earnings will be shown. Also, if goodwill has been created, the income statement may disclose an expense for goodwill impairment. d. The financial statements of the period of the change in the reporting entity should describe by footnote disclosure the nature of the change and the reason for it. In addition, the effect of the change in net earnings, and related per-share amounts 102

should be disclosed for all periods presented. Financial statements of subsequent periods need not repeat the disclosures. Situation 3 a. The change in the method of computing depreciation for all fixed assets (previously recorded and future acquisitions) represents a change in an accounting estimate. b. Accordingly, the effect of the change should be reflected in the current-year future financial statements. c. As a result of the change to straight line, current and future depreciation charges will differ from what they might have been under the accelerated method, the direction of this difference will depend on the life of the individual assets. d. The nature of and justification for the change should also be disclosed in the footnotes to the financial statements. Case 6-8 a.

Morgan should recognize the change in depreciation method as a change in accounting estimate

The effects of the hailstorm should be reported as a separate item of continuing operations in the income statement according to the provisions of ASU 2015-01 because it is unusual in nature and infrequent in occurrence, taking into account the environment in which the entity operates.

Case 6-9 a.

Under the current operating performance concept of income, only changes and events under the control of management that result from current period decisions should be included in income. Normal and recurring items should constitute the basis for evaluating current period performance.

Earnings as defined under SFAC No. 5 reflect the current operating performance concept because it excludes cumulative effects of changes in accounting principles. These effects are the accumulation of differences in earnings of prior periods that would have occurred had the new method been used in the past rather than the old one. Because cumulative effects relate to the past, they are not relevant in assessing current operating performance and as such should be excluded from the current period measurement of income.

Under the all-inclusive concept of income, net income would reflect all items that affected the net increase or decrease in equity (net assets) during the accounting period, 103

with the exception of capital transactions (investments by owners and distributions to owners). d.

The definition of comprehensive income is that it is the change in net assets occurring during the accounting period from non-owner sources. Since it would therefore include the effects of all items that affected the net increase or decrease in equity during the accounting period exclusive of transactions with owners, this definition essentially reflects the all-inclusive concept of income.

Under the financial capital maintenance concept of income, income is the change in the recorded (monetary) values of net assets occurring during the accounting period which do not result from investments by owners or distributions to owners. These changes would include recorded changes due to changes in price level (holding gains and losses) as well as changes due to the cumulative effect of accounting changes. Hence, comprehensive income, which purports to measure these changes in net assets relies upon the financial capital maintenance concept and hence is consistent with it.

For financial reporting practices to be consistent with the concept of physical capital maintenance, assets would need to be measured at current replacement values and holding gains and losses would be removed from the income statement and treated as equity adjustments. Current practice for recording net assets is slowly evolving in this direction. For example, investments in equity securities with readily determinable fair values and investments in debt instruments are reported at fair value, a current value measure. Moreover, the gains and losses resulting from revaluing investments in securities that are classified as available for sale are excluded from net income and treated as adjustments to equity. Accounting for impaired loans and impaired fixed assets also results in the recording of fair value when impairment occurs.

FASB ASC 6-1 Comprehensive Income Reporting Comprehensive Income is contained in sections FASB ASC 220-10-45. It is found by searching comprehensive income or by cross referencing SFAS No. 130.

FASB ASC 6-2 Net Income Found by searching net income 205-10 and 220-10 FASB ASC 6-3 APB Opinion No. 9 Found by cross reference to APB No. 9. 104

225-10-05-05 FASB ASC 6-4 Discontinued Operations Search discontinued operations. 205-20 FASB ASC 6-5 Accounting Changes Search accounting changes 250-10 FASB ASC 6-6 Earnings Per Share Search earnings per share 260-10 Room for Debate Debate 6-1 Comprehensive Income Team 1 Defend comprehensive income 1.

Comprehensive income is the change in net assets during the period, excluding transactions with owners. Thus, it is consistent with the all-inclusive concept of income and provides income measures which are closer to economic (real) income than is provided by net income, and with the financial capital maintenance concept of income. In 1936, the AAA stated that income should reflect all revenue properly given accounting recognition and all costs written off during the accounting period regardless of whether or not they are the results of operations in that period. Such inclusion is needed to determine those amounts that are available for distribution to stockholders. It thus provides an appropriate measure of the change in wealth (income) of the enterprise and the change in wealth provided by the enterprise to its owners.

Comprehensive income would include changes due to price level, holding gains, which under GAAP are excluded from net income. These changes provide information on 105

the effectiveness of the company’s investment strategies and the changes in wealth resulting from those strategies. 3.

Comprehensive income includes the effects of all non-owner changes that previously were reported as separate adjustment to equity. Their inclusion in comprehensive income is preferable because these are non-owner changes, and hence affect owner’s wealth during the accounting period. As such they affect enterprise performance during the period are properly included as components of income.

Comprehensive income is consistent with the concept of financial capital maintenance because it includes all reported items that affect net assets during the accounting period. It does not strictly follow historical cost, but it does include holding gains and losses in the computation of income.

Team 2 Oppose comprehensive income 1.

Comprehensive income should not be reported because it is not consistent with the current-operating performance concept of income and it represents a departure from the realization principle

For the most part, net income includes the results of transactions and events on the performance of the company for the period. It is historical in nature and provides accounting information which is relevant, objective and reliable. It provides information to investors on how their monetary investments were used to generate dollars for the enterprise and to increase investor wealth.

Because net income is primarily based on the current-operating concept of income, it provides predictive ability regarding future performance of the company. It shows the amount of revenues realized or realizable during the accounting period. These amounts can be extrapolated into the future. It shows the expenses associated with generating those revenues. These too can be extrapolated.

Comprehensive income includes items which do not have predictive ability. It includes the effects of price level adjustments and foreign currency translation adjustments. Including holding gains and losses obscures the measure of income available for distribution to stockholders. Holding gains have not been realized and are not yet available for distribution. Foreign currency translation adjustments are bookkeeping “plugs” that result from using the average exchange rate for income statement adjustments and the current rate for balance sheet adjustments. They are not realized and do not affect the amount of dollars that are currently.

Debate 6-2 Income Concepts 106

Comprehensive Income Issues about income reporting have been characterized broadly in terms of a contrast between the current operating performance and the all-inclusive income concepts. Although the FASB generally has followed the all-inclusive income concept, as introduced in Chapter 5, it has made some specific exceptions to that concept. Several accounting standards require that certain items that qualify as components of comprehensive income bypass the income statement. Other components are required to be disclosed in the notes. The rationale for this treatment is that the earnings process is incomplete. Examples of items currently not disclosed on the traditional income statement and reported elsewhere are unrealized gains and losses on available for sale securities and certain foreign currency gains and losses. Current operating performance concept (COPC): The application of this concept is one of the two main approaches to measuring earnings. The concept is explained in International Accounting Standard No.8, “Unusual and Prior Period Items and Changes in Accounting Policy”. When earnings are measured on the basis of this concept, such earnings consist of income from normal enterprise operations before non-recurring items (such as write-offs) and capital gains and losses are accounted for. This latter concept would require the income statement to be designed on what might be called a ‘current operating performance’ basis, because its chief purpose is to aid those primarily interested in what a company was able to earn under the operating conditions of the period covered by the statement.” Team 1 As advocates of the all-inclusive concept of income (sometimes called clean surplus), we hold that net income should reflect all items that affected the net increase or decrease in stockholders’ equity during the period, with the exception of capital transactions. We believe that the total net income for the life of an enterprise should be determinable by summing the periodic net income figures. We advocate the all-inclusive income statement because we feel that it is more transparent to have everything clearly disclosed in the income statement, and that to put items directly into retained earnings does not meet the criterion of full disclosure. Further, we believe that the all-inclusive concept of income aids in the avoidance of biased reporting, where management might be able to pick and choose what to report in the income statement. The FASB noted in SFAC No. 5 that the all-inclusive income statement is intended to avoid discretionary omissions from the income statement, even though “inclusion of unusual or non-recurring gains or losses might reduce the usefulness of an income 107

statement for one year for predictive purposes.” The FASB has also stated that because the effects of an entity’s activities vary in terms of stability, risks, and predictability, there is a need for information about the various components of income. Consistent with the above, the FASB now requires that companies report Comprehensive income – the change in net assets that do not result from transactions with owners. Comprehensive income includes earnings (net income) plus all other changes in net assets from non-owner events or transactions. For example, translation adjustments and changes in the value of investments in available-for-sale securities are not included in net income but are included in comprehensive income. Team 2 Members of our team are proponents of the current operating performance concept of income. We base our arguments on the belief that only changes and events controllable by management that result from current-period decisions should be included in income. This concept implies that normal and recurring items should constitute the principal measure of enterprise performance. That is, net income should reflect the day-to-day, profit-directed activities of the enterprise, and the inclusion of other items of profit or loss distorts the meaning of the term net income. We believe that income statements that report only the current operating performance of the company provide an appropriate basis for comparing one firm with another and for comparing what a company does from one year to the next. A purpose of financial reports is to provide users with a means of predicting future cash flows. If so, a current operating performance measure of income is more relevant for decision-making. It would not include non-recurring items. So, it could be more readily relied upon as a basis for prediction. This helps fulfill the concept of relevance because it would provide predictive and feedback value. WWW Case 6-10 The company’s primary financial statements provide information about the earnings of a company and its present cash flows. The primary financial statements also provide information about financial position, including assets and debt, and can use this information to evaluate risk, such as liquidity risk. Investors can use this information to project the amount and timing of future cash flows. These projections are then used to value the company. Hence, the primary financial statements meet the objectives of financial reporting found in SFAS No. 8. According to SFAS No. 8 financial statements provide information useful for investors, creditors and other users. They provide 108

information useful in projecting the amount and timing of future cash flows. They provide information about resources and claims to resources (provided by balance sheet.) They provide information about how those resources are used and about company performance. Case 6-11 1.

3. 4. 5. 6. 7. 8. 9.

No disclosure is required. The error has “washed out”; that is, subsequent income statement compensated for the error. However, prior year income statements should be restated. Should be reported as depreciation expense in body of income statement, based on the new useful life. Changes in the estimated useful life of assets are changes in estimates that are reported in the current and future periods. No separate disclosure is generally required. This is a change in estimate that is considered part of normal business activity. Report in the body of the income statement, possibly as an unusual item. Adjustment to the beginning balance of retained earnings. A change in inventory methods is a change in accounting principle and prior periods are adjusted. Report in body of the income statement, possibly as an unusual item. Report in body of the income statement, possibly as an unusual item. Prior period adjustment adjust beginning retained earnings. Corrections of errors are shown as prior period adjustments. Discontinued operations. The division’s assets, results of operations, and activities are distinguishable physically, operationally, and for financial reporting purposes.

Case 6-12 1.

The usual but infrequently occurring charge of $8,500,000 should be disclosed separately, assuming it is material. This charge is shown above income before income tax and would not be reported net of tax. This item should be separately disclosed to inform the users of the financial statements that this item is nonrecurring and therefore may not impact next year’s results. The loss on sale of equipment of $6,000,000 should be reported as an "Other expense or loss", included in income from operations. It should not be reported net of tax. As with the first item, if material, it should be separately reported. The adjustment required for correction of an error is inappropriately labeled and also should not be reported in the retained earnings statement. Changes in estimate should be handled in current and future periods through the income statement. Catch-up adjustments are not permitted. To restate financial statements every time a change in estimate occurred would be extremely costly. In addition, adjusting the beginning balance of retained earnings is inappropriate as the increased charge in this case affects current and future income statements.

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Earnings per share should be reported on the face of the income statement and not in the notes to the financial statements. Because such importance is ascribed to this statistic, the profession believes it necessary to highlight the earnings per share figure.

Case 6-13 No, these sales would not be reported as discontinued operations after income from continuing operations. A discontinued operation occurs when two things happen: (1) A company eliminates the results of operations of a component or group of components of the business. A component comprises operations and cash flows that can be clearly distinguished operationally and for financial reporting purposes. (2) The elimination represents a strategic shift, having a major effect on the company’s operations and financial results. Case 6-14 Some situations in which application of different accounting methods or estimates lead to comparison problems include: Inventory methods—LIFO vs. FIFO, Depreciation Methods—straight-line vs. accelerated, Estimates of useful lives or salvage values for depreciable assets, Estimates of bad debts, Estimates of warranty costs Case 6-15 IAS No. 8 indicates that in making that judgment, the following sources should be considered in descending order: •

The requirements and guidance in IASB standards and interpretations dealing with similar and related issues; and

•

The definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework for the Presentation of Financial Statements.

•

The most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards.

•

Other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in paragraph.

Case 6-16 a.

The objective of IAS 1 is to prescribe the basis for presentation of general-purpose financial statements, to ensure comparability both with the entity’s financial statements of previous periods and with the financial statements of other entities. 110

IAS No. 1 indicates that a complete set of financial statements should include a statement of comprehensive income for the period (or an income statement and a statement of comprehensive income). An entity has the choice of presenting a single statement of comprehensive income or two statements: an income statement displaying components of profit or loss and a statement of comprehensive income that begins with profit or loss and displays components of other comprehensive income. It requires that as a minimum, the statement of comprehensive income include line items that present the following amounts for the period: revenue, finance costs, share of the profit or loss of associates and joint ventures accounted for using the equity method, tax expense, a single amount comprising the total of the post-tax profit or loss of discontinued operations, and the post-tax gain or loss recognized on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation, profit or loss, each component of other comprehensive income classified by nature, share of the other comprehensive income of associates and joint ventures accounted for using the equity method, and total comprehensive income.

Case 6-17 The solution to this case depends upon the companies selected. Requiring the students to print the relevant information from the financial statements is a good method to use to check their answers. Case 6-18 . The answer to this case depends on the companies selected by the students. Financial Analysis Case Solution will depend on the companies selected to analyze.

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CHAPTER 7 Case 7-1 a.& b. The weaknesses in the Statement of Financial Position for Linus Construction Company and preferable accounting treatments are: 1. Materials, supplies, labor and overhead charged to construction. The balance of this work in progress inventory account includes actual costs incurred to date (per entry a) plus accrued profits (per entry b) while accounts receivable are carried at cost until a job is completed. Thus the Company is reflecting a balance in this inventory account which might be proper under the percentage-of-completion method. At the same time it reports a substantial balance under Deferred Liabilities in the account, Unearned Revenue on Work in Progress. Clearly, a hybrid accounting procedure is in use which should be explained by a footnote, or the statement should be modified to reflect the completed contract method. If the balance in the Unearned Revenue on Work in Progress account is retained, the portion reflecting anticipated profits should be reclassified and presented as a contra account to Materials, Supplies, Labor and Overhead Charged to Construction. The reductions in the Accounts Receivable account for collections from customers might be classified as an advance and given an appropriate title. 2. Materials and supplies not charged to construction. The basis of valuation of this inventory account (e.g., cost and how arrived at) should be disclosed. 3. Deposits made to secure performance of contracts. Since the first item of additional data suggests that the firm's operating cycle is 18 months, this account appears to be properly classified. Only to the extent that these deposits are not available for meeting obligations properly classified as current should this amount be reported under some noncurrent asset category, such as Other Assets or Investments and Funds. 4. Depreciation and value. Use of these terms in the Property, Plant and Equipment caption is not ideal. "Less accumulated depreciation" or "less depreciation recorded to date" would be more suitable. Substitution of "book value" or "carrying value" for "value" would be desirable since the word "value" standing at the head of the column alone may connote that the amounts shown are current or realizable values. 112

5. Land and buildings should not be presented as a single lump-sum item; the cost of each asset may be significant and only the buildings are subject to depreciation. 6. Payments made on leased equipment. The explanation given indicates that this is an unusual item; thus a note or footnote presenting the initial facts should be incorporated in the statement. The descriptive item and $230,700 amount (or perhaps 70% thereof) should be reported under Other Assets since the assets to which the payments pertain have not been purchased as of the date of the statement. The $1 nominal carrying value is improper and the $230,699 should be eliminated from the statement. Because your client should use a completed-contract basis and because the normal operating cycle probably is around 18 months rather than the usual 12 months, it seems appropriate to classify the $230,700 (or 70% thereof) as an asset rather than as an expense. Under the matching concept, it is not necessary to know the amount of the expense until the amount of the revenue is known, which will be upon completion of a contract. At that time, the client makes a decision concerning the purchase of equipment. If the equipment is not purchased, the total lease rental payments are expensed. If purchased, the purchase price is recorded as an asset and the appropriate depreciation expense is recognized. 7. Prepaid taxes and other expenses were once properly reported as a deferred charge and the practice has not wholly disappeared. A preferred classification would be Current Assets. 8. Points charged on a mortgage note are in reality a discount which raises the effective interest rate on the note. Such discounts should be accounted for in the same manner as discounts on bonds payable and preferably are shown as contra items under liabilities. 9. Deferred liabilities is apparently a substitute for terminology such as Long-Term Liabilities; use of the latter is preferable. 10. Mortgage note payable. Both the interest rate and maturity date should be shown. The security for the note should also be disclosed. 11. Unearned revenue on work in progress. As noted under number 1 above, the portion representing anticipated profits should either be reported in a contra account to Materials, Supplies, Labor and Overhead Charged to Construction or be eliminated from the statement. The balance of this account may be reclassified as Partial Billings on Construction in Progress. 12. 6% preferred stock at par value is inadequately presented. No indication is given as to the number of shares authorized or issued or as to the way(s) in which the 113

stock is preferred. Similarly, details as to dividends, such as participation, cumulation and arrearages have been omitted. 13. Common stock at par value does not indicate the number of shares authorized and issued; these details should be reported. 14. Paid-in surplus is now regarded as obsolete terminology; "capital contributed in excess of par" or "premium on capital stock" would be more suitable titles. Further, there is no indication as to whether all of the balance relates to preferred stock, to common, or both. 15. Treasury stock at cost-370 shares should identify the class or classes of shares represented. A possible question which arises in connection with such stock is whether there also should be an appropriation of retained earnings. Laws of some states make such an appropriation mandatory; discretionary appropriation is a possibility in other jurisdictions. Case 7-2 a.

The determination of current values for: Investments Land Buildings Equipment Patents Copyrights Trademarks Franchises -

Current quotes for stocks and bonds. Current market values or appraisal values. Current market values or appraisal values Current selling prices and/or appraisal values. Appraisal values or current selling price. Appraisal values or current selling price. Appraisal values or current selling price. Current selling price.

The use of current values might cause earnings volatility because of fluctuations in the values of assets from year-to-year. That is, the value of various asset might change thereby causing an increase or decrease in earnings that had nothing to do with the sale of the company's products or services. Such volatility could make investment and credit decisions much more difficult.

Current cost data could be manipulated for example by selecting the most optimistic appraisers to value assets without a determinable market price. SFAS 157 does not require any new fair value measurements rather it is applicable under other accounting pronouncements that require or permit fair value measurements such as, Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS 115 is applicable to the valuation of 114

securities. That is, SFAS 115 requires companies to use fair value to price investments on their balance sheets and 157 outlines the procedures they are to use to determine that fair value. d.

SFAS 157 does not require any new fair value measurements rather it is applicable under other accounting pronouncements that require or permit fair value measurements such as, Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS 115 is applicable to the valuation of securities. That is, SFAS 115 requires companies to use fair value to price investments on their balance sheets and 157 outlines the procedures they are to use to determine that fair value.

Case 7-3 The answers to this question are dependent upon the company selected. The students should be able to easily address each part of this question and reference the section(s) of the statement of cash flows containing the proper information. Case 7-4 A variety of measurement techniques are used to disclose the value of assets and liabilities on the balance sheet. For example, on the asset side, cash is measured at its current value, accounts receivable may be measured at expected net realizable value, marketable securities are measured at market value, inventories are measured at the lower of cost or market, investments are measured at market value, and plant and equipment and intangibles are measured at their unamortized cost. As with assets, liabilities are also measured by a number of different techniques. Most current liabilities are measured by the amount of resources is will take to cancel the obligation without considering the time value of money; whereas, long-term liabilities are frequently measured by the present value of future payments discounted at date of issue yield rate. Case 7-5 a.

The cash inflows and outflows of a business are of primary importance to investors and creditors. The presentation of cash flow information by a business enterprise should enable investors to (1) predict the amount of cash that is likely to be distributed as dividends or interest in the future and (2) evaluate the potential risk of a given investment.

The presentation of cash flow data is necessary to evaluate a firm's liquidity, solvency and financial flexibility. Liquidity is the firm's ability to convert an asset to cash or to pay a current liability. It is referred to as the "nearness to cash" of an 115

entity's economic resources and obligations. Liquidity information is important to users in evaluating the timing of future cash flows; it is also necessary to evaluate solvency and financial flexibility. ii.

Solvency refers to a firm's ability to obtain cash for business operations. Specifically, it refers to a firm's ability to pay its debts as they become due. Solvency is necessary for a firm to be considered a "going concern." Insolvency may result in liquidation and losses to owners and creditors. Additionally, the threat of insolvency may cause the capital markets to react by increasing the cost of capital in the future; that is, the amount of risk is increased.

iii. Financial flexibility is the ability of a firm to use its financial resources to adapt to change. It is the ability of a firm to take advantage of new investment opportunities or to react quickly to a crisis situation. Financial flexibility comes in part to quick access to the company's liquid assets. However, liquidity is only one part of financial flexibility. Financial flexibility also stems from a firm's ability to generate cash from its operations, contributed capital or the sale of economic resources without disrupting continuing operations. Case 7-6 a.

There is no one correct answer to this question. It is intended to make the students think about the relative importance of the individual financial statements. One could argue that both the income statement and the balance sheet are important, but serve different purposes. The balance sheet is intended to report on the status of economic resources and claims to those resources. If those values are measured directly, rather than as income statement residuals, then they should be more meaningful to decision makers. Because the financial statements are articulated, income statement measures are become residuals. Perhaps financial statements should not be articulated.

The balance sheet is useful to investors because it describes the resources and claims to resources at a point in time. This information is considered useful to decision making in SFAC No. 8. The information helps users identify the enterprise’s strengths and weaknesses and assess its liquidity and solvency. It provides direct indications of the cash flow potentials of some resources and of the cash needed to satisfy many, if not most, of its obligations.

The statement “financial statements are articulated” means that measurements in the balance sheet are directly linked to those found in the income statement. According to SFAC No. 6, stocks (assets, liabilities and equity) are changed by flows (revenues, 116

expenses, gains & losses) and at any time are their cumulative result. For example, the value of net plant assets is decreased by the accumulation of depreciation expense. Moreover, an increase (decrease) in an asset cannot occur without a corresponding decrease (increase) in another asset [e.g., the collection of accounts receivable], or a corresponding increase (decrease) in a liability or equity. The result is financial statements that are fundamentally interrelated such that chances in the elements of one are associated with changes in the other. d.

Measurements that are currently reported in balance sheets that are consistent with the physical capital maintenance concept include investments accounted for under SFAS No. 115, impaired fixed assets, and impaired receivables. Also, inventory reported at market under the concept of lower-of-cost or market are consistent with this concept

Many values in the balance sheet are based on the historical cost principle and as such are not consistent with the physical capital maintenance concept of income. These values include inventory reported at cost, property plant and equipment reported at cost less accumulated depreciation, intangible assets reported at cost less accumulated amortization, investments in equity securities reported under the equity method of accounting, investments in debt securities reported at amortized cost, and most debt is reported using amortized cost based on historical interest rates.

Case 7-7 a.

Yes. However, this is the opinion of the authors, the student should be encouraged to express his/her own opinion. There is no one correct answer to this question. One possible solution follows: The investor needs to know what the operating assets (physical plant) of the entity is generating. Interest expense is, in my opinion a financing activity. It is the cost of borrowing not a cost of operations. The corporation could alternatively finance operations by issuing stock. The form of financing should not affect the measurement of inflows and outflows from operations. Similar arguments could be made for interest revenue and other nonoperating items.

Yes. Again, the student should be encouraged to express his/her own opinion. Investments in operating assets generate operating revenues and expenses. Investments in other assets such as stocks and bonds are associated with peripheral activities of the business. The results of investments of this sort are, in my opinion, investing activities. They are associated with cash management, an investing activity, not operations.

Yes. Again, the student should be encouraged to express his/her own opinion. 117

The gain or loss on the sale of investments generates tax payments or tax savings. These tax effects affect the net cash flow from the sale. This idea is consistent with notions of capital budgeting. In the capital budgeting context, decisions to invest are a function of expected cash flows to be generated by making the investment. The sale of the asset is disinvesting. The expected cash flow, net of taxes, determines whether the investment will take place. Since the cash flows associated with investing are considered an investing activity, it follows that the cash flows associated with disinvesting (the cash inflow from the sale as well as its tax effect) are also an investing activity. Moreover, disinvesting is not an operating activity. It does not result from, nor is it associated with, the purchase or sale of goods or services. If not, the tax effect of disinvesting is not associated with operations. Case 7-8 The format required by SFAS No. 95 for the presentation of the statement of cash flows evolved over a number of years. In 1980 the FASB issued a discussion memorandum entitled Reporting Funds Flows, Liquidity and Financial Flexibility as a part of the conceptual framework project. The major questions raised in this Discussion Memorandum included: 1. 2. 3. 4. 5.

Which concept of funds should be adopted? How should transactions not having a direct impact on funds be reported? Which of the various approaches should be used for presenting funds flow information? How should information about funds flow from operations be presented? Should funds flow information be separated into outflows for (a) maintenance of operating capacity, (b) expansion of operating capacity, and (c) nonoperating purposes?

Later in 1981, an exposure draft entitled Reporting Income, Cash Flows, and Financial Position of Business Enterprises was issued by the FASB. This exposure draft concluded that funds flow reporting should focus on cash rather than working capital. However, a final statement was not issued during this time and the FASB decided to consider the subject of cash flow reporting in connection with a study of recognition and measurement concepts. In 1984 the FASB issued SFAC No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises." Included in this statement is the conclusion that a cash flow statement should be part of a full set of financial statements. Concurrently, the Financial Executives Institute was reviewing the issue of cash flow reporting. In 1984 this organization published The Funds Statement: Structure and Use. This study pointed out several areas of diversity inherent in the Statement of Changes in Financial Position. For example, APB Opinion No. 19 allowed different definitions of funds, different definitions of cash and cash flow from operations, and different forms of presentation of the statement of changes in financial position. During 1985 and 1986, the FASB organized a task force on cash flow reporting, and issued an exposure draft that proposed standards for cash flow reporting. The FASB was concerned that 118

the divergence in practice affected the understandability and usefulness of the information presented to investors, creditors, and other users of financial statements. Additionally, some financial statement users were contending that accrual accounting had resulted in net income not reflecting the underlying cash flows of business enterprises. That is, too many arbitrary allocation procedures, such as deferred taxes and depreciation, resulted in a net income figure that was not necessarily related to the earning power of an enterprise. The primary purpose of the statement of cash flows is to provide relevant information about cash receipts and cash payments of an enterprise during a period. This purpose is consistent with the objectives and concepts delineated in SFAC Nos. 8 and 5. SFAC No. 8 stresses that financial reporting should provide information to help present and potential investors assess the amount, timing, and uncertainty of prospective cash receipts from interest, dividends, the sale of securities, and the proceeds from loans. These cash flows are seen as important because they may affect an enterprise's liquidity and solvency. SFAC No. 5 indicated that a full set of financial statements should show cash flows for the period. SFAC No. 5 also described the usefulness of cash flow reporting in assessing an entity's liquidity, financial flexibility, profitability, and risk. These objectives and concepts delineated in SFAC Nos. 8 and 5 (and previously in SFAC No. 1) led the FASB to conclude that the statement of cash flows should replace the statement of changes in financial position as a required financial statement. The statement of cash flows is intended to help investors, creditors, and others assess future cash flows, provide feedback about actual cash flows, evaluate the availability of cash for dividends and investments and the enterprise's ability to finance growth from internal sources, and identify the reasons for differences between net income and net cash flows. An additional reason for the focus on cash rather than working capital is the questionable usefulness of working capital in evaluating liquidity. That is, a positive working capital balance does not necessarily indicate liquidity and a negative working capital balance may not indicate a lack of liquidity. More information is needed on receivable and inventory financing to evaluate the overall liquidity of a business enterprise. FASB ASC 7-1 Classification of Savings Accounts by Credit Unions The answer is found at FASB ASC 942-405-55. Most easily found by searching for credit union share accounts and then using the topic search for 942-405 -55 FASB ASC 7-2 Statement of Cash Flows Link to Presentation-Statement of Cash flows Topic230. Then access printer friendly with sources 119

FASB ASC 7-3 Historical Cost Search historical cost – 29 hits FASB ASC 7-4 Current Cost Search current cost - over 300 hits FASB ASC 7-5 Fair Value Search FAS 157 in Cross Reference Found at 820 Fair Value Measurements and Disclosures FASB ASC 7-6 Statement of Cash Flows The presentation of the statement of cash flows is found at FASB ASC 230. It can be accessed through the presentation link or by searching “statement of cash flows.” The students’ answers should contain the following: FASB ASC 7-7 Development Stage Enterprises Search development stage enterprise – Topic 915 Room for Debate Debate 7-1 Usefulness of the Statement of Cash Flows versus the Income Statement Team 1

Argue that the statement of cash flows, not the income statement, is the most important financial statement.

1. Investors need information to predict the amount and timing of future cash flows and to assess risk. Net income is derived from accrual based accounting procedures and cannot measure cash flow. It is logical that prior cash flows should be useful in predicting future cash flows. 2. The statement of cash flows discloses the effects of earnings activities on cash resources, how cash was acquired and how it was spent. 3. Results of empirical research indicates that cash flow data may provide information which is has incremental information content in addition to that provided by accrual based income figures. Moreover, cash flow data is superior to working capital (an accrual based measure). Taken together this evidence indicates that cash flow data 120

provides information that it results in better decisions. Also knowledge of prior cash flows has been shown to improve predictions of future cash flows. Team 2

Present arguments that the income statement, not the statement of cash flows, is the most important financial statement.

1. SFAC No. 8 stresses the importance of the income statement by indicating that the primary focus of financial reporting is to provide information about a company’s performance provided by measures of earnings. Present and prior performance can be used to evaluate expectations about expected future performance (predictive value) and to compare actual performance with prior expectations (feedback value). According to SFAC No. 8, user interest in future cash flows necessitates that accountants provide information on current period efforts and accomplishments (earnings). Cash flow statements provide inadequate information to assess the amount and timing of future cash flows. Accrual accounting, not cash flow accounting, provide information which adequately reflects the financial effects on the enterprise of transactions and events that have cash consequences for the enterprise. Accrual accounting is concerned with the process of generating and expending cash, not the actual cash flows themselves. It recognizes that activities of a business which affect enterprise performance do not always coincide with the associated or resulting cash flow. 2. The income statement has value as a measure of future cash flows, as a measure of management efficiency in the use of enterprise resources and it provides feedback regarding the accomplishment of management objectives. 3. The income statement provides timely measurement of enterprise performance. The cash flow a subsequent accounting period. Timeliness would indicate that the expected cash flow effects of a transaction be captured in the accounting period when the transaction causing the eventual cash flow occurs. Accrual basis accounting does capture these effects. Cash basis accounting does not. A company could be in financial trouble. If it does not pay bills, it could show a positive cash flow. If so, the cash flow statement would not reveal the extent of the company’s financial difficulties. Accrual basis accounting would. Debate 7-2 Fair (Current) Value vs. Historical Cost Team 1 We believe that historical cost is relevant because it is objective and verifiable. Historical cost is not based on subjective estimations; rather it is the result of the value 121

buyers and sellers have agreed to in an "arm's-length" transaction. As a result, historical cost is more reliable than current value. You can even argue that historical cost actually represents the present value of expected future cash flows at the time the exchange takes place. We also argue that historical cost is relevant based on the financial capital maintenance concept. Financial capital maintenance tracks the dollars invested in a company and the flow of those dollars as they are invested in assets which then return cash inflows to the company. Thus, we argue that historical cost allows that accountants serve a stewardship role, and because cost measures the actual resources exchanged, it is relevant to readers of financial statements. Conversely, current values may not be available for all balance sheet elements. So, its exclusive use would result in both good and bad reported values (i.e., inconsistent measures). Current values require preparers to estimate the amounts and timing of cash flows which are inherently uncertain. And, an appropriate discount rate is difficult to ascertain. In addition, reporting current values on the balance sheet would result in recording unrealized gain and losses on the income statement. This would be a contradiction to accounting’s realization principle and the long-standing concept of conservatism. Finally, because reporting historical cost is objective, it provides unbiased information to users. The resulting financial disclosures would not allow managerial bias in the selection of current costs. They would therefore provide a greater degree of transparency in financial reporting. Team 2 We believe that historical cost may be more objective, but that current costs are more relevant. We oppose the use of historical cost in favor of current cost because values do change over time and, consequently, that historical cost can lose its relevance as a valuation base. We argue that current cost measurement reflects current conditions, and, therefore, represents the current value to the firm. Current cost provides a better measure of a company’s liquidity because all current assets would be measured reflect resources available to cover current liabilities. Current costs are related to expected future cash flows. As such their use provides an approximation of the economic concept of income, the most relevant value to the users of financial statements. Current cost is also consistent with the physical capital maintenance concept of income. It provides a measure of the value of the company’s physical capital. Use of 122

the physical capital maintenance concept allows the company to better survive in the long-run because income is reported only when there is a change in the amount of physical capital on hand. In short, we argue in favor of relevance to investors. We believe that even though current cost estimates may be subjective, they are more relevant than object, meaningless measures utilizing the historical cost concept. WWW Case 7-9 a.

Yes, the loss represents a probably future sacrifice (payment to plaintiff) of economic resources (probably cash) of an entity (the company being sued) resulting from a prior transaction or event (the event that resulted in the plaintiff filing the law suit).

Yes, the gain represents a probable future benefit (inflow of assets from plaintiff) obtained or controlled by an entity resulting from a past transaction or event (event causing the lawsuit to be filed).

The primary reason for the difference is accounting conservatism. Accountants tend to recognize probable bad news but not probable good news. They are reluctant to overstate assets and income.

Case 7-10 a. b. c. d. e. f. g. h.

Stockholders’ Equity. “Treasury stock (at cost). Note: This is a reduction of total stockholders’ equity (reported as contra-equity). Current Assets. Included in “Cash.” Long-Term Investments. “Land held as an investment.” Long-Term Investments. “Sinking fund.” Long-term debt (adjunct account to bonds payable). “Unamortized premium on bonds payable.” Intangible Assets. “Copyrights.” Investments. “Employees’ pension fund,” with sub captions of “Cash” and “Securities” if desired. (Assumes that the company still owns these assets.) Stockholders’ Equity. “Additional paid-in capital

Case 7-11 The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to enterprise creditors, and the owners’ equity in net enterprise resources. That information not only complements information about the 123

components of income, but also contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, and (3) assessing the liquidity and financial flexibility of the enterprise. Case 7-12 The major limitations of the balance sheet are: a. b.

The values stated are generally historical and not at fair value. Estimates have to be used in many instances, such as in the determination of the collectibility of receivables or finding the approximate useful life of long-term tangible and intangible assets. Many items, even though they have financial value to the business, presently are not recorded. For example, the value of a company’s human resources and internally developed goodwill.

Case 7-13 Classification in financial statements helps users by grouping items with similar characteristics and separating items with different characteristics. For example, current assets are expected to be converted to cash within one year or the operating cycle, whichever is longer—property, plant and equipment will provide cash inflows over a longer period of time. Thus, separating long-term assets from current assets facilitates computation of useful ratios such as the current ratio. Case 7-14 a.

In September 2007 the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement specifies how fair value is to be determined when such measurements are required by existing GAAP. It does not indicate when fair value measurements are to be used. The rationale for SFAS No.157 was that previous GAAP contained inconsistent definitions and only limited application guidance for fair value measurements. The most important aspects of SFAS No. 157 are: 1. A new definition of fair value. 2. A fair value hierarchy used to classify the source of information used in fair value measurements. (For example, market based, or non-market based). 3. New disclosures of assets and liabilities measured at fair value based on their level in the hierarchy. 4. A modification of the presumption that the transaction price of an asset or liability equals its initial fair value.

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SFAS No.157 is to be applied to any asset or liability that is measured at fair value under current GAAP. The statement identifies 67 current pronouncements that refer to fair value that will be impacted by its provisions. It also identifies some measurements that are not affected by its provisions including those: (1) related to share-based payments, (2) based on (or that otherwise use) vendor-specific objective evidence of fair value and (3) related to inventory. SFAS No. 157 represents the FASB’s current position on the tradeoff between reliability and relevance of financial information. It also reflects the FASB’s conclusion that investors and creditors find fair value measurement relevant, even in the absence of exact market data. As a result, the trade off now favors relevance and financial statement users will need to be made aware of the quality of the information provided through meaningful and transparent disclosures in order to assess the relative reliability of the fair value measurements provided. Definition of Fair Value SFAS No. 157 defines “fair value” as: “…the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition is exit price based. For an asset, fair value is the price at which it would be sold. In contrast, an entry price for an asset is the price at which it would be bought. The exit price is to be used regardless of whether the entity plans to hold or sell the asset. Additionally, SFAS No. 157 specifies that fair value is market based rather than entity specific. As a result, fair values must be based on assumptions that market participants would use in pricing the asset or liability. Fair Value Hierarchy SFAS No 157 establishes a hierarchy that ranks the quality and reliability of information used to determine fair values. The following exhibit provides a description of the levels in the hierarchy and examples: Hierarchy of the Quality and Reliability of Information Used to Determine Fair Values Level and Inputs Information used to determine fair value Level 1 — Quoted market prices for identical assets or liabilities in active markets

Examples Company A common stock traded and quoted on the New York Stock Exchange.

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Level 2 — Observable market-based inputs, other than Level 1 quoted prices (or unobservable inputs that are corroborated by market data)

Level 3 — Unobservable inputs (that are not corroborated by observable market data)

Company B common stock traded and quoted only on an inactive market in an emerging country. A privately placed bond of Z whose value is derived from a similar Z bond that is publicly traded. An over-the-counter interest rate swap, valued based on a model whose inputs are observable LIBOR forward interest rate curves. A long-dated commodity swap whose forward price curve, used in a valuation model, is not directly observable or correlated with observable market data. Shares of a privately held company whose value is based on projected cash flows.

If the fair value of an asset or liability is based on information from more than one level of the hierarchy, the classification of fair value depends on the lowest level input with significant effect. For example, if a particular measurement contains both Level 2 and Level 3 inputs and both have a significant effect, then the measurement falls in Level 3.

Disclosures The disclosure requirements are designed to indicate the relative reliability of fair value measurements. SFAS No. 157 requires separate disclosures of items that are measured at fair value on a recurring basis (such as an investment portfolio versus items that are measured at fair value on a nonrecurring basis such as an impaired asset). Following are the major disclosures required at each annual and interim balance sheet date: 1.

For items that are measured on a non-recurring basis at fair value: A separate table for assets and for liabilities that displays the balance sheet fair value carrying amount of major categories of assets and of liabilities is required. Within each table, the assets and liabilities measured at fair value in each major category are separated into the level of the hierarchy on which fair value is based. The table also includes total gains and losses recognized for each major category 2. For items that are measured on a recurring basis at fair value: Tables similar to those required for non-recurring items, and additional information regarding fair values based on Level 3 (unobservable) inputs, including a roll forward analysis of fair value 126

balance sheet amounts and disclosure of the unrealized gains and losses for Level 3 items held at the reporting date is required SFAS No. 157 requires disclosures about the fair value measurements in a tabular format for each major category of assets and liabilities measured at fair value on a nonrecurring basis during the period. A table is also required for liabilities measured at fair value on a non-recurring basis, if any exist. A similar set of disclosures is to be made for assets and liabilities that are remeasured at fair value on a recurring basis. b.

The factors (which are not intended to be all inclusive) specified that indicate there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity for the same or similar assets or liabilities include: 1. There are few recent transactions. 2. Price quotations are not based on current information. 3. Price quotations vary substantially either over time or among market makers (for example, some brokered markets). 4. Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability. 5. There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, considering all available market data about credit and other nonperformance risks for the asset or liability. 6. There is a wide bid-ask spread or significant increase in the bid-ask spread. 7. There is a significant decline or absence of a market for new issuances (that is, a primary market) for the asset or liability or similar assets or liabilities. Little information is released publicly.

The circumstances identified that may indicate that a transaction is not orderly include, but are not limited to: 1. There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions. 2. There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant. 3. The seller is in or near bankruptcy or receivership (that is, distressed), or the seller was required to sell to meet regulatory or legal requirements (that is, forced). 4. The transaction price is an outlier when compared with other recent transactions for the same or similar asset or liability.

Case 7-15 127

The main purpose of the statement of cash flows is to show the change in cash from one period to the next. Another objective of a statement of the type shown is to summarize the financing and investing activities of the entity, including the extent to which the enterprise has generated cash or near cash assets from operations during the period. Another objective is to complete the disclosure of changes in financial position during the period. The information shown in such a statement is useful to a variety of users of financial statements in making economic decisions regarding the enterprise.

The following are weaknesses in form and format of Baines Corporation’s Statement of Sources and Application of Cash: 1. The title of the statement should be Statement of Cash Flows. 2. The statement should add back to (or deduct from) net income certain items that did not use (or provide) cash during the period. The resulting total should be described as net cash provided by operating activities. The only apparent adjustments in this situation are the amounts to be added back to net income for the depreciation and depletion expense, for any wage or salary expense related to the employee stock option plans, and for changes in current assets and liabilities. 3. The format used should separate the cash flows into investing, financing, and operating activities. Noncash investing and financing activities, if significant, should be shown in a separate schedule or note. 4. Individual items should not be grouped together, as was the case for the $14,000 item.

1. The $25,000 option plan wage and salary expense should be included in the statement as an amount added back to net income, an expense not requiring the outlay of cash during the period. Since the statement balances and no reference is made to the $25,000 payroll expense, it appears the expense was not recorded or that there is an offsetting error elsewhere in the statement. 2. The expenditures for plant-asset acquisitions should not be reported net of the proceeds from plant-asset retirements. Both the outlay for acquisitions and the proceeds from retirements should be reported as investing activities. The details provide useful information about changes in financial position during the period. 3. Stock dividends or stock splits need not be disclosed in the statement because these trans-actions do not significantly affect financial position. 4. The issuance of the 16,000 shares of common stock in exchange for the preferred stock should be shown as a noncash financing activity. Since these transactions significantly change the corporation’s capital structure, they should be disclosed. 5. The presentation of the combined total of depreciation and depletion is probably acceptable. The general rule is that related items should be shown separately in proximity when the result contributes information useful to the user of the statement, but immaterial items may be combined. In this situation, it is likely that 128

no additional relevant information would be added by showing depletion as a separate item. The total should be added back to net income in the computation of the net cash flow from operating activities. 6. The details of changes in long-term debt should be shown separately. Payments should not be netted against increases in long-term borrowings. The long-term borrowing of $620,000 should be shown as cash provided and the retirement of $441,000 of debt should be shown as use of cash from financing activities. Case 7-16 The purpose of the statement of cash flows is to provide information about the cash receipts and cash payments of an enterprise during a period. It differs from the balance sheet and the income statement in that it reports the sources and uses of cash by operating, investing, and financing activity classifications. While the income statement and the balance sheet are accrual basis statements, the statement of cash flows is a cash basis statement and noncash items are omitted. Case 7-17 a.

Free cash flow is net cash provided by operating activities minus capital expenditures and dividends. The purpose of free cash flow analysis is to determine the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity and financial

flexibility. Case 7-18 The solution to this case depends upon the companies selected. Requiring the students to print the relevant information from the financial statements is a good method to use to check their answers. Financial Analysis Case The answer to this case depends on the companies selected by the students.

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CHAPTER 8 Case 8-1 a.

Prior to the release of ASU 2016-01 companies were required to classify equity and debt securities into one of the following three categories: 1. Trading securities. Securities held for resale 2. Securities available for sale. Securities not classified as trading securities or heldto-maturity securities 3. Securities held to maturity. Debt securities for which the reporting entity has both the positive intent and the ability to hold until they mature Trading securities were reported at fair value, and all unrealized holding gains and losses were recognized in earnings. Available-for-sale securities were reported at fair value. However, unrealized holding gains and losses for these securities were not included in periodic net income; rather, they were reported as a component of other comprehensive income. Held-to-maturity securities were reported at amortized cost, whereby discounts and premiums were amortized over the remaining lives of the securities. All trading securities were reported as current assets on the balance sheet. Individual held-to-maturity and available-for-sale securities were reported as either current assets or investments, as appropriate.

According to the provisions of ASU 2016-01, all equity investments in unconsolidated entities (other than those accounted for using the equity method of accounting) are measured at fair value and all changes in fair value are reported on the income statement. There no longer is a distinction between “trading” and “available-for-sale” securities, and changes in the fair value of equity investments previously classified as “available-for-sale” are not reported in other comprehensive income for equity securities with readily determinable fair values. ASU 2016-01 did not change the FASB ASC 320 treatment for debt securities and they are still accounted for under the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”

Case 8-2 a.

The average cost method is based on the assumption that the average costs of the goods in the beginning inventory and the goods purchased during the period should be used for both the inventory and the cost of goods sold.

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The FIFO (first-in, first-out) method is based on the assumption that the first goods purchased are the first sold. As a result, the inventory is at the most recent purchase prices, while cost of goods sold is at older purchase prices. The LIFO (last-in, first-out) method is based on the assumption that the latest goods purchased are the first sold. As a result, the inventory is at the oldest purchase prices, while cost of goods sold is at more recent purchase prices. b.

In an inflationary economy, LIFO provides a better matching of current costs with current revenues because cost of goods sold is at more recent purchase prices. Net cash inflow is generally increased because taxable income is generally decreased, resulting in payment of lower income taxes.

Where there is evidence that the utility of goods to be disposed of in the ordinary course of business will be less than cost, the difference should be recognized as a loss in the current period, and the inventory should be stated at market value in the financial statements. In accordance with the concept of conservatism, inventory should be valued at the lower of cost or market.

Case 8-3 a.

Inventory cost should include all reasonable and necessary costs of preparing inventory for sale. These costs include not only the purchase price of the inventories, but also the other costs associated with readying inventories for sale.

The lower of cost or market rule produces a realistic estimate of future cash flows to be realized from the sale of inventories. This is consistent with the principle of conservatism and recognizes (matches) the anticipated loss in the income statement in the period in which the price decline occurs.

Steel's inventories should be reported on the balance sheet at market. According to the lower of cost or market rule, market is defined as replacement cost. Market cannot exceed net realizable value and cannot be less than net realizable value less the normal profit margin. In this instance, replacement cost is between net realizable value and net realizable value less the normal profit margin. Therefore, market is established as replacement cost. Since market is less than original cost, inventory should be reported at market.

Ending inventories and net income would have been the same under either lower of average cost or market or lower of FIFO cost or market. In periods of declining prices, the lower of cost or market rule results in a write-down of inventory cost to market under both methods, resulting in the same inventory cost. Therefore, net income using either inventory method is the same. 131

Case 8-4 a.

The direct write-off method overstates the trade accounts receivable on the balance sheet by reporting them at more than their net realizable value. Furthermore, because the write-off often occurs in a period after the revenues were generated, the specific write-off method does not match bad debts expense with the revenues generated by sales in the same period.

One allowance method estimates bad debts based on credit sales. The method focuses on the income statement and attempts to match bad debts with the revenues generated by the sales in the same period. The other allowance method estimates bad debts based on the balance in the trade accounts receivable accounts. The method focuses on the balance sheet and attempts to value the accounts receivable at their future collectible amounts.

Anth should account for the collection of the specific accounts previously written off as uncollectible as follows: * *

Correction of allowance account by debiting accounts receivable and crediting allowance for doubtful accounts. Collection of specific accounts previously written off as uncollectible by debiting cash and crediting accounts receivable.

Anth should report the face amount of the interest-bearing notes receivable and the related interest receivable for the period July 1, 2018 through December 31, 2018, on its December 31, 2018, balance sheet as current assets. Both assets are due on June 30, 2019, which is within one year of the date of the balance sheet. Anth should report interest income from the notes receivable on its income statement for the years ended December 31, 2018 and 2019. The interest income would be equal to the amount accrued on the notes receivable at the stated rate for six months in 2018. Interest accrues with the passage of time, and it should be accounted for as an element of income over this period. The remaining six months of interest will be reported on Arth’s December31, 2019 income statement.

Case 8-5 a.

Cost, which has been defined generally as the price paid or consideration given to acquire an asset, is the primary basis for accounting for inventories. As applied to inventories, cost means, in principle, the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. These applicable expenditures and charges include all acquisition and 132

production costs but exclude all selling expenses and that portion of general and administrative expenses not clearly related to production. b.

Market, as applied to the valuations of inventories, means the current bid price prevailing at the date of the inventory for the particular merchandise in the volume which is usually purchased by the company. The term is applicable to inventories of purchased goods and to the basic elements of cost (materials, labor and overhead) of goods that have been manufactured. Therefore, market means current replacement cost except that it should not exceed the net realizable value (estimated selling price less predicted cost of completion and disposal) and should not be less than net realizable value reduced by an allowance for a normal profit margin.

The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required, however, when the utility of the goods included in the inventory is less than their cost. This loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower of cost or market rule arose from the accounting convention of providing for all losses and anticipating no profits.) In accordance with the foregoing reasoning the rule of "Cost or market, whichever is lower" may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly interprets operations The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product alternative procedures are suitable.

The arguments against the use of the lower of cost or market method of valuing inventories include the following: 1. The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over replacement cost) as definite income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization, a drop in selling price below cost is no more a sustained loss than a rise above cost is a realized gain. 2. A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-down is not made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title "Cost of Goods Sold" therefore becomes a misnomer. 133

3. The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of price advances. 4. The method is also inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost one-year end and at market at the next year end. 5. The lower of cost or market method values the inventory on the balance sheet conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is stated conservatively, the net income on the income statement of the subsequent period may be distorted if the expected reductions in sales prices do not materialize. Case 8-6 a.

The use of the allowance method based on credit sales to estimate bad debt is consistent with the matching principle because bad debts arise from and are a function of making credit sales. Therefore, bad debt expense for the current period should be matched with current credit sales. This is an income statement approach because the balance in the allowance for bad debts account is ignored when computing bad debt expense. The allowance method based on the balance in accounts receivable is not consistent with the matching principle. This method attempts to value accounts receivable at the amount expected to be collected. The method is facilitated by preparing an aging schedule of accounts receivable and plugging bad debt expense with the adjustment necessary to bring the allowance account to the required balance. Alternatively, the ending balance in accounts receivable can be used to determine the required balance in the allowance account without preparing an aging schedule by using composite percentage. Bad debt expense is then determined in the same manner as when an aging schedule is used. However, neither of these approaches associates bad debt expense with the period of sale, especially for sales made in the last month or two of the period.

On the balance sheet, the allowance for bad debts is presented as a contra asset account to accounts receivable with the resulting difference representing the accounts receivable net (i.e., their net realizable value). Bad debt expense would generally be included on Carme's income statement with the other operating (selling/general and administrative) expenses for the period. However, theoretical arguments can be made for (1) reducing sales revenue by the bad debts adjustment in the same manner that sales returns and allowances and trade discounts are considered reductions of the 134

amount to be received from sales of products or (2) classifying the bad debts expense as a financial expense. Case 8-7 a.

Working capital ($43,000 + 32,000 + 67,000 + 92,000 + 23,000) – ($48,000 + 26,000) = $183,000 Current Ratio $43,000 + 32,000 + 67,000 + 92,000 + 23,000 $48,000 + 26,000 = 3.47:1 Acid Test Ratio $43,000 + 32,000 + 67,000 $48,000 + 26,000 = 1.92

These calculations generally indicate that Maxine has a good liquidity position. However, a further evaluation should be made by comparing these results to competitors and industry averages.

Case 8-8 a.

Arguments for the specific identification method are as follows: (1)

It provides an accurate and ideal matching of costs and revenues because the cost is specifically identified with the sales price.

(2)

The method is realistic and objective since it adheres to the actual physical flow of goods rather than an artificial flow of costs.

(3)

Inventory is valued at actual cost instead of an assumed cost

Objections to the specific identification method include the following: (1)

The cost of using it-restricts its use to goods of high unit value. 135

(2)

The method is impractical for manufacturing processes or cases in which units are commingled and identity lost.

(3)

It allows an artificial determination of income by permitting arbitrary selection of the items to be sold from a homogenous group.

(4)

It may not be a meaningful method of assigning costs in periods of changing price levels.

The first-in, first-out method approximates the specific identification method when the physical flow of goods is on a FIFO basis. When the goods are subject to spoilage or deterioration, FIFO is particularly appropriate. In comparison to the specific identification method, an attractive aspect of FIFO is the elimination of the danger of artificial determination of income by the selection of advantageously priced items to be sold. The basic assumption is that costs should be charged in the order in which occurred. As a result, the inventories are stated at the latest costs. When the inventory is consumed and valued in the FIFO manner, there is no accounting recognition of unrealized gain or loss. A criticism of the FIFO method is that it maximizes the effects of price fluctuations upon reported income because current revenue is matched with the oldest costs which are probably least similar to current replacement costs. On the other hand, this method produces a balance sheet value for the asset close to current replacement costs. It is claimed that FIFO is deceptive when used in a period of rising prices because the reported profit is not fully available since a part of it must be used to replace inventory at a higher cost. The results achieved by weighted average method resemble those of the specific identification method where items are chosen at random or there is a rapid inventory turnover. Compared with the specific identification method, the weighted average has the advantage that the goods need not be individually identified; therefore, accounting is not so costly and the method can be applied to fungible goods. The weighted average method is also appropriate when there is no marked trend in price changes. In opposition, it is argued that the method is illogical. Since it assumes that all sales are made proportionally from all purchases and that inventories will always include units from the first purchases, it is argued that the method is illogical because it is contrary to the chronological flow of goods. In addition, in periods of price changes there is a lag between current costs and costs assigned to income or to the valuation of inventories. If it be assumed that actual cost is the appropriate method of valuing inventories, lastin, first-out is not theoretically correct. In general, LIFO is directly averse to the specific identification method because the goods are not valued in accordance with their usual physical flow. An exception is the application of LIFO to piled coal or ores 136

which are more or less consumed in a LIFO manner. Proponents argue that LIFO provides a better matching of current costs and revenues. During periods of sharp price movements, LIFO has a stabilizing effect upon reported profit figures because it eliminates paper profits and losses on inventory and smoothens the impact of income taxes. LIFO opponents object to the method principally because the inventory valuation reported in the balance sheet could be seriously misleading. The profit figure can be artificially influenced by management through contracting or expanding inventory quantities. Temporary involuntary depletion of LIFO inventories would distort current income by the previously unrecognized price gains or losses applicable to the inventory reduction. Case 8-9 a.

According to SFAC 5, net realizable value is the nondiscounted amount of cash, or its equivalent, into which an asset is expected to be converted in the future net of direct costs, if any, necessary to make the conversion.

The balance sheet approach to estimating bad debts provides the better estimate of net realizable value. Aging reports receivables measured in terms of how much is expected to be collected from subsets of the receivables categorized by age. Older receivables would be expected to yield proportionately less cash than more recent receivables. The income statement approach does not purport to measure how much is expected to be collected from the receivables. Rather it measures how much is expected to be uncollectible from a given year’s sales.

ii.

Liquidity is the ability to pay current debt and continue operations. Working capital is the difference between current assets and current liabilities. The balance sheet approach to measuring bad debts would be more useful in providing a measure of liquidity. As stated above this approach provides a better estimate of net realizability and hence the amount of cash that would be available to pay current liabilities.

iii. The income statement approach provides better matching. The matching concept implies that revenues should be matched with the cost of generating them. Estimating bad debts based on net sales attempts to subtract from sales those that will not be collected thereby matching them with cost, those that will not realize cash. iv.

The balance sheet approach is more consistent with the definition of comprehensive income. Comprehensive income is the change in net assets occurring during the accounting period for non-owner transactions. The balance 137

sheet approach provides a direct measure of those changes and hence a direct measure of the effect of those changes on comprehensive income. v.

The income statement approach is more consistent with financial capital maintenance. It provides a direct measure of the effect of transactions, sales, on future cash flows.

vi.

The balance sheet approach is more consistent with physical capital maintenance because it provides balance sheet measures which are closer to current value.

Case 8-10 a.

.i.

Short-term prepaids are classified as current assets because they will be consumed during the current operating cycle or one year whichever is longer. These assets will not be converted into cash. Rather, they would require the use of cash in the near future had cash not already been expended. Prepaids meet the definition of assets found in the conceptual framework because they will provide future benefit. For example, prepaid rent is an asset. The right to use an asset, say office space, was paid for in advance. That payment provides future benefit: the use of the asset over some future time period. Prepaids do not provide working capital in the usual sense of the definition of working capital. Working capital is a measure of the ability of the firm to pay currently maturing debt. Since prepaids will not generate cash, they will not be used to pay debt. However, it may be argued that they indirectly provide liquidity because the services which have already been paid for are needed for operations. If they had not already been paid for, they would require the use of cash which would decrease the firm’s ability to pay current debt.

ii. The most convincing argument for excluding prepaids from working capital is that they will not provide cash to pay currently maturing debt. They have no net realizable value. If not, it is difficult to say that prepaids provide liquidity. b.

Accountants include short-term unearned revenues as current liabilities because they will be earned by performing services during the current operating cycle or year whichever is longer. The conceptual framework defines liabilities as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as the result of prior transactions or events. Yes, unearned revenues meet the definition of liabilities. They are present obligations to provide services to other entities in the future as a result of prior transactions or events (the receipt of cash from an arm’s length transaction). 138

Since they are classified as current liabilities, current unearned revenues decrease working capital. However, they will not require the expenditure of current assets. c.

Current liabilities are defined as liabilities that will be paid out of current assets or replaced by other current liabilities. Current unearned revenues will not be paid with cash or any other assets. Moreover, they will not be replaced by other current liabilities. And if the purpose of classification of liabilities as current is to provide measures of liquidity, it is difficult to see how a liability that will not be paid affects liquidity.

FASB ASC 8-1 Current Assets and Current Liabilities Information on the disclosure of current assets and current liabilities is found at FASB ASC 210. It can be accessed by searching the glossary for current assets and current liabilities. The relevant information is found at 210-10-45. After accessing the topic use the printer friendly with sources option. FASB ASC 8-2 Offsetting Assets and Liabilities Search offsetting assets and liabilities Found at 210-20 Us printer friendly with sources option after accessing the topic FASB ASC 8-3 Inventory The objective of accounting for inventory is found at FASB ASC 330-10-10. Search “objective of accounting for inventory.” Found at FASB ASC 330 Inventory > 10 Overall > 10 Objectives Use the printer friendly with sources option to find the original source. FASB ASC 8-4 Examples of Current Assets From topic list select Presentation and Balance Sheet. Found under Other Presentation Matter Classification of Current Assets Topic 210-10-45 FASB ASC 8-5 Classification of Current Liabilities 139

From topic list select Presentation and Balance Sheet. Found From topic list select Presentation and Balance Sheet. Found under Other Presentation Matter Classification of Current Liabilities Topic 210-10-45 FASB ASC 8- 6 Compensating Balances Search compensating balances Found at 210-10-S99 FASB ASC 8-7 ASU 2016-01 Search Recognition and Measurement of Financial Assets and Financial Liabilities Found at 825-10. FASB ASC 8-8 ARB 43 and Inventory Found through Cross Reference. ARB 43 Topic 330-10-05 Use printer friendly with sources option to find relevant items. Room for Debate Debate 8- 1 LIFO versus FIFO Team 1

Defend LIFO

Cost of goods sold if the purchase is postponed until 2020: Beginning Inventory: First Layer Second Layer Purchases Available Sold Ending Inventory Cost of Goods Sold

10,000 x $15 22,000 x $18 250,000 x $20 $ 282,000 (245,000) $ 37,000

$ 150,000 396,000 5,000,000 $5,546,000 646,000 $4,900,000

Cost of goods sold if the purchase is made in 2019: Available from above Additional Purchase

$ 282,000 40,000 x $17 140

$5,546,000 680,000

Available Sold Ending Inventory Cost of Goods Sold

$ 322,000 (245,000) $ 77,000

Difference

$6,226,000 1,446,000 $4,780,000 $ 120,000

Calculation of ending inventory: Purchase in 10,000 x $15 $150,000 22,000 x $18 5,000 x $20 45,000 x $20 Ending Inventory

2019 $150,000

2020

396,000

396,000 100,000 900,000 $646,000

$1,446,000

Cost of sales Purchase in 40,000 x $17 205,000 x $20 245,000 x $20

2019 $ 680,000 4,100,000 $ 4,780,000

$4,900,000

The difference: 40,000 x ($20-17)

$ 120,000

2020

The use of LIFO allows MVP to expense 40,000 units as cost of sold at $17 rather than $20, thereby lowering cost of sales by $120,000 if the purchase is made in 2019. This shows that management can manipulate earnings under LIFO simply by choosing when to purchase. Even though it is obvious that these items were not sold or consumed during the period. This makes the income statement look better than it otherwise would. Hence, for MVP the use of LIFO has value. To management, it could mean a bigger bonus. The use of LIFO is based on the assumption that current costs should be matched against it. Although LIFO does not use current cost, the most recent costs are used to calculate cost of sales; hence, LIFO yields the closest approximation to current value of any cost-based method of inventory valuation. As such, it provides the closest historical cost measure of “real income” and is consistent with the concept of physical capital maintenance. In addition, LIFO may eliminate inventory holding gains when the inventory remains stable from year to year, and the use of LIFO when prices are rising reduces taxable income and hence, the payment of income tax.

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LIFO is better than FIFO because during inflation, FIFO results in matching older, lower cost against revenues. The result is inflated profits that could be misleading to inventors, creditors and other users. Inflated profits can result in the payment of additional income taxes and it makes it appear as though the company has more available to distribute in dividends than it should. Team 2 Defend FIFO Cost of goods sold under FIFO would be the same regardless of whether the inventory was purchased in 2019 or 2020 because sales would be calculated using old costs, and would not be affected by recent purchases. The following calculations are made under the assumption that the inventory layers result from the application of FIFO. Cost of goods sold if the purchase is postponed until 2015: Beginning Inventory: First Layer Second Layer Purchases Available Sold Ending Inventory Cost of Goods Sold

10,000 x $15 22,000 x $18 250,000 x $20 $ 282,000 (245,000) $ 37,000

$150,000 396,000 5,000,000 $5,546,000 740,000 $4,806,000

Cost of goods sold if the purchase is made in 2019: Available from above Additional Purchase Available Sold Ending Inventory Cost of Goods Sold

$282,000 40,000 x $17 $322,000 (245,000) $ 77,000

Difference

$5,546,000 680,000 $6,226,000 1,42000 $4,806,000 $

Calculation of ending inventory: Purchase in 37,000 x $20 40,000 x $17 Ending Inventory

2019 $ 740,000 680,000 $1,420,000

Cost of sales 142

2020 $ 740,000 $ 740,000

Purchase in 10,000 x $15 22,000 x $18 213,000 x $20

2019 $ 150,000 396,000 4,260,000 $4,860,000

2020 $ 150,000 396,000 4,260,000 $4,860,000

The use of FIFO satisfies the historical cost principle. The valuation of flows is consistent with the typical actual flow of goods. It also satisfies the matching principle since the historical cost is matched with revenue. And, inventory valuation on the balance sheet more closely resembles replacement cost because it comprises recent prices. This allows users to better evaluate future cash flows to replace the inventory. An added advantage of FIFO over LIFO is demonstrated by this case. It is not possible to manipulate cost of sales by the use of FIFO, while manipulation is obviously possible under LIFO. Hence, the use of FIFO would satisfy the qualitative characteristic of neutrality. Debate 8-2 Components of Working Capital Team 1 A company’s working capital is the net short-term investment needed to carry on dayto-day activities. Since inventory is used in day-to-day activities it should be included. The inventory must be sold to generate cash flow. If anything, we could argue that because inventory is reported at cost, it is actually undervalued, but it would not follow that it should be excluded. Except for a few industries (such as breweries) that have long operating cycles, companies typically turn their inventory many times during the year, continuously providing operating cash inflows to pay currently incurred short term obligations. Paton argued that a fixed asset will remain in the enterprise two or more periods, whereas current assets will be used more rapidly; fixed assets may be charged to expense over many periods, whereas current assets are used more quickly; and fixed assets are used entirely to furnish a series of similar services, whereas current assets are consumed. Therefore, all assets that meet the definition of current assets, should be included in calculating working capital The working capital concept provides useful information by giving an indication of an entity’s liquidity and the degree of protection given to short-term creditors. Specifically, the presentation of working capital can be said to add to the flow of information to financial statement users by (1) indicating the amount of margin or buffer available to meet current obligations, (2) presenting the flow of current assets and current liabilities from past periods, and (3) presenting information on which to 143

base predictions of future inflows and outflows. In the following sections, we examine the measurement of the items included under working capital. Prepaid expenses have been included as current assets because if they had not been acquired, they would require the use of current assets in the normal operations of the business Team 2 Current U.S. and international practice is based on the assumption that the items classified as current assets are available to retire existing current liabilities and that the measurement procedures used in valuing these items provide a valid indicator of the amount of cash expected to be realized or paid. Closer examination of these assumptions discloses two fallacies: (1) not all the items are measured in terms of their expected cash equivalent, and (2) some of the items will never be received or paid in cash. However, prepaids will be used rather than exchanged for cash and, therefore, do not aid in predicting future cash flows. If the working capital concept is to become truly operational, it would seem necessary to modify it to show the amount of actual buffer between maturing obligations and the resources expected to be used in retiring them. Such a presentation should include only the current cash equivalent of the assets to be used to pay the existing debts. It would therefore seem more reasonable to base the working capital presentation on the monetary–nonmonetary dichotomy used in price level accounting (See Chapter 17.) because monetary items are claims to or against specific amounts of money; all other assets and liabilities are nonmonetary. The monetary working capital presentation would list as assets: cash, cash equivalents, temporary investments, and receivables and would list as liabilities current payables. It would not include inventories, prepaid assets or deferred liabilities. Also more meaningful information could be provided if all temporary investments were measured by their current market price, including securities held to maturity. This presentation would have the following advantages: (1) it would be a more representative measure of liquidity and buffer because it would be more closely associated with future cash flows, (2) it would provide more information about actual flows because only items expected to be realized or retired by cash transactions would be included, and (3) it would allow greater predictive ability because actual cash flows could be traced. Debate 8-3 Capitalization versus Expense

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Team 1: Present arguments for capitalizing all of the above costs. Your arguments should utilize the Conceptual Framework definitions and concepts. The primary argument in favor of capitalizing all of the costs is the historical cost principle. According to the historical cost principle, the historical cost of an asset is all costs that it takes to acquire the asset and get it ready for its intended use. To apply the historical cost principle to an item, it must first meet the definition of an asset. We argue that all of these costs (the purchase price of the property, the cost to remove the building, the cost to remove the tanks and refine the soil) are necessary to acquire the site for the restaurant and thus will provide future economic benefit. We also argue that the cost to construct the building, as well as the cost of the avoidable interest that was incurred during construction, were necessary to acquire the building and get it ready for its intended use. Thus, they should all be capitalized as part of the historical cost of the assets land and building. SFAC No. 6 defines an asset as a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction. Without question, the acquisition of the site for the restaurant meets this definition of an asset. It will provide a future economic benefit because the restaurant will be built there and is intended to generate a profit for its owner(s). No one would argue that the purchase price of $900,000 should be capitalized as part of the asset’s cost. In addition, it has been standard accounting practice (and thus a part of GAAP) that the $30,000 cost to remove a building is a part of getting the land ready for its intended use and thus should be capitalized as land, along with the purchase price. In addition, Entre is required by the government to remove underground tanks and to refine the soil. The cost to remove the tanks is $40,000 and the cost to refine the soil is $30,000. Like the cost incurred to remove the building these costs are necessary to get the land ready to build the building. Without incurring these costs, Entre cannot build the restaurant and will not be able to receive future benefits (return) from his investment. Thus, we argue that these costs meet the definition of an asset and are consistent with the historical cost principle. Obviously, the $1,800,000 cost incurred to construct the building to house the restaurant should be capitalized as part of the building cost. The building is arguably an asset. It will be used as Entre’s place of business where his employees will prepare and serve food to customers. Thus, it meets the definition of an asset because it provides a probable future benefit. In addition, the FASB determined in SFAS No. 34, that avoidable interest incurred to construct an asset, such as Entre’s restaurant, should be capitalized as a part of the cost 145

of the asset. It is a necessary cost to construct the asset because had the asset not been constructed the debt used to finance the construction and thus the cost of borrowing (interest) could have been avoided. Because it could have been avoided, the interest is deemed to be necessary to acquire the asset and get it ready for its intended use. Thus, capitalization of $22,000 of avoidable interest incurred during construction as part of the asset’s cost is consistent with the historical cost principle. Team 2:

Criticize capitalization of the cost to remove the tanks and refine the soil and the capitalization of interest during construction. Do they provide added service potential? Your arguments should utilize the Conceptual Framework definitions and concepts

We believe that neither the costs of removing the tanks and refining the soil nor the cost of avoidable interest incurred during construction of the restaurant should be capitalized and reported as costs of assets. Our argument is based primarily on the position that these expenditures do not add future service potential to the land or to the building. Thus, they do not meet the definition of an asset. This means that if we report these costs as assets we would be violating the qualitative characteristic of representational faithfulness. We would be reporting a non-asset as an asset. Thus, it would not be what it purports to be. SFAC No. 6 defines an asset as a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction. Neither removing the tanks at a cost of $40,000 nor incurring a $30,000 expenditure to refine the soil once the tanks are removed does not increase the expected future cash inflow from the operation of the restaurant. Thus, it provides no future benefit and is not an asset. Furthermore, if we were to purchase an identical adjacent site that does not have a service station on it, the current site would not be more valuable than the adjacent site. Since both sites could be used to generate the same future cash flows and profit, one is not more valuable than the other. As a result, if we were to capitalize the costs of removing the tanks and refining the soil, we contend that the historical cost of the land would be overstated. Is not the initial value of an asset equivalent to the present value of the future cash flows expected from its use? With regard to the capitalization of the $22,000 of “so called” avoidable interest that is incurred during construction, we can make similar arguments. It does not add to the future service potential of the building because it has no impact on the future cash flows or profit expected from the building’s use and thus does not add to its value. Moreover, the source of financing has nothing to do with the cost or value of the asset itself. Modern finance theory would separate the two. What would make a building financed with debt more valuable than a building that was financed with equity? Nothing would. If Entre financed the building with equity, it would produce the same future cash flows as it would if he financed it with debt. Moreover, we could argue 146

that the cost of financing with equity is potentially more expensive than the cost of financing with debt. Due to the riskiness associated with uncertain returns to investors, the return on an equity investment is generally higher than the company’s incremental borrowing rate. We argue that if capitalization of avoidable interest should be added to the cost of the asset, then so should the avoidable cost of capital that is effectively incurred when financing the construction with equity. WWW Case 8-11 a. b. c.

Working capital is the excess of total current assets over total current liabilities. The operating cycle is defined ad as the average time intervening between the acquisition of materials or services . . . and the final cash realization Working capital represents the net amount of a company’s relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands of the operating cycle.

Case 8-12 a. b.

An increase in inventories increases current assets, which is in the numerator of the current ratio. Inventory increases will generally increase the current ratio An increase in the current ratio indicates a company has greater liquidity, since there are more current assets relative to current liabilities.

Case 8-13 The theoretical superiority of the allowance method over the direct write-off method of accounting for bad debts is two-fold. First, since revenue is considered to be recognized at the point of sale on the assumption that the resulting receivables are valid liquid assets merely awaiting collection, periodic income will be overstated to the extent of any receivables that eventually become uncollectible. The proper matching of revenue and expense requires that gross sales in the income statement be partially offset by a charge to bad debt expense that is based on an estimate of the receivables arising from gross sales that will not be converted into cash. Second, accounts receivable on the balance sheet should be stated at their estimated net realizable value. The allowance method accomplishes this by deducting from gross receivables the allowance for doubtful accounts. The latter is derived from the charges for bad debt expense on the income statement

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Case 8-14 a.

If the terms of the purchase are f.o.b. shipping point (manufacturer’s plant), Zippy Enterprises should include in its inventory goods purchased from its suppliers when the goods are shipped. For accounting purposes, title is presumed to pass at that time.

Freight-in expenditures should be considered an inventoriable cost because they are part of the price paid or the consideration given to acquire the asset.

Theoretically the net approach is the more appropriate because the net amount (1) provides a correct reporting of the cost of the asset and related liability and (2) presents the opportunity to measure the inefficiency of financial management if the discount is not taken. Many believe, however, that the difficulty involved in using the somewhat more complicated net method is not justified by the resulting benefits.

Products on consignment represent inventories owned by Zippy Enterprises, which are physically transferred to another enterprise. However, Zippy Enterprises retains title to the goods until their sale by the other company (Touk Inc.). The goods consigned are still included by Zippy Enterprises in the inventory section of its balance sheet. Frequently the inventory is reclassified from regular inventory to consigned inventory

Case 8-15 Arguments for the specific identification method of inventory valuation are: 1. 2. 3.

It provides an accurate and ideal matching of costs and revenues because the cost is specifically identified with the sales price. The method is realistic and objective since it adheres to the actual physical flow of goods rather than an artificial flow of costs. Inventory is valued at actual cost instead of an assumed cost.

Arguments against the specific identification method include: 1. 2. 3. 4.

The cost of using it restricts its use to goods of high unit value. The method is impractical for manufacturing processes or cases in which units are commingled and identity lost. It allows an artificial determination of income by permitting arbitrary selection of the items to be sold from a homogeneous group. It may not be a meaningful method of assigning costs in periods of changing price levels.

Case 8-16 148

The first-in, first-out method approximates the specific identification method when the physical flow of goods is on a FIFO basis. When the goods are subject to spoilage or deterioration, FIFO is particularly appropriate. In comparison to the specific identification method, an attractive aspect of FIFO is the elimination of the danger of artificial determination of income by the selection of advantageously priced items to be sold. The basic assumption is that costs should be charged in the order in which they are incurred. As a result, the inventories are stated at the latest costs. Where the inventory is consumed and valued in the FIFO manner, there is no accounting recognition of unrealized gain or loss. A criticism of the FIFO method is that it maximizes the effects of price fluctuations upon reported income because current revenue is matched with the oldest costs which are probably least similar to current replacement costs. On the other hand, this method produces a balance sheet value for the asset close to current replacement costs. It is claimed that FIFO is deceptive when used in a period of rising prices because the reported income is not fully available since a part of it must be used to replace inventory at higher cost. The results achieved by the average-cost method resemble those of the specific identification method where items are chosen at random or there is a rapid inventory turnover. Compared with the specific identification method, the average-cost method has the advantage that the goods need not be individually identified; therefore accounting is not so costly and the method can be applied to fungible goods. The average-cost method is also appropriate when there is no marked trend in price changes. In opposition, it is argued that the method is illogical. Since it assumes that all sales are made proportionally from all purchases and that inventories will always include units from the first purchases, it is argued that the method is illogical because it is contrary to the chronological flow of goods. In addition, in periods of price changes there is a lag between current costs and costs assigned to income or to the valuation of inventories. If it is assumed that actual cost is the appropriate method of valuing inventories, last-in, firstout is not theoretically correct. In general, LIFO is directly adverse to the specific identification method because the goods are not valued in accordance with their usual physical flow. An exception is the application of LIFO to piled coal or ores which are more or less consumed in a LIFO manner. Proponents argue that LIFO provides a better matching of current costs and revenues. During periods of sharp price movements, LIFO has a stabilizing effect upon reported income figures because it eliminates paper income and losses on inventory and smoothies the impact of income taxes. LIFO opponents object to the method principally because the inventory valuation reported in the balance sheet could be seriously misleading. The profit figures can be artificially influenced by management through contracting or expanding inventory quantities. Temporary involuntary depletion of LIFO inventories would distort current income by the previously unrecognized price gains or losses applicable to the inventory reduction

149

Case 8-17 a. Working capital management is a strategy that focuses on maintaining efficient levels of the components of working capital, current assets, and current liabilities. The goal of working capital management is to ensure that a company has sufficient cash flow to meet its short‐term debt obligations and operating expenses. b. The internal and external factors affecting a company’s working capital needs are: Internal factors: • Company size and growth rates • Organizational structure • Sophistication of working capital management • Borrowing and investing positions/activities/capacities External factors: • Banking services • Interest rates • New technologies and new products • The economy • Competitors c. The ratios available to assist in assessing a company’s liquidity include: working capital, current ratio, acid test or quick ratio, accounts receivable turnover, inventory turnover, accounts payable turnover and cash flow from operations to current liabilities ratio. d. The objective of inventory management is to determine and maintain the level of inventory that is sufficient to meet demand but not more than necessary. e. The motives for holding inventory are: Transaction motive: To hold enough inventory for the ordinary production‐to‐sales cycle Precautionary motive: To avoid stock‐out losses, which can result in foregone sales as a result of insufficient inventory Speculative motive: To ensure the availability and pricing of inventory f.

The approaches to managing levels of inventory include the following: Economic order quantity and the reorder point. Computes the amount of inventory to acquire and the point in time when the company orders more inventory, thereby minimizing the sum of order costs and carrying costs Just in time: Order inventory as it is needed, thereby reducing or eliminating carrying costs 150

Materials or manufacturing resource planning: A computer‐based, time‐phased system for planning and controlling the production and inventory function of a firm from the purchase of materials to the shipment of finished goods Case 8-18 In IAS No. 2, the IASB held that the objective of inventory reporting is to determine the proper amount of cost to recognize as an asset and carry forward until the related revenues are recognized. The board stated a preference for the specific identification method of inventory valuation when the items are interchangeable or are produced and segregated for specific projects. This method was viewed as inappropriate when large numbers of interchangeable items are present. In these cases, the IASB stated a preference for either FIFO or weighted average methods; however, LIFO was an allowed alternative. Under the revised IAS No. 2, the use of LIFO is no longer allowed. Additionally, under IAS N0. 2, inventory is to be measured at the lower of cost or net realizable value (estimated selling price less estimated costs of completion and sale). Inventory write-downs are calculated using net realizable value on an item-by-item basis but allows write-downs to occur by groups of similar products in special circumstances. IAS No. 2 requires inventory to be written down to net realizable value (floor) on an item-by-item basis but allows write-downs to occur by groups of similar products in special circumstances. This contrasts to U. S. GAAP under which write-downs are normally determined either on an item-by-item, group, or categorical basis. Also, IAS No 2 allows previous inventory write-down reversals to be recognized in the same period as the write-down; whereas, any inventory write-downs under U.S. GAAP cannot subsequently be reversed. If the FASB and the IASB move toward convergence of accounting standards, the LIFO issue will need to be resolved. Although the process of converging U.S. GAAP with international GAAP has made a great deal of progress, there are still many issues yet to be addressed, including the fate of the LIFO method. For over a decade, FASB and the IASB have had an ongoing agenda of projects, the objective of which is to move the process of convergence forward. For the period 2006–2008, numerous convergence-related issues were identified as either being on an active agenda or on a research agenda prior to being added to an active agenda. However, the issues of LIFO and inventory valuation in general are not included on the active or the research agenda of either board. Case 8-19 Answer will depend on companies selected. Financial Analysis Case Answer will depend on company selected. 151

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CHAPTER 9 Case 9-1 a.

Under FASB ASC 958-605, the land would be recorded at fair value. The inflow is considered revenue. The land would be reported in the balance sheet at $100,000. A corresponding amount of revenue would appear in the income statement.

FASB ASC 958-605 defines a donation as a nonreciprocal transfer. Recording the land at fair value is consistent with the full disclosure principle. It is also consistent with the Conceptual Framework's qualitative criterion, relevance. If users wish to value the firm, fair value of firm assets is relevant to their decision models. The primary defense of recording a donated asset at fair value is that fair value represents the cash equivalent value of the asset. If cash had been received, instead, the dollars would have been recorded. Then the dollars received could have been used to purchase the asset at fair value. Recording the inflow as revenue is consistent with the Conceptual Framework's definition of earnings, as the change in net assets from nonowner sources. The asset was received from a third party, not an owner. Its inflow adds value to the firm.

ii. Recording the donated asset at fair value is inconsistent with the cost principle. According to the cost principle, the recorded cost of an asset is equivalent to the consideration given in return. Because a donation is a nonreciprocal transfer, nothing was given in return, hence, no cost can be recorded. A second, though less convincing argument, would be that fair value may be too subjective to be reliable. It can also be argued that if fair value is the appropriate and relevant measurement for a donated asset, then the credit should be considered a gain, not a revenue. The Conceptual Framework defines revenues as inflows from the production or delivery of goods and services. A donated asset does not result from the production or delivery of goods or services. Rather it is more like a gain - resulting from peripheral or incidental transactions.

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Under previous practice, the credit for fair value of the donated asset would have been to donated capital. Because the credit to revenue required under FASB ASC 958-605 is closed to retained earnings, the composition of stockholders' equity would differ, but total stockholders' equity is unaffected by the SFAS No. 116 requirements. Comparative balance sheets containing summary information would appear the same as before, as follows: ASSETS ($800,000 + 100,000)

Liabilities S/E

$900,000

LIABILITIES $350,000 550,000

Hence, balance sheet ratios such as debt/equity are not affected. Placing the inflow of fair value on the income statement would increase income from continuing operations, net income and EPS. Case 9-2 a.

Postponing the purchase of the equipment until the next year will have the following financial statement impacts assuming that the equipment will be placed into use when it is purchased: Balance Sheet: Plant assets will be less by Cost Less Accumulated Depr ((400,000/10) x 1/2)

$400,000 20,000

$380,000

Notes Payable will be less by

$400,000

Interest Payable will be less by ((400,000/10) x 1/4)

10,000

Deferred Tax Liability will be less by Accumulated Depr tax (400,000 x 2/7 x 1/2) Accumulated Depr books Temporary difference

$57,143 20,000 $ 37,143x tax rate

Income Statement: Interest Expense will be less by

$10,000 153

Depreciation Expense will be less by

$20,000

Income Tax Expense will be more by the tax rate times lost interest and depreciation tax shield (tax rate x ($10,000 + 57,143)) and less by the change in the deferred tax liability (tax rate x $37,143). Statement of Cash Flows: The inflow from Operating Activities will be affected by the tax savings on the interest and depreciation taken on the tax return. The supplemental schedule disclosing financing and investing activities not affecting cash will include the purchase of the machine with the note. According to the efficient market theory, the only impact that postponing the purchase would have on stock price would result from cash flow impacts. These are described in part b. Finance theory on capital structure would suggest that the lower debt to equity ratio that would result from the postponement would imply less risk, because the debt to equity ratio is thought to be correlated with the firm's beta. If the debt to equity ratio is significantly affected, the market could perceive the increased risk in a negative manner. b.

The cash flow impacts of postponing the purchase of the equipment comprise the time value of the tax effects of the interest and depreciation tax shields which total $77,143 ($20,000 + $57,143). Although the purchase would only be delayed three months, the first year depreciation is taken one year earlier and one fourth of the first year's interest is taken earlier. On the downside, the interest payments and the payment of principal are both shifted three months earlier. However, this shift is unlikely to have a material impact.

Purchasing before year-end would be more favorable to stockholders. The market assesses the value of the firm in terms of the present value of future cash flows. The depreciation and interest tax shields that would occur during the current year would accelerate the tax benefits of these deductions for one year. The timing of the interest and loan principal payment would occur three months earlier. But, the tax timing difference would produce a more significant effect.

Case 9-3

154

The conventional concept of depreciation accounting usually is defined as a system of accounting that aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year is the portion of the total charge under such a system that is allocated to the year.

This is a static concept of depreciation in which the initial cost or other value is not changed during the life of the asset; thus total depreciation charges over the life of the asset are equal to the initial cost or value of the asset less any salvage value. This concept is based upon the cost, realization and matching concept of conventional financial accounting. Cost represents the amount that is recorded as the value of the asset to the entity at the date of acquisition. In subsequent periods cost less accumulated depreciation is considered to represent the minimum value to the entity of the services to be received from the plant asset during the remainder of its life. The realization concept requires that during the life of an asset its valuation should not be greater than cost or cost less accumulated depreciation; if a higher valuation were recorded, the entity would recognize unrealized income.

ii. The matching concept requires that the portion of the cost (or value basis) of the asset to be allocated to each accounting period should be matched with the expected revenue or net revenue contribution of the period. Matching can take the form of (1) adjusting depreciation charges for the effects of interest during the entire life of the asset, (2) associating depreciation allocations with net revenue contributions of the asset so that they are proportional to the net revenue contributions of each period, (3) associating depreciation allocations with nonmonetary, physical service units (e.g., input or output measures, such as machine-hours or miles of operation or number of units produced) so that they are proportional to the units of service provided each period or (4) associating depreciation allocations with units of time (e.g., months or years) so that they are equal for periods of equal length. iii.

Since this concept merely requires that the allocation be systematic and rational, much discretion is left to management in the selection of a depreciation method. But the requirement that the allocation be rational probably means that it should be related to the expected benefits to be received from the asset. Since the conventional accounting concept of depreciation is a process of cost allocation, not valuation, the concern here is with determining what portion of the cost of the computer system should be assigned to expense in a given accounting period. The estimate of periodic depreciation is dependent upon three separate variables: 155

Establishing the depreciation base. Since an asset may be sold before its service value is completely consumed, the depreciation base is the cost of asset services that will be used by the firm and charged to expense during its service life; this usually is less than the original cost of the asset. The depreciation base of an asset is its acquisition cost plus removal costs at time of retirement and minus gross salvage value.

ii. Estimating the service life. This involves selecting the unit in which the service life of the asset is to be measured and then estimating the total number of units of service embodied in the asset. Although service life usually is measured in units of time, it may be more appropriate to use units of output or activity which usually are expressed in physical units such as tons, gallons, miles or machine-hours. In selecting the appropriate unit of service for each asset, consideration should be given to the factors that decrease the service life of an asset. These factors may be divided into two classes: (1) physical causes including casualties and (2) economic and functional causes. The physical causes are the physical deterioration and impaired utility of the asset that result (1) from wear and tear that is due to operating use and (2) from other forms of decay that are due to the action of the elements. Damage resulting from unusual events such as accidents, earthquakes, floods, hurricanes, and tornadoes also may reduce or end asset usefulness. An asset that is in good physical condition may lose its economic usefulness as a result of technological obsolescence and inadequacy (or economic obsolescence). Technological obsolescence results from innovations and improvements that make the existing plant obsolete. Inadequacy usually results from the effects of growth and change in the scale of a firm's operations that reduce or terminate the service life of assets. iii. Choosing the method of cost apportionment. The problem here is to determine the relative portion of services that has expired in each accounting period. This might be approached by estimating whether all units of service are equally valuable (and have an equal cost) or whether some service units have a higher value and cost than others. The two major variables to be considered in reaching the rational and systematic solution to this problem are: (1) whether the quantity of services withdrawn from the bundle will be equal or will vary during the periods of service life and (2) 156

whether the value or cost of various units of service will be equal or will vary during the periods of service life. d.

There are a number of systematic depreciation methods that recognize these factors in varying degrees and could be used for the computer system; these may be classified as follows: i. On the basis of time-1. A constant charge per period, i.e., the straight-line method. 2. A decreasing charge per period, i.e., a declining- balance or the sum-of-the year’s digits method. 3. An interest (increasing charge) method in which the depreciation charges are adjusted using the entity's average internal rate of return. ii. On an output measure basis-1. A charge based upon a ratio of a constant cost to net revenue contribution; i.e., the cost allocation for each period would be a constant proportion of the net revenue contribution of the computer system. 2. A charge based upon the expected physical services from the computer system; i.e., the cost allocation would be in terms of hours, days or months of operation or some other measure of input or output related to the computer services.

Case 9-4 a.

A firm may wish to construct its own fixed assets rather than acquire them from outsiders to utilize idle facilities and/or personnel. In some cases, fixed assets may be self-constructed to effect an expected cost savings. In other cases, the requirements for the asset demand special knowledge, skills, and talents not readily available outside the firm. Also, the firm may want to keep the manufacturing process for a particular product as a trade secret.

Costs which should be capitalized for a self-constructed fixed asset include all direct and indirect material and labor costs identifiable with the construction. All direct overhead costs identifiable with the asset being constructed should also be capitalized. Examples of costs elements which should be capitalized during the construction period include charges for licenses, permits and fees, depreciation of equipment used in the construction, taxes, insurance, and similar charges related to the assets being constructed.

The increase in overhead caused by the self-construction of fixed assets should be capitalized. These costs would not have been incurred if the assets had not been constructed. This proposition holds regardless of whether or not the plant is operating at full capacity. It is improper to increase the cost of finished goods with 157

costs which were not incurred in their manufacture and which would not have been incurred if fixed assets had not been produced. However, if the total construction costs on self-constructed fixed assets were substantially in excess of their business and economic usefulness, the excess cost should not be capitalized but should instead be recorded as a loss. ii. It is clear that the capitalized costs of self-constructed assets should include a proportionate share of overhead on the same basis as that applied to goods manufactured for sale when the plant is operating at full capacity at the time the fixed asset in constructed. Under these circumstances costs of finished goods produced should not be increased for overhead for goods for which production was foregone. The activity replacing the production of goods for sale should be charged with the related overhead. When idle plant capacity is used for the construction of a fixed asset, opinion varies as to the propriety of capitalizing a share of general factory overhead allocated on the same basis as that applied to goods manufactured for sale. The arguments to allocate overhead maintain that constructed fixed assets should be accorded the same treatment as inventory, new products, or joint products. It is maintained that this procedure is necessary, or special favors or exemptions from undercosting of fixed assets will cause a consequent overcosting of inventory assets. Those arguing against allocating overhead to fixed assets where the assets are constructed when idle capacity exists maintain that since normal production will not be affected or overhead increased, capitalization will result in increased reported income for the period resulting from construction rather than production of goods for sale. It is also sometimes maintained that the full cost of the constructed asset should not include overhead that would be incurred in the absence of such construction. d.

The $90,000 cost by which initial machines exceeded the cost of the subsequent machines should be capitalized. Without question there are substantial future benefits expected from the use of this machine. Because future periods will benefit from the extra outlays required to develop the initial machine, all development costs should be capitalized and subsequently associated with the related revenue produced by the sale of products manufactured. If, however, it can be determined that the excess cost of producing the first machine was the result of inefficiencies or failures which did not contribute to the machine's successful development, these costs should be reported as a separate item of income from counting operations according to the provisions of Accounting Standards Update 2015-01. Capitalizing the excess costs as a cost of the initial machine can be justified under the general rules of asset valuation. That is, an asset acquired should be charged with all 158

costs incurred in obtaining the asset and placing it in productive use. A case could also be made for prorating the excess cost of developing the first machine equally to all four machines on the grounds that these costs were necessary in order to obtain the four machines. In this case, the acquisition of the four machines is analogous to a "basket" purchase where proration is acceptable. Although less supportable, another alternative treatment of the excess costs of developing the initial machine is to treat the costs as research and development. Under current GAAP costs of research and development are expensed as incurred. Case 9-5 a.

The fair market value of the acquired site, as evidenced by the contract price, is $60,000. It is the amount that represents the actual bargained price of the land in a cash transaction. To charge any portion of the option costs to the land account is to disregard the bargained price of the acquired site and, further, implies that the land is more valuable because of the options. The purchase of the options enabled the client to delay his/her selection of a site until the advantages and disadvantages of each were carefully weighted. The benefits to be derived from the net advantage of the selected site over the rejected sites will accrue to the operations of the contemplated plant facility. The cost of the options should therefore be separately capitalized and allocated to the periods benefited. It may also be argued that the cost of the options represents management's failure to plan for the acquisition of a site. Such a contention leads to the conclusion that the cost of the option is a loss and should be expensed immediately, and it supports the recording of the cost of the acquired site at $60.000.

The actual cost of the selected site is the sum of the contract price plus the cost of the option which was exercised to purchase the land. All costs incurred to secure title to the land are properly includable as part of its cost. However, to capitalize the cost of the options that were allowed to lapse would be inappropriate. They have no bearing on the acquisition of effective title to the selected site and should be treated as a loss.

The options were purchased with full knowledge that, after the relative advantages of the three locations were investigated, only one of the options would be exercised. Because the intent was to purchase only one of the three sites, the options should be viewed as an integrated plan for acquiring the site which was ultimately selected. Thus, the cost of all three options should be capitalized as a part of the cost of acquiring the selected site.

Case 9-6 159

Relative to plant assets, a cost incurred, or an expenditure made, that is assumed to benefit only the current accounting period is called a revenue expenditure and is charged to expense in the period believed to benefit. A capital expenditure is similarly a cost incurred or an expenditure made but is expected to yield benefits either in all future accounting periods (acquisition of land) or in a limited number of accounting periods. Capital expenditures (if material in amount) are capitalized, that is, recorded as assets, and, if related to assets of limited life, amortized over the periods believed to benefit. The distinction between capital and revenue expenditures is of significance because it involves the timing of the recognition of expense and, consequently, the determination of periodic earnings. It also affects the amounts reported as assets whose costs generally have to be recouped from future periods' revenues. If a revenue expenditure is improperly capitalized, current earnings are overstated, assets are overstated, and future earnings are understated for all the periods to which the improperly capitalized cost is amortized. If the cost is not amortized, future earnings will not be affected but assets and retained earnings will continue to be overstated for as long as the cost remains on the books. If a nonamortizable capital expenditure is improperly expensed, current earnings are understated and assets and retained earnings are understated for all periods for which unamortized cost should have remained in the accounting records. If an amortizable capital expenditure is improperly expensed, current earnings are understated, assets and retained earnings are understated, and future earnings are overstated for all periods to which the cost should have been amortized.

Depreciation is the accounting process of allocating an asset's historical cost (recorded amount) to the accounting periods benefited by the use of the asset. It is a process of cost allocation, not valuation. Depreciation is not intended to provide funds for an asset's replacement; it is merely an application of the matching concept.

The factors relevant in determining the annual depreciation for a depreciable asset are the initial recorded amount (cost), estimated salvage value, estimated useful life, and depreciation method. Assets are typically recorded at their acquisition cost, which is in most cases objectively determinable. But cost assignments in other cases --"basket purchases" and the selection of an implicit interest rate in asset acquisition under deferred-payment plans--may be quite subjective involving considerable judgement.

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The salvage value is an estimate of a potentially realizable when the asset is retired from service. It is initially a judgment factor and is affected by the length of its useful life to the enterprise. The useful life is also a judgment factor. It involves selecting the "unit" of measure of service life and estimating the number of such units embodied in the asset. Such units may be measured in terms of time periods or in terms of activity (for example, years or machine hours). When selecting the life, one should select the lower (shorter) of the physical life or the economic life to this user. Physical life involves wear and tear and casualties; economic life involves such things as technological obsolescence and inadequacy. Selecting the depreciation method is generally a judgment decision; but, a method may be inherent in the definition adopted for the units of service life, as discussed earlier. For example, if such units are machine hours, the method is a function of the number of machine hours used during each period. A method should be selected that will best measure the portion of services expiring each period. Once a method is selected, it may be objectively applied by using a predetermined, objectively derived formula. d.

Because revenue usually represents an inflow of funds, and expense usually represents an outflow of funds, net earnings represent a net inflow of funds. However, the revenues and expenses reported in the income statements are accrual-based, not cashbased measures. Hence, net income must be adjusted to measure the net cash flows from operations. Depreciation reduces reported net earnings but does not involve an outflow of cash. Therefore, it is added back to reported net earnings to calculate cash provided by operations. On a statement of cash flows, depreciation should be clearly shown as an adjustment to net earnings not requiring a use of cash rather than be shown as a source of cash. Depreciation is not a direct source of cash. It can be considered an indirect source only through income tax savings.

Case 9-7 a.

The following costs, if applicable, should be capitalized as a cost of land: (a) Negotiated purchase price (b) Brokers' commission (c) Legal fees (d) Title fees (e) Recording fee (f) Escrow fees (g) Surveying fees (h) Existing unpaid taxes, interest, or liens assumed by the (i) Clearing, grading, landscaping and subdividing 161

buyer

(j) Cost of removing old building (less salvage) (k) Special assessments such as lighting or sewers if they are permanent in nature. b.

A plant asset acquired on a deferred-payment plan should be recorded at an equivalent cash price excluding interest. If interest is not stated in the sales contract, an imputed interest should be determined. The asset should then be recorded at its present value, which is computed by discounting the payments at the stated or imputed interest rate. The interest portion (stated or imputed) of the contract price should be charged to interest expense over the life of the contract.

In general, plant assets should be recorded at the fair value of the consideration given or the fair value of the asset received, whichever is more clearly evident. Specifically, under the criteria contained at FASB ASC 845, when exchanging an old machine and paying cash for a new machine, the new machine should be recorded at the amount of monetary consideration (cash paid plus the undepreciated cost of the nonmonetary asset (old machine) surrendered if there is no indicated loss. No indicated gain should be recognized by the party paying monetary consideration. If cash is received, gains are not recognized; however, a loss should be recognized if the fair value of the asset exchanged is less than its book value (i.e., an impairment is evident). The resulting amount initially recorded for the acquired asset is equal to the book value of the exchanged asset (adjusted to its fair value, when there is an apparent impairment) plus or minus any cash (boot) paid or received.

Case 9-8 a.

Expenditures should be capitalized when they benefit future periods. The cost to acquire the land should be capitalized and classified as land, a nondepreciable asset. Since tearing down the small factory is readying the land for its intended use, its cost is part of the cost of the land and should be capitalized and classified as land. As a result, this cost will not be depreciated as it would if. it was classified with the capitalizable cost of the building. Since rock blasting and removal is required for the specific purpose of erecting the building, its cost is part of the cost of the building and should be capitalized and classified with the capitalizable cost of the building. This cost should be depreciated over the estimated useful life of the building. The road is a land improvement, and its cost should be capitalized and classified separately as a land improvement. This cost should be depreciated over its estimated useful life.

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The added four stories is an addition, and its cost should be capitalized and classified with the capitalizable cost of the building. This cost should be depreciated over the remaining life of the original office building because that life is shorter than the estimated life of the addition. b.

The gain should be recognized on the sale of the land and building because income is realized whenever the earning process has been completed and the sale has taken place. The net book value at the date of sale would be composed of the capitalized cost of the land, the land improvement, and the building, as determined above, less the accumulated depreciation on the land improvement and the building. The excess of the proceeds received from the sale over the net book value at the date of the sale would be accounted for as a gain and included in income from continuing operations in the income statement.

Case 9-9 a.

The expenditures that should be capitalized when equipment is acquired for cash should include the invoice price of the equipment (net of discounts) plus all incidental outlays relating to its purchase or preparation for use, such as insurance during transit, freight, duties, ownership search, ownership registration, installation, and breaking-in costs. Any available discounts, whether taken or not, should be deducted from the capitalizable cost of the equipment.

When the market value of the equipment is not determinable by reference to a similar cash purchase, the capitalizable cost of equipment purchased with bonds having an established market price should be the market value of the bonds.

ii. When the market value of the equipment is not determinable by reference to a similar cash purchase, and the common stock used in the exchange does not have an established market price, the capitalizable cost of equipment should be the equipment's estimated fair value if that is more clearly evident than the fair value of the common stock. Independent appraisals may be used to determine the fair values of the assets involved. iii. When the market value of equipment acquired is not determinable by reference to a similar cash purchase, the capitalizable cost of equipment purchased by exchanging similar equipment having a determinable market value should be the lower of the recorded amount of the equipment relinquished or the market value of the equipment exchanged. c.

The factors that determine whether expenditures relating to property, plant, and equipment already in use should be capitalized are as follows: 163

. . . . d.

Expenditures are relatively large in amount. They are nonrecurring in nature. They extend the useful life of the property, plant, and equipment. They increase the usefulness of the property, plant, and equipment.

The net book value at the date of the sale (cost of the property, plant, and equipment less the accumulated depreciation) should be removed from the accounts. The excess of cash from the sale over the net book value removed is accounted for as a gain on the sale and reported on the income statement, while the excess of net book value removed over cash from the sale is accounted for as a loss on the sale and reported on the income statement.

Case 9-10 a.

Historical cost is the amount of cash, or its equivalent, paid to acquire an asset. It includes the purchase price and all cost necessary to acquire the asset and get it ready for its intended use. Use of historical cost presents the economic facts as they actually occurred. Thus, it is relevant and reliable. It is relevant because accountants are stewards to owners. The stewardship role implies that accountants must report how moneys invested are spent. This information is disclosed by historical prices paid to acquire assets. Historical cost is reliable because it is objective and verifiable. Historical exchange prices are objectively determinable and verifiable because they are based on evidence that an exchange has taken place and amounts are typically supported by a paper trail, e.g., invoices. Hence, they these measurements represent what they purport to represent and as such are represenationally faithful and neutral. An asset is defined as an economic resource that has future benefit to the entity and results from prior transactions and events. The prior transaction resulting in its existence is the exchange that occurred when the asset was acquired. Those moneys were invested in the asset to provide economic benefit to the company. So long as the asset is in use, cost provides benefit. Hence, cost is a relevant attribute to report to investors, creditors, and other users.

Under the present accounting model, the cost of cleanup would be considered cost of land. The cost of land includes its acquisition price and all costs incurred to get it ready for its intended use. In this example the intended use to have a building built on it. Since, the cleanup is necessary before building can begin, the cost of cleanup is a cost to get the land ready for its intended use and should be capitalized as land. Under this scenario the presumption is that the cleanup cost was necessary to acquire the asset, hence it provides future benefit. The cleanup itself provides value because without it the land is not usable as a building site, and would presumably be worth less. Hence, this expenditure fits the definition of an asset. 164

Case 9-11 a.

The stewardship role of accounting implies that accountants should report on how moneys were invested in assets and the performance resulting from making those investments. This notion is consistent with reporting assets at historical cost. Longterm assets provide benefits for a number of time periods. Investments are made in fixed assets so that over the long-run revenues will be generated. Fixed asset investments thus generate revenues over multiple accounting periods. The matching principle implies that these revenues should be matched with the cost of generating them. Because an element of this cost is the cost of long-term fixed assets these costs should be matched with the revenues they generate, implying that the cost should be allocated to those periods in which the revenues (benefits) are expected to occur.

Accountants believe that cost allocation provides relevant information because it attempts to match cost with revenue and thus provides measures of performance. On the other hand, all allocation schemes are by their very nature arbitrary. As such, they are not objective. Also, one could argue that cash flow is all that matters with regard to fixed assets. In other words, purchasing a fixed asset is an investing activity, a cash outflows. It is not an operating activity. It provides physical assets to generate revenue, but it is a sunk cost and does not recur on an annual basis.

If the purpose of the balance sheet is to disclose resources and claims to resources, historical cost once the asset has been purchased may no longer be relevant. Historical cost does not provide a measure of the current value of the asset in use. Each period the company in effect makes a conscious decision to keep the asset. These decisions imply that the company is, in effect, reinvesting in the asset. Reinvestment decisions are made based on replacement cost. Hence, replacement cost would provide relevant measures of fixed assets.

Yes, a current value approach to the valuation of fixed assets would be consistent with the physical capital maintenance concept. The concept of physical capital maintenance is concerned with maintaining productive capacity, the operating assets of the entity. Assets must eventually be replaced in order to maintain the current level of productive capacity. Hence, measurement of assets at their replacement cost, a current cost measure, is consistent with the physical capital maintenance concept.

The major problems associated with use of replacement cost relate to determining the amount of replacement cost. Once purchased, the replacement cost of fixed assets may be difficult if not practically impossible to determine. Replacement cost is the cost to replace the assets with similar assets in similar condition. But, there may be no ready market for the assets. In these cases, it may be necessary to obtain appraisal values in order to approximate replacement cost. In some cases, specific price indexes may be 165

used, but these measures provide reasonably approximations only when the price of the asset being measured moves in the same way as the movement of the price index. Moreover, relevance of replacement cost may be questionable. It can be argued that entry values are relevant only when purchase is contemplated. For owned assets replacement cost may be irrelevant because these assets will either be used or sold. Hence, a better measure of current value may be net realizable value. Case 9-12 There is a social responsibility aspect to this case. That is, even if there is a slight chance the obligation will not be enforced, McMann should obey the law, and both record the full value of the asset retirement obligation and return the land to its original condition regardless of whether the obligation is enforced. From a purely accounting standpoint, McMann Company would need persuasive evidence to record the obligation based on unlikely enforcement. The company should be able to support that an independent third party (market participant) would similarly assume a 10% probability of enforcement. If such evidence exists (e.g., past history with that governmental agency and data from other available sources) McMann Company could assign a probabilityweighted cash flow of $100,000 ((90% × $0) + (10% × $1,000,000)) to the fair value of the asset retirement obligation. FASB ASC 9-1 Depreciation FASB ASC 360-10-35 Found by searching “depreciation and property, plant and equipment” or by accessing the Assets link and selecting Property, plant and equipment, overall. Specifically, the definition of depreciation is contained in FASB ASC 350-10-35-4. The pronouncements dealing with depreciation can be found by accessing the Printer Friendly with sources link. . FASB ASC 9-2 Asset Impairment A search of “asset impairments” resulted in over 130 entries. The EITF issues can be found by searching asset impairment and EITF. FASB ASC 9-3 Asset Retirement Obligations The discussion of asset retirement obligations is contained at FASB ASC 410 Found by searching “asset retirement obligations” or through the cross reference section using the original pronouncement number FAS 143. The EITF issues can be found by accessing the Printer Friendly with sources link at topic 410. 166

FASB ASC 9-4 Disclosure of Depreciation Found by accessing the Assets link, selecting Property, plant and equipment and selecting disclosure. Topic 360-10-50 FASB ASC 9-5 Overhaul Costs in the Airline Industry Select the industry link and then choose airlines. Select Property and Equipment and then Initial Measurement. Topic 908-360 FASB ASC 9-6 Accounting for the Mining Extractive Industry Select the industry link and then choose extractive industry-mining. Topic 930-330 FASB ASC 9-7 Franchise Prematurity Period Select the industry link and then choose franchises. Topic 952. Debate 9-1 Capitalization of Interest Team 1 Argue for the capitalization of interest The FASB considers interest incurred during construction of the asset as an element of historical cost. Historical cost is the amount of cash, or its equivalent, paid to acquire an asset. It includes the purchase price and all cost necessary to acquire the asset and get it ready for its intended use. Use of historical cost presents the economic facts as they actually occurred. Thus, it is relevant and reliable. It is relevant because accountants are stewards to owners. The stewardship role implies that accountants must report how moneys invested are spent. This information is disclosed by historical prices paid to acquire assets. Historical cost is reliable because it is objective and verifiable. Historical exchange prices are objectively determinable and verifiable because they are based on evidence that an exchange has taken place and amounts are typically supported by a paper trail, e.g., invoices. Hence, they these measurements represent what they purport to represent and as such are representationally faithful and neutral. 167

An asset is defined as an economic resource that has future benefit to the entity and results from prior transactions and events. The prior transaction resulting in its existence is the exchange that occurred when the asset was acquired. Those moneys were invested in the asset to provide economic benefit to the company. So long as the asset is in use, cost provides benefit. Hence, cost is a relevant attribute to report to investors, creditors, and other users. According to SFAS No. 34, (See FASB ASC 835-20) interest during construction is a cost of getting the asset ready for its intended use. Moneys were spent to construct the asset. Debt existed so that the moneys could be available to spend on construction costs. If the moneys had not been spent on constructing the asset, the moneys could have been used to extinguish the debt. Hence, the interest on the debt was avoidable. Because the interest was avoidable, its incurrence during the construction period implies that it was directly attributable to the construction itself. As such, it is properly classified as a construction cost, i.e., costs attach. It is a cost of getting the asset ready for its intended use and should be capitalized along with other construction costs. Team 2 Argue against the capitalization of interest Interest is the cost of debt, not the cost of an asset. Interest is a function of time. As such it is a period cost, i.e., an expense of the accounting period. Debt is incurred to acquire assets which will be employed to generate future cash inflows, or revenues. The assets generate the revenue, not the debt. Hence, the assets constitute the physical plant, the operating assets of the business enterprise. When operating assets are used up their cost expiration is considered an expense of operations. Alternatively, because debt is not a part of the physical plant, the cost of debt (interest) is not considered an operating expense. Rather, it is a nonoperating cost, or expense, of doing business. According to SFAC No. 6, expenses are outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. Debt provides moneys to acquire assets. The assets are used to deliver or produce goods, etc. Interest is incurred to provide debt. Thus, indirectly, the interest is an outflow of assets, incurred in the process of delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. It is incurred during the accounting period in which those activities take place and is a cost, or expense, of the period. It should not be capitalized as a part of the historical cost of the constructed asset. Finance theory is consistent with the argument that interest incurred during construction should not be capitalized. Modern capital structure theory views creditors as capital providers. The corporation determines how much debt versus common stock 168

it wants in its capital structure. In other words, moneys can be supplied to acquire assets with debt or by issuing common stock. According to finance theory, the interest on the debt, like dividends to common stockholders, is a payment to capital providers, a return on their investment in the business. As such it represents a distribution of income, not a cost incurred to acquire an asset. Under this theory, interest would not only not be a part of the historical cost of the asset, it would not even be considered an expense. Debate 9-2 Donated Assets Team 1. Donated assets should not be reported in a company’s balance sheet. Firstly, a donation is a non-reciprocal transfer. The company did not give up anything to acquire donated assets. Therefore, there is no cost. According to the historical cost principle, the cost of an asset includes all costs that were necessary to acquire an asset and get it ready for its intended use. Since, nothing was expended to acquire the asset or get it ready for its intended use, the historical cost principle would be consistent with reporting no value on the company’s balance sheet. Secondly, non-reporting of donated assets is consistent with financial capital maintenance, noted by the FASB in the Conceptual Framework as appropriate for financial reporting. Accordingly, financial accounting would report what was done with the dollars invested by owners. Since no investor dollars were spent to acquire a donated asset, there is nothing to report. Finally, not reporting a value for donated assets is objective. Reporting fair value would require subjective estimates that may not be unbiased, or if unbiased may not reflect the fair value of the donated assets. If so, the reported values may not be relevant to users. Team 2. Donated assets should be reported in a company’s balance sheet at fair value. They represent an inflow of assets to the company from non-owner sources. They meet the definition of assets. They are probable future benefits owned or controlled by the company that resulted from a prior transaction or event (the donation). Thus, representational faithfulness would require that they be reported in the balance sheet until used up as an expense. Reporting fair value of donated assets would provide relevant information to users regarding the financial position of the company. The company would not have a hidden asset and the principle of full disclosure would be met. 169

WWW Case 9-13 a.

Under current GAAP an asset is considered impaired when the total expected future cash inflows are less than the book value (carrying value) of the asset. That is, the carrying value of the asset if not recoverable.

Under current GAAP, an impairment loss is equal to the difference between the book value of the asset and its fair market value.

Less conservative. The recoverable amount is equal to the gross (total) expected cash flows. This amount would be greater than fair value. Fair value is typically presumed to be the present value of expected future cash flows. Hence, the loss measured using the recoverable amount would be smaller, and income would be higher (not conservative). Conservatism implies that when choosing between two alternatives, the one resulting in the lower net income would be selected.

Current GAAP measurement of the loss would be more consistent with the economic concept of income. The economic concept views income as the change in wealth (the value of the company) from one period to the next, excluding investments by and distributions to owners. Fair value is a current value measure of wealth, gross future cash flows would not measure current value.

Case 9-14 a.

The position that no fixed overhead should be capitalized assumes that the construction of plant (fixed) assets will be timed so as not to interfere with normal operations. If this were not the case, the savings anticipated by constructing instead of purchasing plant assets would be nullified by reduced profits on the product that could have been manufactured and sold. Thus, construction of plant assets during periods of low activity will have a minimal effect on the total amount of overhead costs. To capitalize a portion of fixed overhead as an element of the cost of constructed assets would, under these circumstances, reduce the amount assignable to operations and therefore overstate net income in the construction period and understate net income in subsequent periods because of increased depreciation charges. Capitalizing overhead at the same rate as is charged to normal operations is defended by those who believe that all manufacturing overhead serves a dual-purpose during plant asset construction periods. Any attempt to assign construction activities less overhead than the normal rate implies costing favors and results in the misstatement of the cost of both plant assets and finished goods. 170

Case 9-15 a.

b. c.

The justification for capitalizing interest on self-constructed assets is that all costs associated with the construction of an asset, including interest, should be capitalized in order that the costs can be matched to the revenues which the new asset will help generate. The interest rate on the amount to be capitalized is the rate of the avoidable interest, or the actual interest rate incurred, whichever is lower. The amount of interest to be capitalized is determined by multiplying the interest rate by the weighted-average amount of accumulated expenditures on qualifying assets. For the portion of weighted-average accumulated expenditures which is less than or equal to any amounts borrowed specifically to finance construction of the assets, the capitalization rate is the specific interest rate incurred. For the portion of weightedaverage accumulated expenditures which is greater than specific debt incurred, the interest rate is a weighted average of all other interest rates incurred.

Case 9-16 Three approaches have been suggested to account for actual interest incurred in financing the construction or acquisition of property, plant, and equipment. 1.

Capitalize no interest during construction. Under this approach interest is considered a cost of financing and not a cost of construction. It is contended that if the company had used stock financing rather than debt financing, this expense would not have developed. The major arguments against this approach are that an implicit interest cost is associated with the use of cash regardless of the source. Capitalize the actual interest costs. This approach relies on the historical cost concept that only actual transactions are recorded. It is argued that interest incurred is as much a cost of acquiring the asset as the cost of the materials, labor, and other resources used. As a result, a company that uses debt financing will have an asset of higher cost than an enterprise that uses stock financing. The results achieved by this approach are held to be unsatisfactory by some because the cost of an asset should be the same whether cash, debt financing, or stock financing is employed. Charge construction with all costs of funds employed, whether identifiable or not. This approach is an economic cost approach that maintains that one part of the cost of construction is the cost of financing whether by debt, cash, or stock financing. An asset should be charged with all costs necessary to get it ready for its intended use. Interest, whether actual or imputed, is a cost of building, just as labor, materials, and overhead are costs. A major criticism of this approach is that imputation of a cost of equity capital is subjective and outside the framework of a historical cost system. 171

Current GAAP requires that the lower of actual or avoidable interest cost be capitalized as part of the cost of acquiring an asset if a significant period of time is required to bring the asset to a condition or location necessary for its intended use. Interest costs would be capitalized (provided interest costs are being incurred) starting with the first expenditure related to the asset and would continue until the asset is substantially completed and ready for its intended use. Capitalization should occur only if the benefits exceed the costs. Case 9-17 a.

The cost of the warehouse is the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition for its intended use. For Hakie, this is: Purchase price $20,000 Tax ($20,000 x .06) 1,200 Installation 5,200 Total cost $26,200

Weighted-Average Accumulated Expenditures × Interest Rate = Avoidable Interest Or $700,000×.08 = $56,000 Since Hakie has outstanding debt incurred specifically for the construction project, in an amount greater than the weighted-average accumulated expenditures of $700,000, the interest rate of 8% on the borrowed funds is used for capitalization. Capitalization ceases upon completion of the project at December 31, 2020. Therefore, the avoidable interest is $56,000, which is less than the actual interest. The investment revenue of $15,000 is irrelevant because such interest earned on the unexpended portion of the loan is not allowed to be offset against the amount eligible for capitalization.

Case 9-18 a. b.

An impairment loss would not be recognized because the undiscounted cash flows exceed the carrying amount of the asset. An impairment loss of $4 million would be recognized. In this case, a $400,000 decrease in the cash flow estimate, which may be based on a cash flow projection many years in the future, would result in the recognition of a $4 million loss.

Case 9-19 Even though $1.0 million is the most likely outcome (50% chance of occurring), the measurement of the ARO liability should be based on the probability-weighted expected cash flow of $2.0 million 172

Case 9-20 a.

From a conceptual point of view, the method which best matches revenue and expenses should be used; in other words, the answer depends on the decline in the service potential of the asset. If the service potential decline is faster in the earlier years, an accelerated method would seem to be more desirable. On the other hand, if the decline is more uniform, perhaps a straight-line approach should be used. Many firms adopt depreciation methods for more pragmatic reasons. Some companies use accelerated methods for tax purposes but straight-line for book purposes because a higher net income figure is shown on the books in the earlier years, but a lower tax is paid to the government. Others attempt to use the same method for tax and accounting purposes because it eliminates some recordkeeping costs. Tax policy sometimes also plays a role. The three basic questions to be answered before the amount of the depreciation charge can be computed are; 1. What is the depreciation base to be used for the asset? 2. What is the asset’s useful life? 3. What method of cost apportionment is best for this asset?

Case 9-21 a.

The issues discussed in IAS No. 16 are the timing of recognition of assets, the determination of their carrying amounts, and the associated depreciation charges to be recognized. The revised IAS No. 16 did not change the fundamental approach to accounting for property, plant and equipment. The Board’s purpose in revising the standard was to provide additional guidance on selected matters.

IAS No. 16 indicates that items of property, plant, and equipment should be recognized as assets when it is probable that the future economic benefit associated with these assets will flow to the enterprise and that their cost can be reliably measured.

Case 9-22 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution. Financial Analysis Case Answers will vary depending on company selected

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_____________________________________________ CHAPTER 10 _____________________________________________ Case 10-1 a.

MG would have larger total assets than MoWay since they would include $50 billion of intangible assets and goodwill. MoWay will have a higher net income than MG because they will not have the amortization expense that MG will have from the $50 billion of intangible assets they have acquired. Combined this will cause MoWay to have higher ROA compared to MG.

The differences are primarily a result of the different accounting treatment given these companies strategies. R&D is expensed as incurred so the MoWay strategy will not have the negative effect on earnings coming from the amortization of intangible assets. On the other hand, companies that acquire R&D that has already been developed by purchasing other companies or by purchasing the patents developed by other companies are permitted to capitalize these costs and amortize them over their useful lives. Consequently, the financial statement differences arise because the accounting treatments are different. The two companies did the same thing – they spent money to develop an autonomous vehicle that has now become popular and profitable. But their accounting information is different due to the different treatment given to purchased R&D and internal developed R&D.

Case 10-2 a.

To determine whether its equity interest in Ernst Company has been impaired, Investor Corp should first determine whether the deterioration in Ernst Company’s business will have an adverse effect on the fair value of its investment in Ernst Company. Poole Company would likely conclude that an impairment has occurred given the presence of the following impairment indicators: • The significant deterioration in the ability to attract new business • The obsolescence of Ernst Company’s technology relative to the environment it operates in • The downward revision to cash flow projections Poole Company would therefore need to estimate the fair value of the investment. If the estimated fair value is below its carrying amount, the investment is impaired and its carrying amount should be written down to the estimated fair value (determined in accordance with ASC 820) with the offset recorded in net income.

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Since the additional round of financing is an observable price of an identical security, Poole Company should remeasure its equity investment in Ernst Company to $35 per share by recording the following journal entry. Dr. Investment in Ernst Company equity interest $25,000 Cr. Gain on equity interest $25,000

Case 10-3 a.

Dynamic Company should follow the equity method of accounting for its investment in Cart Company because Dynamic Company is presumed, because of the size of its investment, to be able to exercise significant influence over the operating and financial policies of Cart Company. In 2020, Dynamic Company should report its interest in Cart Company's outstanding capital stock as a long-term investment. Following the equity method of accounting, Dynamic Company should record the cash purchase of forty percent of Cart Company at cost, which is the amount paid. Forty percent of Cart Company's total net income from July 1, 2020 to December 31, 2020, should be added to the carrying amount of the investment in Dynamic Company's balance sheet and shown as revenue in its income statement to recognize Dynamic Company's share of the net income of Cart Company after the date of acquisition. This amount should reflect adjustments similar to those made in preparing consolidated statements, including adjustments to eliminate intercompany gains and losses, and to amortize, if appropriate, any difference between Dynamic Company's cost and the underlying equity in net assets of Cart Company on July 1, 2020. The cash dividends paid by Cart Company to Dynamic Company should reduce the carrying amount of the investment in Dynamic Company's balance sheet and have no effect on Dynamic Company's income statement. As a result of following the equity method of accounting, Dynamic Company would generally need to report deferred income taxes in its balance sheet and income statement.

If Dynamic elects to report the investment at fair value, it is reported in the balance sheet at fair value. Fair value is to be measured using exit prices on the balance sheet date. SFAS No. 159 defines fair value as the price that reporting entity would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants. All unrealized holding gains and losses are to be reported in earnings. Dynamic must separately disclose assets and liabilities pursuant to electing fair value in a manner that clearly separates them from the carrying values of other assets and liabilities, either parenthetically by a single line that includes both or on separate lines in the balance sheet. Moreover, if the fair value option is elected for available175

for-sale and/or held-to-maturity securities when SFAS No. 159 is adopted, they are to be reported as trading securities. The cumulative effect of the gains and losses for these securities are to be reported as an adjustment to retained earnings. Case 10-4 a.

Research, as defined in Statement of Financial Accounting Standards No.2, is "planned research or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service...or a new process or technique...or in bringing about a significant improvement to an existing product or process." Development, as defined in Statement of Financial Accounting Standards No. 2, is "the translation of research findings or other knowledge into a plan or design for a new product or process for a significant improvement to an existing product or process whether intended for sale or use."

The current accounting and reporting practices for research and development costs were promulgated by the Financial Accounting Standards Board (FASB) in order to reduce the number of alternatives that previously existed and to provide useful financial information about research and development costs. The FASB considered four alternative methods of accounting: (1) charge all costs to expense when incurred; (2) capitalize all costs when incurred: (3) selective capitalization; and (4) accumulate all costs in a special category until the existence of future benefits can be determined. The FASB concluded that all research and development costs should be charged to expense as incurred. (Statement of Financial Accounting Standards No. 2 does not apply to activities that are unique to enterprises in the extractive industries, and accounting for the costs of research and development activities conducted for other under a contractual agreement is a part of accounting for contracts in general and is beyond the scope of that statement.) In reaching this decision, the FASB considered the three pervasive principles of expense recognition: (1) associating cause and effect; (2) systematic and rational allocation, and (3) immediate recognition. The FASB found little or no evidence of a direct causal relationship between current research and development expenditures and subsequent future benefits. The high degree of uncertainty surrounding future benefits, if any, of individual research and development projects makes it doubtful that there is any useful purpose to be served by capitalizing the costs and allocating them over future periods. In view of the above, the FASB concluded that the first two principles of expense recognition do not apply, but rather that the "immediate recognition" principle of expense recognition should apply.

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The high degree of uncertainty about whether research and development expenditures will provide any future benefits, the lack of objectivity in setting criteria, and the lack of usefulness of the resulting information led the FASB to reject the alternatives of capitalization, selective capitalization, and accumulation of costs in a special category. c.

In accordance with Statement No. 2 of the Financial Accounting Standards Board, the following costs attributable only to research and development should be expensed as incurred: 1. 2. 3. 4.

Design and engineering studies. Prototype and manufacturing costs. Administrative costs related solely to research and development. The cost of equipment produced solely for development of the product ($200,000).

The remaining $300,000 of equipment should be capitalized and shown on the statement of financial position at cost. The depreciation expense resulting from the current year is a part of research and development expense for the year. The market research direct costs and related administrative expenses are not research and development costs. These costs are treated as period costs and are shown as expense items in the current earnings statement. Case 10-5 a. b.

Bentley Company should record the debt securities as an asset at their cost of $15,000 on January 1, 2020. In accordance with FASB ASC 320, Bentley Company would measure the availablefor-sale securities at fair value on a quarterly basis and record any unrealized gains or losses in other comprehensive income. To recognize the change in the fair value of the debt securities from January 1, 2020 to December 31, 2020, Bentley Company should increase the recorded value of the debt securities and record an unrealized gain in other comprehensive income of $3,000 When the debt securities are sold, Bentley should remove the debt securities asset of $18,000 and the $3,000 unrealized other comprehensive income gain from its accounting records. Additionally, Bentley will record a $20,000 receipt of cash and a realized gain of $5,000.

Case 10-6 2nd State Bank should evaluate all available information and consider its experience with Similar borrowers and circumstances. If it determines that the Morgan Hoffman’s default is probable in the foreseeable future, it would likely conclude that the Morgan Hoffman is experiencing financial difficulty. 177

Case 10-7 1.

2. 3.

Watson’s investment in Fowler Corp. bonds should be accounted for as held-tomaturity securities because they have a specific maturity date and Watson has the intent and ability to hold them until the maturity date. Watson’s investment of idle cash in equity securities should be accounted for as fair value securities. Watson’s investment in its supplier should be accounted for as fair value securities. Watson’s ownership stake is far less than 20%, and there is no evidence that Watson can exert significant influence over the supplier, so the investment does not qualify for classification as an equity method investment. Watson’s investment in Stein Corp. stock should be accounted for as fair value securities. However, the $50,000 impairment loss should be recorded, thereby reducing the carrying value of the investment to $25,000. Watson’s investment in Love Co. common stock should be accounted for as an equity method investment because its holdings are greater than 20% and Watson exerts significant influence over Love.

Case 10-8 Scenario 1 – All of the indicators suggest that the historical loss rate will understate the loss rate and should be adjusted up. Both national and regional unemployment rates are forecasted to increase which would increase the expected loss rate. Similarly, the decline in the GDP growth rate would also suggest that the historical loss rate will be too low for the current period. Scenario 2 – All of the indicators suggest that the historical loss rate will overstate the loss rate and should be adjusted down. Both national and regional unemployment rates are forecasted to decrease which would decrease the expected loss rate. Similarly, the increase in the GDP growth rate would also suggest that the historical loss rate will be too high for the current period. Scenario 3 – The indicators provide a mixed set of signals about how to adjust the historical loss rate. On a national level, both the increase in the forecasted unemployment rate and the decrease in the forecasted GDP growth rate, suggest that the historical loss rate will understate the loss rate and should be adjusted up. However, at the regional level both the decrease in the forecasted unemployment rate and the increase in the forecasted GDP growth rate, suggest that the historical loss rate will overstate the loss rate and should be adjusted down. The company will need to decide if they should place more weight on the national or the regional information. If they are not able to determine that one indicator is more

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predictive than the other they will probably leave the loss rate at about the same level as the historical rate. Case 10-9 a.

Yes. Goodwill is considered to result from the ability of an enterprise to generate excess returns - returns greater than would be expected for investments in similar enterprises. This ability can be the result of management efficiency, market share, a better, more competent sales force, etc. Kallus is an industry leader and does generate profits in excess of others in similar lines of business.

Yes. Goodwill is an asset. Assets are defined in SFAC No. 6 as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. The ability to generate excess profits has value. Excess profits are without question economic benefits. These benefits are obtained by the company which has goodwill. It can be argued that they result from prior transactions or events because the increased profits occur now and are expected to recur in the future to prior activities of management to increase market share, etc. Others argue that goodwill meets the definition of an asset only when an exchange transaction takes place, such as the purchase of a business.

The theoretical valuation of goodwill involves capitalizing expected excess earnings. The procedure would be as follows. First, determine what prior earnings have been. Eliminate nonrecurring items. Determine what the company typically earns (average earnings). Compute what earnings would be if the company earned what others in the industry earn. The difference between the company’s average earnings and that of the typical company are considered excess earnings. Take the present value of the expected excess earnings (divide excess earnings by the capitalization rate). The present value is the estimated value of goodwill.

No. Under current GAAP goodwill is not reported unless it is acquired in an arm’s length transaction, e.g., a purchase. First, financial accounting under the traditional accounting model is transaction based. Hence, goodwill should not be recorded unless a transaction occurs. Second, the theoretical value of goodwill is too subjective and would not provide an objective, verifiable balance sheet measure.

Case 10-10 a.

Lincoln National Bank should record the loan at a balance of $93,000, which is the $83,000 purchase price and the $10,000 expected credit loss.

Lincoln National Bank should account for this decrease in expected credit losses as it would for any other instrument subject to the CECL model. As a result, Lincoln 179

National Bank should decrease its allowance for expected credit losses with an offsetting entry to income. Note that the impact of the decrease in the expected credit loss is reported through net income even though the initial credit loss estimate was recognized as an adjustment to the amortized cost basis of the instrument. FASB ASC 10-1 Debt and Equity Investments 1.

Information on accounting for debt and equity securities is found at FASB ASC 32010 and can be found by accessing assets and then investments, and finally debt and equity investments.” To find EITF pronouncements, use the Printer friendly with Sources function

FASB ASC 10-2 Research and Development Research and development implementation issues can be found by searching research and development implementation. Topic 730.To find EITF pronouncements, use the Printer friendly with Sources function FASB ASC 10-3 Best-Efforts-Basis, Research-and-Development-Cost-Sharing Arrangements Search Industries-contractors-federal government-research and development Topic 912-730-25

FASB ASC 10-4 Direct-Response Advertising Search Direct-Response Advertising Topic 340-20

FASB ASC 10-5 Accumulated Losses on Equity Method Investments Link Assets-Investments-Equity method and joint ventures 323-10-35-20 through 22 180

FASB ASC 10-6 Intangible Costs Search cable industry Topic 922 1. Found under 922-350 2. Found under 922-350-25-1 3. Found under 922-350-25-3 4. Found under 922-350-35-2 . Room for Debate Debate 10-1 Goodwill Team 1. Present arguments in favor of the capitalization of “purchased” goodwill. You may consider tying your arguments to theories of capital maintenance and/or the conceptual framework. The primary argument for capitalization of purchased goodwill is that it meets the definition of an asset. Thus, it satisfies the qualitative characteristic of representational faithfulness and which allows us to fulfill the objective of usefulness. 1.

Definition of assets

SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Purchased goodwill is an asset. It represents the amount that the purchaser was willing to pay over and above the fair value of the acquired company’s net assets. As such, it is a measure of additional value of the company, as a whole. Economic theory tells us that a purchaser will not pay more for something than it is worth in an arms’ length transaction. Thus, the inference in the case of purchased goodwill is that the additional amount paid was paid for something of value. Accountants believe that this extra value is related to the acquired company’s ability to generate returns in excess of those generated by a typical company in the same industry. The purchase price of an asset is equal to the present value of future cash flows. Hence, the amount paid for goodwill represents the present value of those expected future cash flows and goodwill is an asset. 2.

Objectives of financial reporting 181

Decision usefulness requires that companies report the status of enterprise resources. As stated above, goodwill provides future service potential. As such, it meets the definition of an asset found in SFAC No. 6, and must be reported as an asset so that the acquiring company can report the status of enterprise resources. 3.

Representational faithfulness

The qualitative characteristic of reliability requires representational faithfulness of items reported. Since goodwill meets the definition of an asset, it must be reported in the balance sheet as an asset so that assets reported in the balance sheet will represent what they purport to represent. 4.

Capital maintenance

Theories of capital maintenance require that income measurement be based on changes in net assets. Since goodwill is an asset, appropriate measurement of net assets, and thus capital maintenance requires that it be included as an asset so that when its value changes (such as an impairment) such changes can be incorporated into the measure of income.

Team 2. Present arguments against the capitalization of “purchased” goodwill. You may consider tying your arguments to theories of capital maintenance and/or the conceptual framework. The primary argument against capitalization of purchased goodwill is that the excess amount paid for a business may not represent goodwill at all, or at best only part of it would. Therefore, purchased goodwill, even if parts of it represent assets, all of it doesn’t and thus it should not be reported as an asset. Purchased goodwill, as currently measured, is likely to be a combination of a number of unidentifiable items, some of which might actually be goodwill. It may simply be the result of ability to bargain on the part of the selling company, and may not represent any excess earnings capacity. It may represent a control premium that the purchaser is willing to pay, just to own the acquired company, and as such does not represent goodwill. It could include other intangible assets that are not readily identifiable. Therefore, purchased goodwill, in a particular situation, may not meet the definition of an asset, or only part of it might. Because of the uncertainty associated with the nature of any excess payment to purchase a company, we cannot say that it is an asset. Thus, to report goodwill as an asset may violate representational faithfulness. The assets reported, when goodwill is 182

included, may or may not be assets. If so, the qualitative characteristic of reliability would be violated. In addition, including a non-asset as an asset would result in improper measurements of capital maintenance. If all or part of goodwill is not an asset, it should be written off in the year of purchase. If not, then income is overstated in the year of purchase. At a later date, if the goodwill is deemed to be impaired, income for the future period would be understated. In other words, proper matching of revenue and cost would not occur. Debate 10-2 The Fair Value Option Team 1 Arguments in favor of the fair value option Reporting financial assets and liabilities at fair value provides decision-relevant information to users. Under the fair value option investments in financial assets and liabilities are reported in the balance sheet at fair value. And, all changes in fair value are reported in earnings. Also, all financial assets to which the fair value option is applied are classified as trading securities. Companies may elect this option even for investments that heretofore were reported using the equity method. The fair value option allows users to better evaluate a company’s investment strategies. It displays what the assets are worth and reporting gains and losses in earnings provides income numbers reflecting increases and decreases in wealth resulting from those strategies. It also discloses the effects of management’s choice to keep the asset (i.e., to reinvest in the asset by choosing not to dispose of it). Treating these assets as trading securities also has merit. Management may dispose of these assets in the market place whenever they choose. The results are unbiased reporting that could occur by allowing management to pick and choose how they will treat a financial asset based on proclaimed “management intent”. Similarly, reporting financial liabilities at fair value has merit because the resulting balance sheet and income statement amounts display the results of management’s decision not to extinguish debt. If, for example, interest rates fall the fair value of debt would rise. To extinguish the debt in the market would require payment at the higher value. The extra cost would decrease company wealth. The fair value option would require management to report the potential decrease in earnings. Finally, we feel that SFAS No. 115 is inadequate because it does not cover financial assets that are not traded in organized exchanges. As a result, those financial assets that are not covered by SFAS No. 115 will be treated differently, even when management’s intention for their disposal is the same as that of assets that are covered by SFAS No. 115. Also, investments in assets over which a company has significant 183

influence are really no different than investments in assets covered by SFAS No. 115. They may be actively traded and could be disposed at any time. Team 2 Arguments in opposition to the fair value option We are opposed to the fair value option. We feel that the other methods that are required to account for financial assets and liabilities are adequate. Management strategies for investing in financial assets differ and we feel that those differences should not be disguised by treating investments in financial assets as trading securities regardless of management’s intent. Those investments over which management has significant influence are not typically investments that will be sold in the near future. Fair value for these assets will not be realized and, thus need not be disclosed. Instead, they are similar to business ownership. We feel that the equity method best displays the results of this type of investment strategy. SFAS No. 115 is intended to disclose the results and financial position of investments in financial assets. Investments that management does not intend to sell in the near future to realize short term gains are different from trading securities. If management does not plan to sell those assets in one year or the current operating cycle, whichever is longer, they should not be reported as trading securities. So, we feel that the fair value option basically means that the FASB believes that the intent of SFAS No. 115 is not valid. If so, then there should not be an “option” and all investments in financial assets should be treated the same. Because some financial assets are not traded, opting to report them at fair value would entail use of estimates of fair value that may not be reliable. If so, the option would compromise the reliability of the resulting financial statements and could result in biased reporting, and thus a loss of transparency. Finally, we do not agree that financial liabilities should be reported at fair value. If management does not plan to extinguish the debt in the market place, the company will never have to pay fair value. WWW Case 10-11 a.

Theoretically yes. These costs are incurred to organize the business and get it ready for business. Hence, they benefit the business over its life because they were incurred so the business could act as a business and generate future cash flows. As such, they represent future benefits of the entity resulting from past transactions or events. 184

Yes. They lack physical substance. They benefit the entity over its useful life, i.e., are long term. The amount of the benefit is difficult to measure (a typical characteristic of intangible assets)

Under the provision of FASB ASC 720-15-25-1, organization costs are expensed as incurred. This treatment was originally required by AICPA Statement of Position 985 which noted that some companies were expensing start-up costs while other companies were capitalizing them, using a variety of periods over which to amortize the costs. This disparate treatment of these costs diminished the comparability of companies' financial statements. Accordingly, Sop 98-5 sought to bring uniformity to the treatment of start-up and organization costs by dictating that these costs be expensed as incurred.

If the cost of intangibles benefits the business over its life, then because the life of the organization is indefinite (essentially perpetual for a corporation), a strong argument can be made for deferring organization costs and not amortizing them at all.

Case 10-12 a.

Garcia Company should record the following journal entry and then report the following amounts on its balance sheet. December 31, 2019 Realized Holding Gain or Loss Fair Value Adjustment (Available-for-Sale) Balance Sheet—December 31, 2019 Long-term investment: Equity investments at cost Less: Fair value adjustment Equity investments at fair value

1,100 1,100

49,500 1,100 $48,400

Yes, Garcia Company did properly account for the sale of the Summerset Company stock. Assuming the securities were adjusted to their fair value on December 31, 2019, their net carrying value was 8,800 on December 31, 2020. 185

December 31, 2020 Fair Value Adjustment (Available-for-Sale) Realized Holding Gain or Loss—Equity

1,500 1,500

The Rossi and Boliva securities are reported at their fair value. Therefore, an adjusting entry must be made to show the $400 excess of fair value over cost in the portfolio. The unrealized holding loss from the previous period must be reversed. As a result, $1,500 adjustment is needed to correctly state the available-for-sale portfolio. Securities Cost Rossi Corp. stock $20,000 Boliva Company stock 20,000 Total of portfolio $40,000 Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.

Fair Value $19,900 20,500 $40,400

Unrealized Gain (Loss) $ (100) 500 $ 400 (1,100) $1,500

The reporting of securities at fair value provides the financial statement user with more relevant financial information. The fair value of the securities is essentially the present value of the securities’ future cash flows and so this helps investors and creditors assess the entity’s liquidity. Also, the fair value of the securities helps the financial statement user to assess the entity’s investment strategies. The financial statements of the entity will reflect which investments have increased in fair value and which investments have decreased in fair value Case 10-13 The fair value option gives companies the option to report most financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrument by instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership. Case 10-14 When intangibles are created internally, it is often difficult to determine the validity of any future service potential. To permit deferral of these types of costs would lead to a great deal of subjectivity because management could argue that almost any expense could be capitalized on the basis that it will increase future benefits. The cost of purchased intangibles, however, is capitalized because its cost can be objectively verified and reflects its fair value at the date of acquisition.

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Case 10-15 The factors to be considered in determining the useful life of intangibles are: 1. The expected use of the asset by the entity. 2. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate. 3. Any legal, regulatory, or contractual provisions that may limit useful life. 4. Any legal, regulatory or contractual provisions that enable renewal or extension of the asset’s legal or contractual life without substantial cost. 5. The effects of obsolescence, demand, competition, and other economic factors. 6. The level of maintenance expenditure required to obtain the expected future cash flows from the asset. Case 10-16 a.

Research, as defined in GAAP (FASB ASC 730-10-25), is “planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service . . . or a new process or technique . . . or in bringing about a significant improvement to an existing product or process.” Development, as defined in GAAP (FASB ASC 730-10-25), is “the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use.”

The current accounting and reporting practices for research and development costs were promulgated by the Financial Accounting Standards Board (FASB) in order to reduce the number of alternatives that previously existed and to provide useful financial information about research and development costs. The FASB considered four alternative methods of accounting: (1) charge all costs to expense when incurred, (2) capitalize all costs when incurred, (3) selective capitalization, and (4) accumulate all costs in a special category until the existence of future benefits can be determined. The FASB concluded that all research and development costs should be charged to expense as incurred. (The authoritative guidance for R&D (FASB ASC 730-10-25) does not apply to activities that are unique to enterprises in the extractive industries. Accounting for the costs of research and development activities conducted for others under a contractual arrangement is a part of accounting for contracts in general and is addressed in other literature See FASB ASC 730-20-5.) In reaching this decision, the FASB considered the three pervasive principles of expense recognition: (1) associating cause and effect, (2) systematic and rational allocation, and (3) immediate recognition. The FASB found little or no evidence of a direct causal relationship between current research and development expenditures and subsequent future benefits. The FASB also stated that the high degree of uncertainty 187

surrounding future benefits, if any, of individual research and development projects make it doubtful that there is any useful purpose to be served by capitalizing the costs and allocating them over future periods. In view of the above, the FASB concluded that the first two principles of expense recognition do not apply, but rather that the “immediate recognition” principle of expense recognition should apply. The high degree of uncertainty about whether research and development expenditures will provide any future benefits, the lack of objectivity in setting criteria, and the lack of usefulness of the resulting information led the FASB to reject the alternatives of capitalization, selective capitalization, and accumulation of costs in a special category. c.

The following costs attributable only to research and development should be expensed as incurred: Design and engineering studies. Prototype manufacturing costs. Administrative costs related solely to research and development. The cost of equipment produced solely for development of the product ($500,000). The remaining $1,500,000 of equipment should be capitalized and shown on the statement of financial position at cost, less accumulated depreciation. The depreciation expense resulting from the current year is a part of research and development expense for the year. The market research direct costs and related administrative expenses are not research and development costs. These costs are treated as period costs and are shown as expense items in the current income statement.

Case 10-17 a.

A dollar to be received in the future is worth less than a dollar received today because of an interest or discount factor—often referred to as the time value of money. The discounted value of the expected royalty receipts can be thought of either in terms of the present value of an annuity of 1 or in terms of the sum of several present values of 1.

If the royalty receipts are expected to occur at regular intervals and the amounts are to be fairly constant, their discounted value can be calculated by multiplying the value of one such receipt by the present value of an annuity of 1 for the number of periods the receipts are expected. On the other hand, if receipts are expected to be irregular in amount or if they are to occur at irregular intervals, each expected future receipt would have to be multiplied by the present value of 1 for the number of periods of delay expected. In each case some interest rate (discount factor) per period must be assumed and used. As an example, if receipts of $10,000 are expected each six months over the next ten years and an 8% annual interest rate is selected, the present value of the twenty $10,000 payments is equal to $10,000 times the present value of an annuity of 1 for 20 188

periods at 4%. Twice as many periods as years and half the annual interest rate of 8% are used because the payments are expected at semiannual intervals. Thus the discounted (present) value of these receipts is $135,903 ($10,000 X 13.5903). Because of the interest rate, this discounted value is considerably less than the total expected collection of $200,000. Continuing the example, if instead it is expected that $10,000 will be received six months hence, $20,000 one year from now, and a terminal payment of $15,000 is expected 18 months hence, the calculation is as follows: $10,000 X present value of 1 at 4% for 1 period = $10,000 X .96154 = $9,615. $20,000 X present value of 1 at 4% for 2 periods = $20,000 X .92456 = $18,491. $15,000 X present value of 1 at 4% for 3 periods = $15,000 X .88900 = $13,335. Adding the results of these three calculations yields a total of $41,441 (rounded), considerably less than the $45,000 total collections, again due to the discount factor. c.

The basis of valuation for patents that is generally accepted in accounting is cost. Evidently the cartons were developed, and the patents obtained directly by the client corporation. Those costs related to the research and development of the cartons must be expensed in accordance with GAAP. The costs of securing the patent should be capitalized. If the infringement suit is unsuccessful, an evaluation of the value of the patent should be made to ascertain the reasonableness of carrying forward the patent cost. If the suit is successful, the attorney’s fees and other costs of protecting the patent should be capitalized and amortized over its remaining useful or legal life, whichever is shorter.

Intangible assets represent rights to future benefits. The ideal measure of the value of intangible assets is the discounted present value of their future benefits. For Steinfeld Company, this would include the discounted value of expected net receipts from royalties, as suggested by the financial vice-president, as well as the discounted value of the expected net receipts to be derived from Steinfeld Company’s production. Other valuation bases that have been suggested are current cash equivalent or fair market value.

The amortization policy is implied in the definition of intangible assets as rights to future benefits. As the benefits are received by the firm, the cost or other value should be charged to expense or to inventory to provide a proper matching of revenues and expenses. Under the discounted value approach, the periodic amortization would be the decline during the year in the present value of expected net receipts. In practice, generally straight-line amortization is used because it is simple and provides a uniform amortization approach. Another approach would be the units-of-production method.

The litigation should be mentioned in notes to the financial statements. Some indication of the expectations of legal counsel in respect to the outcome can properly accompany the statements. It would be inappropriate to record a contingent asset reflecting the expected damages to be recovered. Costs incurred to September 30, 189

2016, in connection with the litigation should be carried forward and charged to expense (or to loss if the cases are lost) as royalties (or damages) are collected from the parties against whom the litigation has been instituted; however, the conventional treatment would be to charge these costs as ordinary legal expenses. If the final outcome of the litigation is successful, the costs of prosecuting it should be capitalized. Similarly, if the client were the successful defendant in an infringement suit on these patents, the generally accepted accounting practice would be to add the costs of the legal defense to the Patents account. Developments between the balance sheet date and the date that the financial statements are released would properly be reflected in notes to the statements as post-balance sheet (or subsequent events) disclosure. Case 10-18 To determine if the loan is impaired, first he present value of the new expected future cash flows based on the loan's implicit rate of return (7%) is computed.

Date 2021 2022 2023

Contractual Cash flows of interest and principal $7,000 7,000 7,000; $107,000

Present Value Factor .9346 .8734 .8163

Impairment $6,542 6114 92,758 $105,441

Since the present value ($105,441) of cash flows is less than the loan's carrying amount ($107,000), a $1,559 impairment loss is recognized. Case 10-19 When companies perform goodwill impairment evaluations, they often only look at companyspecific information, such as current-year and future financial performance. While this information is crucial for comparing a reporting unit’s fair value with its carrying amount, companies also must consider external factors that could affect the fair value or carrying amount of their reporting units. Based on the company-specific information alone, Fowler Corporation appears to have a sufficient level of positive evidence to support a qualitative assertion that its reporting unit’s goodwill is not impaired. However, once the industry and market information are considered, the conclusion requires further consideration. With this negative information (overall markets declined, the reporting unit growing slower than the industry and losing market share), it is clear that Fowler Corporation must perform further analysis to determine the significance that 190

each of these factors and other relevant information may have on the fair value of its reporting unit and weigh such factors into its qualitative screen. Case 10-20 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution. Financial Analysis Case Answers will vary depending on company selected

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CHAPTER 11 Case 11-1 a.

The nominal interest rate, expressed as a percentage of the face value, is used to determine the periodic payment promised in a bond indenture. The effective interest rate is the rate at which bonds can be sold in the market. The nominal and effective rates of interest will be the same only when bonds are sold at face value. If bonds sell at less than face value (a discount), the effective rate is higher than the nominal rate. If bonds sell at more than face value (a premium), the effective rate is lower than the nominal rate.

The $25,000 difference is the adjustment of the nominal interest rate specified in the bond indenture to the market rate. In other words, for an investment of $975,000 the Company's bondholders will receive an annual interest payment of $40,000 plus $25,000 more than they invested when the bonds mature. Though earned throughout the life of the bond contract the bondholders do not receive this portion of the "effective" interest until maturity. This difference is disclosed on the balance sheet as a contra liability in the Discount on Bonds Payable account.

The $10,000 increase in the market value of the bonds from January I to June 30 is primarily the result of a decrease in the rate of interest at which the Company's bonds will trade in the market. The decrease in the market rate of interest at which the bonds will trade may be due to a general change in the conditions of the bond market, to a change in the Company's credit ratings or to a combination of the two. A minor portion of the increase is due to the fact that the bonds were issued at a discount and are now six months closer to maturity. This portion of the increase is due only to the passage of time and would have taken place without any change in the market rate of interest. In other words, assuming no change in the market rate of interest, the market value of the bonds will increase gradually from $975,000 to $1,000,000 at maturity because of the increase in the present value of the unpaid but accruing interest (discount) of $25,000. Assuming the discount is accumulated on an interest basis, this position of the increase in the market value of the bonds will be reported in the Company's financial statements. The portion of the increase in the market value of the bonds which is due to the decrease in the market rate of interest, though not reported in the financial statements, is significant because only by comparing the effective rate of interest at which the bonds were issued with the current market rate of interest can the Company judge whether or 192

not the rate they are paying is advantageous to them. If the market rate is lower it may be to the Company's advantage to refund the old issue even though the funding itself would result in a loss. d.

$975,625. This basis for valuing the bond liability--its effective amount as at the date of the issue, plus accumulated discount on a straight-line basis for the six months since then--is theoretically superior to the other three. It would; however, be more precise to accumulate the discount on an interest basis. The Company actually borrowed $975,000, and the immediate liability incurred cannot be more or less than this amount. The present value of the bond liability is less than maturity value because the effective rate of interest is greater than the nominal rate which appears on the face of the bonds. The actual difference between the present value of the bond liability at the date of issue ($975,000) and its maturity value ($1,000,000) represents that portion of the effective interest on the amount borrowed ($975,000) that will not be paid until maturity. As this amount is accumulated by charges to interest expense and credits to the bond liability, the effective amount of the liability gradually approaches maturity value. $1,000,000. This basis for valuing bond liabilities, the amount due at maturity, is widely used in practice. Its use is frequently supported on the grounds that it represents the amount of true legal liability, since it is this amount that would be due and payable in the event of default. This support disregards the accounting assumption of the going concern and, instead, emphasizes liquidation values. This valuation basis is also supported on the grounds that the discount represents prepaid interest and should therefore be classified as an asset. This argument has no merit because the discount represents unpaid interest, not prepaid interest. Any bookkeeping entry which classifies discount as prepaid interest does so only by failing to properly adjust to amount borrowed to its effective amount. The practice of recording bond liabilities at maturity value and setting up the discount as a deferred charge is defensible only if the amounts involved are not material and it can be shown that this treatment is expedient. $1,780,000. The basis for this alternative--the total amount the Company is obligated to repay over the remaining life of the bonds ($1,000,000 at maturity, plus 39 semiannual interest payments of $20,000 each) --has no justification. It would require the difference between the amount actually borrowed ($975,000) and the total amount the Company became obligated to repay ($1,800,000) to be treated as an asset or a loss when the bonds were issued. To assume that assets were acquired in excess of the amount actually borrowed or that a loss was incurred in an arm's-length transaction is indefensible. The original bondholders invested $975,000 for the right to receive 193

$1,800,000 under the conditions stipulated in the contract (an annuity of $20,000 for forty periods and $1,000,000 at the end of the fortieth period). Thus, at the date of issuance the Company incurs a liability equal to the amount of the bondholders' investment. The difference between this amount and $1,800,000 is the total amount of interest which will accrue with the passage of time. It does not exist at the date the bonds are issued. Except for the materiality of the amounts involved, the use of this alternative as a valuation basis suffers from the same theoretical shortcomings as does the use of face value when bonds are issued at a discount. Case 11-2 a.

Under current GAAP (FASB ASC 470-60) for restructured debt where there is a modification of terms, the debtor recognizes a gain on troubled debt restructure when the total future cash flows are less than the book value of the restructured debt. Whiley Company will recognize a gain on troubled debt restructuring of $10,000 in the income statement, calculated as follows: Current book balances: Note Payable Interest Payable Total future cash flows under the new agreement Gain on Troubled Debt Restructuring

$100,000 10,000

$110,000 100,000 $ 10,000

This requirement implies that the book value of the debt will be written down to equal the total future cash flows of $100,000. Therefore, Whiley Company will report the restructured liability at 12/31/20 at $100,000. Because the recorded value of the restructured debt is equal to the total future cash flows, there will be no interest expense recorded. That is, the debt will be treated as though the effective rate is zero. b.

Current GAAP for the creditor, Security, is found at FASB ASC 310-40. According to this guidance, Security may report the restructured receivable at $75,815, the present value of the future cash flows. This value presumes that Security expects to receive all four payments. If Security believes that it is not probable that all of the $100,000 will be received, the present value of the expected amounts discounted at 10% should be reported.

194

As an alternative, GAAP allows restructured receivables to be recorded at the loan's observable market price. Since the Whiley note has no observable market price, Security may not use this alternative. In addition, GAAP also allows a collateralized receivable to be record at the fair value of the collateral. In this case, the note is secured by equipment having a fair value of $80,000. As a practical matter, this amount would represent the minimum recoverable value of the receivable. Thus, theoretically, it represents the minimum value at which the creditor should report the restructured receivable. The effect on the income statement for 2020 would be that Security would recognize a loss for the difference between the recorded value of the restructured receivable and its book value immediately prior to restructure, as follows: 1. If the restructured receivable is recorded at its present value: Book value of receivable prior to restructuring Recorded value of restructured receivable Loss on Restructured Receivable

$110,000 75,815 $ 34,185

2. If the restructured receivable is recorded at the value of the collateral: Book value of receivable prior to restructuring Recorded value of restructured receivable Loss on Restructured Receivable

$110,000 80,000 $ 30,000

GAAP allows two alternatives for reporting income in the income statement. 1. Security may report changes in the present value due to the passage of time as interest revenue. When interest income is recognized, changes in the present value (or floor value) that are due to changes in expectations regarding future cash flows are reported as adjustments to bad debt expense. 2. All changes in the present value of expected future cash flows (or presumably the floor value) may be treated as adjustments to bad debt expense. c.

Under FASB ASC 470-60 the creditor, Security, would not recognize any loss. It is clear that due to the time value of money and the risk inherent in collecting the future cash flows, Security has suffered a loss. Hence, the asset (the restructured receivable) would be overstated. It is also evident that to allow the debtor more time, implies that there is income associated with the receipt of the future cash flows, assuming they are 195

collected. Hence, this treatment can be viewed as providing financial statements that are more representationally faithful and relevant. Recording the restructured receivable at the present value of the expected cash flows has merit. Balance sheet values for receivables should reflect expectations about future cash flows. The FASB proposed that these cash flows should be discounted at the interest rate on the original financial instrument. This position is defended on the basis that the restructuring represents an effort to recover an existing debt and is not a new financial instrument. Opponents of this view counter that the restructuring is replacing the expected cash flows under the prior, original agreement, hence the interest rate used to discount the original debt instrument is no longer relevant. Recording the restructured receivable at the fair value of the collateral has merit in that this value could presumably be recovered. However, it could be argued that this value should serve only as a floor. If the present value of the expected future cash flows exceeds the fair value of the collateral, it would provide a more relevant measure of the future service potential of the asset. d.

If debtors were allowed to record the transaction in the same manner as creditors, Whiley would recognize a gain for the difference between the present value of the future cash flows and the prerestructure book value of the debt or for the difference between the fair value of the collateral and the prerestructure book value. These values would be equivalent to those reflected above in b. for Security. For example, under the assumption that Whiley will record the restructured debt at $75,815. Total debt would be less by $24,185 ($100,000 - 75,815) than it is under current GAAP. This measurement would have a positive effect on Whiley's debt to equity ratio. At the same time the gain recognized in the income statement would be greater by $24,185 ($34,185 - 10,000). This would increase EPS. Also, because the gain would be closed to retained earnings, the debt to equity ratio would be further enhanced. A similar balance sheet effect would occur in 2020. The debt would again be lower. Debt balance under current GAAP (100,000 - 25,000) $75,000 Debt balance under creditor treatment Beginning balance $75,815 Interest at 10% 7,582 $83,397 Payment received 25,000 58,397 Difference $16,603 Retained earnings under current GAAP 196

Beginning balance Interest expense

$10,000 $10,000

Retained earnings under creditor treatment Beginning balance $34,185 Interest expense ( 7,582) 26,603 Difference $16,603 However, the reported net income in future years would be less by the recognition of interest expense. There would be no difference in the effect on operating cash flows in the statement of cash flows. Case 11-3 a.

Convertible bonds are complex financial instruments comprising two fundamental financial instruments - debt and the option to convert. Financial economics suggests that each feature has value. Hence, the issue price of convertible debt is a function of the two sources of value. The theoretical accounting treatment for convertible bonds would be to separate the fair values of the debt and the option to convert, because it is felt that each has decision relevance to users. Many accounting theorists feel that the option to convert is an equity feature and if a separate value is reported for the option it should be reported as an element of stockholders' equity. This view is consistent with the argument that the value of the option is a function of the value of the stock. The option has value only because it can be converted into stock, hence it is in essence equity. Others contend that the option does not meet the definition of equity because option holders do not act as owners. Rather, they feel that the option is an obligation that should be reported as debt. It is an obligation to issue stock which when satisfied yields capital contributions that are less than what would have been infused into the company had the stock been sold at its then current market price. It is argued therefore, that the conversion is at the expense of preexisting stockholders, hence, the option holder is not acting as an owner. Proponents of this view hold that the value of the option should be separated from debt. Some feel that the separated value should be disclosed as debt, others feel that it should appear between debt and equity, as quasi-equity. Under current generally accepted accounting principles, the value of the option to convert is not separated from debt. Rather the debt is recorded initially at its issue price, and no amount is reported for the option to convert, or equity feature. This 197

treatment is considered practicable because there is no current consensus on how to independently or objectively value the option. b.

FASB ASC 480 requires mandatorily redeemable preferred stock not be disclosed within the stockholders' equity section of the balance sheet. Instead, it is disclosed as a liability This disclosure is required because the FASB feels that mandatorily redeemable preferred stock has characteristics that are more like debt than equity - i.e., that there is a probable future sacrifice of resources. However, the SEC does not allow the stock to be included in total liabilities. Hence the SEC appears to consider redeemable preferred stock as quasi equity.

If convertible debt is issued, the balance sheet would report $100,000 of bonds payable. Each year $10,000 in interest would be paid and reported as an expense. The interest would be tax deductible. Hence, the net effect on reported earnings would be the interest multiplied by one minus the tax rate. The debt to equity ratio would be higher. It would approach the debt covenant restriction and investors may perceive the company to be a risky investment. Upon conversion, there would be no cash flow. The debt would be replaced by stock (equity securities) and the debt to equity ratio would improve. The company would have the alternative of recording conversion at book value or at fair value. If the fair value method is selected there would be an income statement gain or loss. The effect on preexisting stockholders would be that the after-tax interest cash flows would be replaced by and may not be equal to dividend cash flows. However, unlike the redeemable preferred stock, the company would be able to retain its capital without resorting to alternative or new sources of financing. If redeemable preferred stock is issued, it would be recorded at its issue price. Under GAAP, the preferred stock would be debt and would appear on the balance sheet. The debt to equity ratio would be higher. It would approach the debt covenant restriction and investors may perceive the company to be a risky investment. The preferred stock dividend payments would equal the interest payments that would have been made to the holders of the convertible debt, but the dividends would not provide a tax shield. Redemption would require a cash outflow but would have no income statement effect.

The change from reporting the conversion feature as debt to equity would shift balance sheet numbers from debt to equity, thereby enhancing the debt to equity ratio for the convertible debt option and alleviating the constraint on debt covenant restrictions. However, management decisions should be based on economic consequences of alternatives. Managerial action should not be motivated merely by accounting representations. Whether the "equity feature" is reported as debt or equity will, in and 198

of itself, have no cash flow effects and should therefore not affect management's decision. Hence, if the debt covenant restrictions are not a factor, management's decision to issue convertible debt versus redeemable preferred stock should not be affected. However, there is documented evidence is that consistent with the argument that management's decisions are affected by financial statement appearances. The decision to select one alternative over another may be affected by the debt covenant restrictions. If the classification of the "equity feature" materially affects the debt to equity ratio, then management may be more prone to select convertible debt because the debt provides a tax shield and no cash flow will be required to convert the debt to equity. Case 11-4 a.

The effective interest method of amortization of bond discount or premium applies a constant interest rate to the carrying value of debt as opposed to the straight-line method that applies a constant dollar amount over the life of the debt resulting in a changing effective rate paid based on the carrying value of the debt. Either method, however, computes the premium or discount to be amortized as the difference between the par value of the debt and the proceeds from the issuance.

Before the interest method of amortization can be used, the effective yield or interest rate of the bond must be computed. The effective yield rate is the interest rate that will discount the two components of the debt instrument to the amount received at issuance. The two components in the value of a bond are the present value of the principal amount due at the end of the bond term and the present value of the annuity represented by the periodic interest payments during the life of the bond. Interest expense using the interest method is based upon the effective yield or interest rate multiplied by the carrying value of the bond (par value effected for unamortized premium or discount). The amount of the amortization is the difference between recognized interest expense and the interest actually paid (par value multiplied by nominal rate). When a premium is being amortized, the dollar amount of the periodic amortization will increase over the life of the instrument due to the decreasing carrying value of the bond instrument multiplied by the constant effective interest rate, which is subtracted from the amount of cash interest paid. In the case of a discount, the dollar amount of the periodic amortization will increase over the life of the bond due to the increasing carrying value of the bond instrument multiplied by the constant effective interest rate from which is subtracted the amount of cash interest paid. The varying amounts of amortization occur because of the changing carrying value of the bond over the life of the instrument. In contrast, the straight-line method of amortization yields a constant dollar amount of amortization based upon the life of the instrument regardless of effective yield rate demanded in the marketplace. 199

The effective interest method of amortization does not provide an appropriate liability balance amount because the amount disclosed is not the amount necessary to retire the liability on the balance sheet date.

Case 11-5 a.

Gain or loss to be amortized over the remaining life of old debt. The basic argument supporting this method is that if refunding is done to obtain debt at a lower cash outlay (interest cost), then the gain or loss is truly a cost of obtaining the reduction in cash outlay. As such, the new rate of interest alone does not reflect the cost of the new debt, but a portion of the gain or loss on the extinguishment of the old instrument must be matched with the nominal interest to reflect the true cost of obtaining the new debt instrument. This argument states that this matching must continue for the unexpired life of the old debt in order to reflect the true nature of the transaction and cost of obtaining the new debt instrument. Gain or loss to be amortized over the life of the new debt instrument. This argument states that the gain or loss from early extinguishment of debt actually affects the cost of obtaining a new debt instrument. However, this method asserts that the effect should be matched with the interest expense of the new debt for the entire life of the new debt instrument. This argument is based on the assumption that the debt was refunded to take advantage of new lower interest rates or to avoid projected high interest rates in the future and that any gain or loss on early extinguishment should be reflected as an element of this decision and total interest cost over the life of the new instrument should be stated to reflect this decision. Gain or loss recognized in the period of extinguishment. Proponents of this method state that the early extinguishment of debt to be refunded actually does not differ from other types of extinguishment of debt where the consensus is that any gain or loss from the transaction should be recognized in full in current net earnings. The early extinguishment of the debt is prompted for the same reason that other debt instruments are extinguished, namely, that the value of the debt instrument has changed in light of current financial circumstances and early extinguishment of the debt would produce the most favorable results. Also, it is argued that any gain or loss on the extinguishment is directly related to market interest fluctuations related to prior periods. If the true market interest rate had been known at the time of issuance, there would be no gain or loss at the time of extinguishment. Also, even if market interest rates were not known but the carrying value of the bond was periodically adjusted to market, any gain or loss would be reflected at the interim dates and not in a future period. The call premium paid on extinguishment and nay unamortized premium or discount are actually adjustments to the actual effective interest rate over the outstanding life of the bond. 200

As such, any gain or loss on the early extinguishment of debt is related to prior-period valuation differences and should be recognized immediately. b.

Recognizing the gain or loss from refunding debt in the period of extinguishment would provide a balance sheet measure that reflects the present value of the future cash flows discounted at the interest rate that is commensurate with the risk associated with the new debt issue. This measure is equivalent to the issue price of the new debt. The issue price of the new debt is set by the market. The market sets the issue price by discounting the future cash flows set forth in the debt instrument by the market rate of interest.

Recognizing the gain or loss from refunding debt in the period of extinguishment is the generally accepted approach. Originally, these gains and losses were classified as extraordinary, hoverer, in 2002 the FASB concluded that debt extinguishments that are used as a part of an entity's risk management strategy do not meet the criteria for classification as extraordinary items. As noted in Chapter 6, the category of extraordinary items was eliminated by Accounting Standards Update 2015-01.

Case 11-6 a.

Angela should report the estimated loss from the safety hazard as an expense in the income statement and a liability in the balance sheet because both of the following conditions were met. * It is considered probable that liabilities have been incurred. * Based on past experience, a reasonable estimate of the amount of loss can be made. In addition, Angela should disclose the nature of the safety hazard in the notes to the financial statements.

Angela should not report the estimated loss from the noninsurable flood risk as an expense in the income statement or a liability in the balance sheet because no losses have occurred since the warehouse has been uninsured and the asset has not been impaired. Thus, a loss should not be recognized, and a liability does not exist. Furthermore, disclosure of the noninsurable risk in the notes to the financial statements is not required because no losses have occurred since the warehouse has been uninsured. Disclosure in the notes to the financial statements is, however, permitted.

The purchase of movie tickets should be accounted for by debiting an asset account-movie tickets inventory--and crediting cash. An accrual for the estimated promotion expense and liability should be accounted for by debiting promotion expense and crediting an accrued liability for those costs associated with 60 percent of the coupons issued. The coupons actually redeemed this year should be accounted for by debiting 201

the accrued liability and crediting the asset account--movie tickets inventory--for 40 percent of the coupons. Case 11-7 a.

A note received in exchange for property, goods, or services should be recorded at its present value which is presumably the value of the property exchanged. In the case of a note bearing interest at a reasonable rate and issued in an arm's-length transaction, the face value of the note should be used, as explained below. A note received for property, goods, or services represents two elements which may or may not be stipulated in the note: (1) the principal amount, equivalent to the bargained exchange price of the property, goods or services as established between the seller and the buyer and (2) an interest factor to compensate the seller over the life of the note for the use of funds he would have received in a cash transaction at the time of the exchange. Notes so exchanged are accordingly valued and accounted for at the present value of the consideration exchanged between the contracting parties at the date of the transaction in a manner similar to that followed for a cash transaction. When a note is exchanged for property, goods, or services in a bargained transaction entered into at arm's-length, there is a presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the seller for the use of the related funds. In these circumstances the note's present value is identical with its face value. Furthermore, where the rate of interest is reasonable and separately stated, the face value of the note is equal to the bargained exchange price for the property.

ii. When a note bears no interest (or has a stated interest rate that differs sharply from the prevailing rate) and/or is not issued in an arm's-length transaction, the present value must be determined through consideration of the economic substance of the transaction. The note and the sales price of the property, goods or services exchanged for the note should be recorded at the fair value of the property, goods, or services or at an amount that reasonably approximates the market value of the note, whichever is the more clearly determinable. That amount may or may not be the same as the face amount; any resulting discount or premium should be accounted for as an element of interest over the life of the note. In the absence of established exchange prices for the related property, goods or services or evidence of the market value of the note, the present value of a note that stipulates no interest (or a rate of interest that differs sharply from the 202

prevailing rate) should be determined by discounting all future payments on the note, using an imputed rate of interest as described below. This determination should be made at the time the note is issued; any subsequent changes in prevailing interest rates should be ignored. The variety of transactions encountered precludes any specific interest rate from being applicable in all circumstances. However, some general guides may be stated. The choice of a rate may be affected by the credit standing of the issuer, restrictive covenants, the collateral, payment, other terms pertaining to the debt, and the tax consequences to the buyer and seller. The prevailing rates for similar instruments of issuers with similar credit ratings will normally help determine the appropriate interest rate. In any event, the rate used for valuation purposes will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction. The objective is to approximate the rate that would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase that bears the prevailing rate of interest to maturity. b.

If the recorded value of a note differs from its face value, the difference should be treated as discount or premium and amortized as interest over the life of the note in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. This is the "interest" method. Other methods of amortization may be used if the results obtained are not materially different from those which would result from the "interest" method.

ii. The discount or premium is not an asset or liability separable from the note that gives rise to it. Therefore, the discount or premium should be reported in the balance sheet as a direct deduction from or an addition to the face amount of the note. It should not be classified as a deferred charge or deferred credit. The description of the note should include the effective interest rate. A valid alternative would be to report the note at its net value, disclosing the face amount of the note and the effective rate of interest on the face of the financial statements or in the notes to the statements. Amortization of discount or premium should be reported as interest expense in the income statement. Case 11-8 a.

The market price of the term bonds would be the sum of the present values of all of the expected net future cash flows discounted at an effective annual interest rate (yield) of 10 percent. The net future cash outflows are the maturity amount (face value) and the series of future semiannual interest payments adjusted for accrued interest received. 203

The market price of the serial bonds would be determined by computing the market price for each serial separately in the same way that a term bond would be determined and then totaling these prices for the various serials. i.

Immediately after the term bond issue was sold, the current asset--cash--would be increased by the proceeds from the sale of the term bond issue. A noncurrent liability--term bonds payable--would be presented in the balance sheet at the face value of the term bonds, plus the premium. In addition, a current liability--accrued interest payable--would be presented in the balance sheet for accrued interest received (March 1, 2020, to Apri1, 2020).

ii. Immediately after the serial bond issue was sold, the current asset --cash--would be increased by the proceeds from the sale of the serial bond issue. A noncurrent liability--serial bonds payable--would be presented in the balance sheet at the face value of the serial bonds, less the discount.

Previously, the bond issue costs incurred in preparing and selling the bond issue could be accounted for as a noncurrent asset--deferred charge, deducted from the proceeds of the bond issue or charged as an expense. However, No. 2015-03 “Interest—Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs to the Bonds Payable Section” requires bond issue costs to be presented on the balance sheet as a direct deduction from the carrying amount of that debt.

To determine the amount of interest expense for the term bonds for 2020, the net carrying value of the term bonds on April 1, 2020, would be multiplied by the effective interest rate (yield) of 10 percent for 9/12 of the year. (April 1, 2020 to December 31, 2020) To determine the amount of interest expense for the serial bonds for 2020, the net carrying value of the serial bonds on November 1, 2020, would be multiplied by the effective interest rate (yield) of 11 percent and by one sixth (November 1, 2020. to December 31, 2020).

Case 11-9 The two basic requisites for the accrual of a loss contingency (probability of loss and reasonable estimation) are the results of the interaction of several concepts of accounting theory. Three of these concepts are (1) periodicity (time periods), (2) measurement, and (3) objectivity. The first of these concepts relates to the first characteristic of an event necessary before accruing a loss contingency, and the second and third concepts listed relate to the second necessary requirement for the accrual of a loss contingency. 204

The first requirement that must be satisfied for the accrual of a loss contingency is that at a time prior to the issuance of the financial statements there is an indication that it is probable that an asset has been impaired, or a liability has been incurred at the date of the financial statements. A basic objective in the recognition of losses is to record them in the particular period in which they are incurred. With respect to the accrual of a loss contingency, a probable loss should be recognized in the same period in which it resulted in the probable impairment of an asset or the probable incurrence of a liability. The failure to accrue the loss contingency in the period of occurrence will generally overstate earnings initially and understate earnings in future periods. The second requirement for the accrual of a loss contingency states that the amount of the loss must be reasonably estimable. The concept of measurement requires that the event must be quantifiable in terms of a standard unit of measure (dollars). In the case of a loss contingency related to the period covered in the current financial statements, the exact timing and magnitude of the loss may not be known in advance but based on past experience or other methods of analysis, a reasonable estimate of the loss contingency can be made. In making the estimate, the probability that a reasonable amount will be determined statistically is enhanced by a large population of accounts from which the probable loss will occur (law of large numbers). Also related to the reasonable estimation of the probable future loss, the concept of objectivity requires that the estimate be supported by quantitative data. The basis for the estimate must yield essentially the same estimate when computed by different individuals using the available supporting data. The concept of objectivity is supportive of the contention that future events will confirm the occurrence of a loss at the date of the financial statements. Of course, the loss must be probable as well as estimable and justified in light of future events. Relevant accounting information can make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations. Consequently, reasonable estimation of the probable future loss provides financial statement users with information that has predictive value, feedback value, and timeliness. Case 11-10 Situation 1 When a company sells a product subject to warranty, it is probable that there will be expenses incurred in future accounting periods relating to revenues recognized in the current period. As such, a liability has been incurred to honor the warranty at the same date as the recognition of the revenue. Based on prior experience or technical analysis, the occurrence of warranty claims can be reasonably estimated, and a probable dollar estimate of the liability can be made. The contingent liability for warranties meets both 205

of the requirements for the accrual of a loss contingency, and the estimated amount of the loss should be reflected in the financial statements. In addition to recording the accrual, it may be advisable to disclose the factors used in arriving at the estimate by means of a footnote especially when there is a possibility of a greater loss than was accrued. Situation 2 Even though (1) there is a probable loss on the contract, (2) the amount of the loss can be reasonably estimated and (3) the likelihood of the loss was discovered prior to the issuance of the financial statements, the fact that the contract was entered into subsequent to the date of the financial statements precludes accrual of the loss contingency in financial statements for periods prior to the incurrence of the loss. However, the fact that a material loss has been incurred subsequent to the date of the financial statements but prior to their issuance should be disclosed by means of a footnote in the financial statements. The disclosure should contain the nature of the contingency and an estimate of the amount of the probable loss or a range into which the loss will probably fall. Situation 3 The fact that a company chooses to self-insure the contingency of injury to others caused by its vehicles is not basis enough to accrue a loss contingency that has not occurred at the date of the financial statements. An accrual or "reserve" cannot be made for the amount of insurance premium that would have been paid had a policy been obtained to insure the company against this particular risk. A loss contingency may only be accrued if prior to the date of the financial statements a specific event has occurred that will impair an asset or create a liability and an amount related to that specific occurrence can be reasonably estimated. The fact that a company is selfinsuring this risk should be disclosed by means of a footnote to alert the financial statement reader to the exposure created by the lack of insurance. FASB ASC 11-1 Disclosure of Liabilities by Not-For-Profit Entities The disclosure of liabilities for not-for-profit entities as found at FASB ASC 958405. It is found by searching “liabilities and not-for-profit entities.” FASB ASC 11-2 Indirect Guarantees Guidelines for accounting for indirect guarantees are found at FASB ASC 460-10-50. It can be accessed by searching “contingencies and indirect guarantees.” The pronouncement that clarified the issue was FIN 45. 206

Found by using the Print with Sources function FASB ASC 11-3 Derivatives Implementation issues for SFAS N. 133 are found at FASB ASC 815-10-55 and can be accessed through the cross reference feature. After accessing the topic, u se the Print with Sources function. to answer the question. FASB ASC 11-4 The Fair Value Option and Health Care Businesses Search performance indicator Topic 954-825 FASB ASC 11-5 The Use Of Zero Coupon Bonds In A Troubled Debt Restructuring Search troubled debt restructuring and zero coupon Topic 310-40-55 FASB ASC 11-6 Accounting for Loss Contingencies by Regulated Entities Search regulated operations and loss contingencies Topic 980-450-25

FASB ASC 11-7 Hedging and Gas Balancing Arrangements Search gas balancing arrangement Topic 932-815-55 Room for Debate Debate 11-1 Liabilities versus Equity Team 1 Argue for presenting redeemable preferred stock as debt The SEC prohibits the presentation of mandatorily redeemable preferred stock as equity. Since, there are only three balance sheet elements, assets, liabilities and equity, 207

if redeemable preferred stock is not equity, then it must be a liability under the present accounting model as described in the conceptual framework. SFAC No. 6 defines liabilities as the probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. This definition implies that a liability has three characteristics: (1) it embodies a present duty to another entity(ies) that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, on demand, (2) the duty obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and (3) the transaction or other event obligating the entity has already happened. The first characteristic and third characteristics inherent in this definition are easily satisfied by examining the very nature of redeemable preferred stock. Mandatorily redeemable preferred stock embodies an obligation to redeem it at a specified price and time. It thus embodies a nondiscretionary obligation to transfer enterprise assets to the holder, which suggests that it may be a liability rather than equity. In addition, the transaction or event obligating the entity was the issuance of the preferred stock. The issue of whether mandatorily redeemable preferred stock is a liability hinges on determining whether the entity has little or no discretion to avoid the future sacrifice. First, mandatorily redeemable preferred stock is senior to all other stock of the enterprise. This seniority prohibits declaration or payment of dividends to other stock unless the full cumulative dividend has been declared and set aside for holders of redeemable preferred stock. Redemption is not optional on the part of either the issuer or the holder of the stock. Hence, the holder of redeemable preferred shares has a contractual right to receive cash at the specified time and to enforce a contractual provision not to pay dividends on other issues of stock if the preferred dividends have not been paid. And, at redemption, the holder has the right to receive the redemption price, which typically includes unpaid dividends. That right normally becomes a creditor’s interest at the redemption date. If the company were to declare bankruptcy, the holder of mandatorily redeemable preferred stock may be a member of the creditors’ committee that petitions a court for involuntary bankruptcy or reorganization of the debtor. However, the redemption value would not be included in determining insolvency, nor would the holder be able, by themselves, to place the issuer in involuntary bankruptcy. Thus, it appears that owners of mandatorily redeemable preferred stock have essentially the same legal rights as creditors as long as the issuer is solvent and some of the same legal rights as creditors when the issuer is insolvent. Thus, it is argued that the mandatorily redeemable provisions convert what otherwise would be an equity instrument into a liability because the essence of a liability is the obligation to transfer 208

assets to another party. As such, this debt instrument imposes a duty to sacrifice assets that the enterprise has little discretion to avoid. The obligation is virtually unavoidable because the only way it can be avoided is for the company to become financially incapable of paying a return to its owners. Team 2 Argue for presenting redeemable preferred stock as equity Redeemable preferred stock is characterized for legal purposes as “stock.” All financial instruments that are characterized for legal purposes as “stock” are therefore subject to restrictions on distributions to shareholders that stem from corporate law rather than contract. Hence, these securities should be considered equity instruments even when the issuer has a contractual obligation to redeem them. Whether the issuer can be required to satisfy its obligation to redeem depends on the adequacy of the assets and equity as defined by applicable legal provisions. The issuer may avoid the contractually required sacrifice of assets if the applicable legal requirements for a distribution to owners are not met. For example, in a court of law, the amount due upon redemption of preferred stock cannot force a company into bankruptcy. Moreover, this amount due to holders of redeemable preferred stock is not includible in the determination of insolvency. Arguably, the effect of the redemption provision is analogous to cumulative dividends on nonredeemable preferred stock. Cumulative dividends do not become a liability until they become due and payment has effectively been declared. SFAC No. 6 defines equity as the residual interest in the assets of an entity that remains after deducting liabilities. If redeemable preferred stock does not meet the definition of a liability, it must be equity. Separate balance sheet classification of redeemable preferred stock (i.e., separate from equity) is not required under GAAP. All preferred stockholders are considered “stock” holders by law. They are treated in the same way as owners in liquidation - i.e., they are residual owners, but they have claims senior to all other classes of stock. Debate 11-2

Fair Value Option

Team 1 Arguments in favor SFAS No. 159 (FASB ASC 825) allows users to measure financial assets and liabilities at fair value, providing an opportunity to mitigate reported earnings volatility without having to apply complex hedge accounting. Rather than designating a fair value hedging relationship under Statement 133, entities may elect to apply the fair value option to the hedged item at its inception.

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Reporting financial instruments at fair value and including unrealized changes in fair value in earnings would reflect the economic events in the periods in which they occur and faithfully represent the underlying economics—a key objective of the conceptual framework. Thus, the effect of a company’s credit worthiness on its capital structure would be reflected in balance sheet measurements of debt and equity. The FASB believes fair values for financial assets and financial liabilities provide more relevant and understandable information than cost or cost-based measures. The Board considers fair value measurements of financial instruments to be more relevant to financial statement users than cost-based measurements because fair value reflects the current cash equivalent of the entity’s financial instruments rather than the price of a past transaction. The FASB also believes that, with the passage of time, historical prices become irrelevant in assessing an entity’s current financial position. Reporting holding gains and losses for debt would reveal the results of management decision to pay or not pay off debt, to replace debt with new debt (that would reflect current market conditions and credit worthiness) and to substitute or not substitute debt for equity, or vice-versa. In other words, the effects of credit-worthiness and changes in interest rates due to current economic conditions on firms are not captured using the historical cost model Team 2 Arguments opposed If you believe that current value should be applied to liabilities, then giving an option rather than a mandate to do so is inappropriate and could lead to biased reporting whereby management would pick and choose which liabilities to apply fair value to. Stated differently, providing an “option” to continue the use of historical-cost based measurement will lead to accounting that potentially misrepresents the underlying economics. We do not share the FASB’s belief that fair value measure of a company’s liabilities is preferable to historical cost. If management is not going to extinguish debt in the near term, then adjusting it to fair value will not provide the user to figures with which to project future cash flows (an objective of financial reporting, described in SFAC No. 8). Perhaps a criterion based on management intent would be preferable to providing a blanket option to elect fair value. However, past management practices of deceit would indicate that even this criterion would likely result in reduced, rather than enhanced financial statement transparency.

Debate 11-3 Convertible debt 210

Should we separate the debt and equity features of convertible debt? Team 1: Pro Separation. Present arguments in favor of separating the debt and equity features of convertible debt. Convertible debt is a complex financial instrument. Complex financial instruments combine two or more fundamental financial instruments. Convertible debt combines two fundamental financial instruments – debt and equity (the option to convert). The conversion feature has a value that is derived from the value of the stock, not the debt. That value should be separated from the issue price of the convertible debt and reported in the balance sheet as equity, just like other options whose value derives from the value of stock are reported. Convertible debt can be converted into a predetermined number of shares of the issuing company’s capital stock. From the investor’s perspective, convertible debt has a valueadded component built into it – the option to convert the debt into equity. As a result, the debt sells for more than it would, if it were issued as straight debt. This extra issue price is the value of the option to convert. The option is not debt and its value should be reported separately from the value of the debt itself. Stated differently, the issuing company has issued two things as a package deal to the investor – debt (a bond) and the option to convert the debt. The convertible debt can be viewed as similar to debt issued with warrants attach. The warrants give the investor the right to purchase equity shares at a predetermined price. Since this is an issuance of two things – debt and options to purchase shares the issue price is separated into its debt and equity components and reported in the balance sheet as debt and equity. We argue that the same treatment should be afforded to convertible debt. The value of the equity feature (the option to convert) should be separated from the value of the debt itself and the two items (debt and equity) should be reported separately in the balance sheet. Current accounting practice treats convertible debt as straight-debt. It does not separate the option to convert from the debt. We believe that this overstates the amount of debt owed by the company. As a result, the amount of interest expense reported in the income statement is understated each accounting period. This makes the debt look like it was issued at a more favorable interest rate than it actually was. Team 2: Against Separation. Present arguments against the separation of the debt and equity features of convertible debt. According to APB Opinion No. 14, convertible debt should be reported in the balance sheet as straight-debt. We agree that the convertible debt is issued at a higher price than straight-debt is, but any value added due to the ability of the investor to convert 211

the debt to equity shares is not separable from the debt. There is either debt of equity outstanding at any one time, not two different securities. Until conversion takes place, there is only debt outstanding. After conversion takes place, there is only equity outstanding. Convertible debt is not like debt that is issued with warrants. The warrants are separate securities. They can be sold or exercised. If the investor sells the warrants, the debt is still outstanding. If the investor exercises the right to purchase shares of stock, the debt is still outstanding. The debt and the warrants are clearly two separate securities. Conversely, the convertible debt is not two securities that can be separated and treated differently by the investor. It is an either or situation, the issuer has either a debt security or equity securities, never both. Another argument for treating convertible debt as straight-debt lies in the notion that it should be classified according to its governing characteristic. In other words, we ask whether the debt instrument satisfies the definition of a liability or equity at its issuance. At issuance, the company has an obligation to pay the principle and interest until conversion takes place. Thus, the contractual terms of convertible debt indicate that it is a liability. Secondly, the convertible debt instrument embodies an obligation to transfer financial instruments (the stock) to the holder, if and when the option to convert is exercised. Thirdly, we should classify in accordance with the fundamental financial instrument that has the higher value. At issuance, the debt component has a higher market value than the option to convert. WWW Case 11-11 a. b. c. d. e. f.

Mortgage bonds are bonds secured by real estate. Debenture bonds are unsecured bonds. Callable bonds are bonds that may be recalled and retired by the issuer prior to maturity. Convertible bonds are bonds that can be converted into other securities of the issuing corporation for a specified time after issuance. Zero-coupon bonds are bonds sold at a discount, the difference between the selling price and the face value provides the buyer’s total interest payoff at maturity. Bond indenture is the contractual agreement (signed by the issuer of bonds) between the bond issuer and the bondholders. The bond indenture contains covenants or restrictions for the protection of the bondholders.

Case 11-12

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1. This is a common balance sheet presentation and has the advantage of being familiar to users of financial statements. The face or maturity value of $1,000,000 is shown in an obvious manner. The total of $1,085,800 is the objectively determined exchange price at which the bonds were issued. It represents the fair market value of the bond obligations given. Thus, this is in keeping with the generally accepted accounting practice of using exchange prices as a primary source of data. 2. This presentation indicates the dual nature of the bond obligations. There is an obligation to make periodic payments of $55,000 and an obligation to pay the $1,000,000 at maturity. The amounts presented on the balance sheet are the present values of each of the future obligations discounted at the initial effective rate of interest. The proper emphasis is placed upon the accrual concept, that is, that interest accrues through the passage of time. The emphasis upon premiums and discounts is eliminated. 3. This presentation shows the total liability which is incurred in a bond issue, but it ignores the time value of money. This would be a fair presentation of the bond obligations only if the effective-interest rate were zero.

When an entity issues interest-bearing bonds, it normally accepts two types of obligations: (1) to pay interest at regular intervals and (2) to pay the principal at maturity. The investors who purchase Weiss Company bonds expect to receive $55,000 each January 1 and July 1 through January 1, 2040 plus $1,000,000 principal on January 1, 2040. Since this ($55,000) is more than the 10% per annum ($50,000 semiannually) that the investors would be willing to accept on an investment of $1,000,000 in these bonds, they are willing to bid up the price—to pay a premium for them. The amount that the investors should be willing to pay for these future cash flows depends upon the interest rate that they are willing to accept on their investment(s) in this security. The amount that the investors are willing to pay (and the issuer is willing to accept), $1,085,800, is the present value of the future cash flows discounted at the rate of interest that they will accept. Another way of viewing this is that the $1,085,800 is the amount which, if invested at an annual interest rate of 10% compounded semiannually, would allow withdrawals of $55,000 every six months from July 1, 2020 through January 1, 2040 and $1,000,000 on January 1, 2040. Even when bonds are issued at their maturity value, the price paid coincides with the maturity value because the coupon rate is equal to the effective rate. If the bonds had been issued at their maturity value, the $1,000,000 would be the present value of future interest and principal payments discounted at an annual rate of 11% compounded semiannually. 213

Here the effective rate of interest is less than the coupon rate, so the price of the bonds is greater than the maturity value. If the effective rate of interest was greater than the coupon rate, the bonds would sell for less than the maturity value. c.

1. The use of the coupon rate for discounting bond obligations would give the face value of the bond at January 1, 2020, and at any interest-payment due thereafter. Although the coupon rate is readily available while the effective rate must be computed, the coupon rate may be set arbitrarily at the discretion of management so that there would be little or no support for accepting it as the appropriate discount rate. 2. The effective-interest rate at January 1, 2020 is the market rate to Weiss Company for long-term borrowing. This rate gives a discounted value for the bond obligations, which is the amount that could be invested at January 1, 2020 at the market rate of interest. This investment would provide the sums needed to pay the recurring interest obligation plus the principal at maturity. Thus, the effectiveinterest rate is objectively determined and verifiable. The market or yield rate of interest at the date of issue should be used throughout the life of the bond because it reflects the interest obligation which the issuer accepted at the time of issue. The resulting value at the date of issue was the current value at that time and is similar to historical cost. Also, this yield rate is objectively determined in an exchange transaction. The continued use of the issue-date yield rate results in a failure to reflect whether the burden is too high or too low in terms of the changes which may have taken place in the interest rate.

Using a current yield rate produces a current value, that is, the amount which could currently be invested to produce the desired payments. When the current yield rate is lower than the rate at the issue date (or than at the previous valuation date), the liabilities for principal and interest would increase. When the current yield is higher than the rate at the issue date (or at the previous valuation date), the liabilities would decrease. Thus, holding gains and losses could be determined. If the debt is held until maturity, the total of the interest expense and the holding gains and losses under this method would equal the total interest expense using the yield rate at issue date.

Case 11-13 a.

A discount on bonds payable results when investors demand a rate of interest higher than the rate stated on the bonds. The investors are not satisfied with the nominal interest rate because they can earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds and cannot change the nominal rate. However, by lowering the amount paid for the bonds, investors can alter the effective rate of interest. 214

A premium on bonds payable results from the opposite conditions. That is, when investors are satisfied with a rate of interest lower than the rate stated on the bonds, they are willing to pay more than the face value of the bonds to acquire them, thus reducing their effective rate of interest below the stated rate.

Case 11-14 a.

1. The selling price of the bonds would be the present value of all of the expected net future cash outflows discounted at the effective annual interest rate (yield) of 11 percent. The present value is the sum of the present value of its maturity amount (face value) plus the present value of the series of future semiannual interest payments. 2. Immediately after the bond issue is sold, the current asset, cash, would be increased by the proceeds from the sale of the bond issue. A noncurrent liability, bonds payable, would be presented in the balance sheet at the face value of the bonds less the discount. The bond issue costs would be classified as either an expense or a reduction of the related debt liability.

Interest expense would be included for ten months (March 1, 2020, to December 31, 2020) at an effective-interest rate (yield) of 11 percent. This is composed of the nominal interest of 9 percent adjusted for the amortization of the related bond discount. Bond discount should be amortized using the effective-interest method over the period the bonds will be outstanding, that is, the period from the date of sale (March 1, 2017) to the maturity date (March 1, 2022).

The amount of bond discount amortization would be lower in the second year of the life of the bond issue. The effective-interest method of amortization uses a uniform interest rate based upon a changing carrying value which results in increasing amortization each year when there is a bond discount.

The retirement of the bonds would result in a loss from extinguishment of debt that should be included in the determination of net income and classified as an ordinary loss.

Case 11-15 Part 1

Before the effective-interest method of amortization can be used, the effective yield or interest rate of the bond must be computed. The effective yield rate is the interest rate that will discount the two components of the debt instrument to the amount received at issuance. The two components in the value of a bond are the present value of the 215

principal amount due at the end of the bond term and the present value of the annuity represented by the periodic interest payments during the life of the bond. Interest expense using the interest method is based upon the effective yield or interest rate multiplied by the carrying value of the bond (par value adjusted for unamortized premium or discount). The amount of amortization is the difference between recognized interest expense and the interest actually paid (par value multiplied by the nominal rate). When a premium is being amortized, the dollar amount of the periodic amortization will increase over the life of the instrument. This is due to the decreasing carrying value of the bond instrument multiplied by the constant effective-interest rate, which is subtracted from the amount of cash interest paid. In the case of a discount, the dollar amount of the periodic amortization will increase over the life of the bond. This is due to the increasing carrying value of the bond instrument multiplied by the constant effective-interest rate from which is subtracted the amount of cash interest paid. b.

The varying amounts of amortization occur because of the changing carrying value of the bond over the life of the instrument. In contrast, the straight-line method of amortization yields a constant dollar amount of amortization based upon the life of the instrument regardless of effective yield rates demanded in the marketplace.

. Part II. a.

1. Gain or loss to be amortized over the remaining life of old debt. The basic argument supporting this method is that if refunding is done to obtain debt at a lower cash outlay (interest cost), then the gain or loss is truly a cost of obtaining the reduction in cash outlay. As such, the new rate of interest alone does not reflect the cost of the new debt, but a portion of the gain or loss on the extinguishment of the old instrument must be matched with the nominal interest to reflect the true cost of obtaining the new debt instrument. This argument states that this matching must continue for the unexpired life of the old debt in order to reflect the true nature of the transaction and cost of obtaining the new debt instrument. 2. Gain or loss to be amortized over the life of the new debt instrument. This argument states that the gain or loss from early extinguishment of debt actually affects the cost of obtaining a new debt instrument. However, this method asserts that the effect should be matched with the interest expense of the new debt for the entire life of the new debt instrument. This argument is based on the assumption that the debt was refunded to take advantage of new lower interest rates or to avoid projected high interest rates in the future and that any gain or loss on early extinguishment should be reflected as an element of this decision and total interest cost over the life of the new instrument should be stated to reflect this decision. 3. Gain or loss recognized in the period of extinguishment. Proponents of this method state that the early extinguishment of debt to be refunded actually does not differ from other types of extinguishment of debt where the consensus is that any gain or loss from the transaction should be recognized in full in current net earnings. The 216

early extinguishment of the debt is prompted for the same reason that other debt instruments are extinguished, namely, that the value of the debt instrument has changed in light of current financial circumstances and early extinguishment of the debt would produce the most favorable results. Also, it is argued that any gain or loss on the extinguishment is directly related to market interest fluctuations related to prior periods. If the true market interest rate had been known at the time of issuance, there would be no gain or loss at the time of extinguishment. Also, even if market interest rates were not known but the carrying value of the bond was periodically adjusted to market, any gain or loss would be reflected at the interim dates and not in a future period. The call premium paid on extinguishment and any unamortized premium or discount are actually adjustments to the actual effectiveinterest rate over the outstanding life of the bond. As such, any gain or loss on the early extinguishment of debt is related to prior-period valuation differences and should be recognized immediately. b.

The immediate recognition principle is the only acceptable method of reflecting gains or losses on the early extinguishment of debt, and these amounts, if material, must be reflected as ordinary gains and losses.

Case 11-16 According to the provisions of ASU 2015-03, bond issue costs should be recorded as a reduction to the issue amount and then amortized into expense over the life of the bond. A deferred charge account is established and subsequently amortized over the life of the bond issue, separately from but in a manner similar to that used for discount on bonds. Case 11-17 Each of these derivatives carries risk that can be identified as market, credit, operational, legal, and systems. a.

b. c. d.

Market risk is the exposure to the possibility of financial loss resulting from an unfavorable movement in interest rates, exchange rates, stock prices, or commodity prices. Estimating the market value of a derivative at any point is difficult because it is influenced by a variety of factors such as exchange rates, interest rates, and time until settlement. Credit risk is the exposure to the possibility of financial loss resulting from the other party’s failure to meet its financial obligations. Operational risk is the exposure to the possibility of financial loss resulting from inadequate internal controls, fraud, or human error. Legal risk is the exposure to the possibility of financial losses resulting from an action by a court, regulatory agency, or legislative body that invalidates all or part of an existing derivative contract. 217

Systems risk is the exposure to the possibility of financial losses resulting from the disruption at a firm, in a market segment, or to a settlement system that in turn could cause difficulties at other firms, in other market systems, or in the financial system as a whole.

Case 11-18 Types of Derivatives Purpose

Type of Contract

Forward Over-thecounter

Transfer risk

Future

Organized exchange

Transfer risk

Option

Over-thecounter or organized exchange

Transfer risk

Swap

Over-thecounter

Transfer risk

Hybrid

Over-thecounter

Transfer risk

Negotiated on a Obligates the holder case-by-case to buy or sell a specified basis amount of currency at a specified price on a specified date in the future Fixed as to face Obligates the holder value, period, to buy or sell a specified and point of amount of currency at settlement a specified price on a specified date in the future Either negotiated Grants the purchaser or fixed period the right, but not the obligation, to buy or sell a specific amount of currency at a specified price within a specified period Negotiated on a Agreement between case-by-case the parties to make basis periodic payments to each other during the swap period Negotiated on a Incorporates various case-by-case provisions of any or basis all of the preceding types

Type

Market

218

Definition

Case 11-19 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution.

Financial Analysis Case Answers will vary depending on the company selected.

219

CHAPTER 12 Case 12-1 There is insufficient information to calculate the amount of depreciation that would be deducted from the $200,000 pretax accounting income if the purchase were made; hence, the solution will ignore it and concentrate only on the deferred tax impacts. a.

The projected amount of income tax expense that would be recognized if Whitley waits until next year to purchase the equipment is calculated as follows: Pretax accounting income Reversal of deductible amount Reversal of taxable amount Taxable income Tax rate Taxes payable Decrease in deferred tax asset Decrease in deferred tax liability (42,500 x 40%) Income tax expense

$200,000 (37,500) 42,500 $205,000 x 40% $ 82,000 15,000 (17,000) $ 80,000

The projected amount of income tax expense that would be recognized if Whitley purchases the equipment in 2019 is calculated as follows: Income tax expense calculated in a. Increase in deferred tax liability (50,000 x 40%) Income tax expense

$80,000 20,000 $100,000

If the goal of management is to improve the appearance of their financial statements, the purchase should be postponed. The following financial statement effects would occur if the purchase were made in 2019. Current assets (cash) would decrease by the amount of the purchase price. Long term assets would increase by the same amount less depreciation. Current liabilities would be unaffected. The result would be a decline in liquidity measures, such as the current ratio and working capital.

220

The deferred tax increase would increase long-term liabilities. At the same time net income would decrease by the amount of depreciation expense and by the amount of the deferred tax liability increase. The effect would be to increase the debt to equity ratio. The decrease in net income would result in a decline in EPS. Ignoring depreciation expense on the acquired asset, the following differences in EPS would occur: EPS - Postpone purchase: ($200,000 - 80,000)/55,500 = EPS - purchase in 2006: ($200,000 -100,000)/55,500 Decline in EPS

$ 2.16 1.80 $ 0.36

Not only would EPS decline if the purchase were made, but it would fall below the prior year EPS, $1.95. The company would no longer display the historic steadily increasing EPS. d.

The company would continue to project a steadily increasing EPS if the purchase were postponed. Although the EPS would be historically correct, i.e., representationally faithful, the projections implied by it may mislead potential investors, particularly, if next year is no better, or is even worse than 2019. The ethical dilemma is that a company should not base economic decisions on financial statement effects. Rather, the financial statements should portray economic reality regardless of what that reality is.

Case 12-2

Supporters of discounting deferred taxes argue that the present value of liabilities provides measures that are more representationally faithful. If deferred taxes portray future tax consequences (cash outflows) and those tax consequences are liabilities, then because of the time value of money they should be discounted. As a result, discounted deferred taxes provide better measures of future cash flows, and are thus more relevant. By deferring taxes, the company is economically better off, and discounting better reflects the resulting well-offness. Also, discounting deferred taxes is consistent with measurements of other liabilities such as notes and bonds.

Opponents of discounting deferred taxes argue that the result is a mismatching of the deferred tax consequences with the temporary differences and reversals causing them to occur. Moreover, discounting conceals the actual tax burden by reporting part of the future tax consequences as interest expense. Finally, it can be argued that there is no interest expense because the government is in effect making an interest free loan to the company; hence, there is no interest rate with which to discount the deferred taxes. 221

Case 12-3 a.

Intraperiod income tax allocation is necessary to obtain an appropriate relationship between income tax expense and each element of earnings and between income tax expense and prior-period adjustments. Any prior-period adjustment is shown net of the corresponding income tax consequences as an adjustment to beginning retained earnings.

Some accountants cite the argument that income taxes are an expense rather than a distribution of earnings. They apply the matching concept of accrual accounting, thus relating the income taxes presented on the earnings statement to the earnings that gave rise to those taxes. Their argument is that income tax expense for financial reporting should be related to the respective pretax accounting earnings. Implicit in this argument is the notion that a distribution of earnings is not allocated to periods.

Under the guidance contained at FASB ASC 740 (original pronouncement SFAS No. 109), deferred tax accounts reflect deferred, future tax consequences. The tax consequences of temporary differences between taxable income and pretax accounting income that will result in future taxable income greater than future pretax accounting income (future taxable amounts) represent the deferral of tax payments and are considered liabilities. The tax consequences of temporary differences between taxable income and pretax accounting income that will result in future taxable income less than future pretax accounting income (future deductible amounts) represent future benefits and are therefore considered assets. In addition, NOL carryovers and unused tax credits embody future tax benefits which are considered assets. The deferred tax assets and liabilities are measured by projecting the future tax consequences and calculating their balance sheet amounts using tax rates that will be in effect in future years based on currently enacted tax law. The deferred tax assets may be reduced by a valuation allowance if it is more likely than not that some or all of their future benefits will not be realized. At the balance sheet date, a determination is made as to whether deferred tax assets (net of their valuation allowance) and deferred tax liabilities are current or noncurrent. Deferred taxes are considered current or noncurrent based on whether the related balance sheet accounts are classified as current or noncurrent. For example, a deferred tax liability would be classified as noncurrent if it results from a temporary difference in depreciation because the related net plant asset is classified as noncurrent. If there is no related balance sheet account, the determination is made based on whether reversal is expected to occur within the operating cycle or one year, whichever is longer. 222

In the balance sheet, current deferred tax assets are netted against current deferred tax liabilities. A resulting net liability is reported as a single amount as a current liability. A resulting net asset is reported as a single amount as a current asset. Noncurrent deferred tax assets and liabilities are netted and reported in a similar manner as a single noncurrent asset or liability amount. d.

Temporary difference. The full estimated three years of warranty expenses reduce the current year's pretax accounting earnings but will reduce taxable income in varying amounts each respective year, as incurred. Assuming the estimate as to each warranty is valid, the total amounts deducted for accounting and for tax purposes will be equal over the three-year period for a given warranty. This is an example of an expense that, in the first period, reduces pretax accounting earnings more than taxable income and, in later years, reverses and reduces taxable income without affecting pretax accounting earnings.

ii. Permanent différence. This difference in depreciation for pretax accounting earnings and taxable income will never reverse because the depreciation is based on different recorded amounts of the assets in question. The income tax expense per books would be reflected based on the amount actually paid (or due) in this situation. iii. Temporary difference. The investor's share of earnings of an investee (other than subsidiaries and corporate joint ventures) accounted for by the equity method is included in pretax accounting earnings, while only dividends received are included in taxable income. This difference between pretax accounting earnings and taxable income is assumed to be related either to probable future dividend distributions or to anticipated realization on disposal of the investment and is a factor in determining income tax expense. Future dividends imply ordinary income, and future disposal of an investment implies capital-gains income. Because dividend income is subject to an 85% dividends-received deduction, the effective rate would, in this case, be lower for the ordinary dividend income than for capital gains. e.

Estimated warranty costs (covering a three-year period) that are expensed for accounting purposes when incurred result in future deductible amounts because they are not deductible for tax purposes until paid. The resulting tax benefit is a deferred tax asset. Normally equity method income will exceed the taxable portion of dividends received. A reversal would therefore be a taxable amount and would result in a deferred tax liability. 223

Case 12-4 a.

The term "temporary differences" is the differences between taxable and financial accounting income that occur either because revenue is recognized in one period for income tax purposes and in a different period for accounting purposes or because expenses are recognized in either an earlier or later period for accounting purposes than for tax purposes. Temporary differences are also caused by management decisions regarding the timing of tax payments. This difference will reverse in some later period.

Examples of temporary differences contained at FASB ASC 740-10-25-20 (original pronouncement SFAS No. 109) include: 1. Revenues or gains that are taxable after they are recognized in financial accounting income. 2. Expenses or losses that are deductible after they are recognized in financial accounting income. 3. Revenues or gains that are taxable before they are recognized in financial accounting income. 4. Expenses or losses that are deductible before they are recognized in financial accounting income. 5. A reduction in the tax basis of depreciable assets because of tax credits. 6. The investment tax credit accounted for by the deferred method. 7. Foreign operations for which the reporting currency is the functional currency. 8. An increase in the tax basis of assets because of indexing for inflation. 9. Business combinations accounted for by the purchase (now acquisitions) method.

SFAS No. 109 defended interperiod tax allocation on the basis that temporary differences have future tax consequences. They therefore result in deferred tax assets and deferred tax liabilities. The recognition of deferred tax assets and liabilities affects the amount reported for income tax expense. This effect is consistent with the definition of earnings as changes in net assets attributable to non-owner events and transactions. Interperiod tax allocation can also be defended as being consistent with the matching concept, even in the context of SFAS No. 109. If the future tax consequences argument holds, the effect of applying SFAS No. 109 is to match in the current accounting period, the expected, deferred tax consequences of transactions and events reported in the income statement with their future tax consequences measured at the tax rate expected to occur when the reversal is expected to take place, given currently enacted tax law. Changes in tax rates in future periods due to changes in tax law are treated as changes in estimate in a manner consistent with other balance sheet and income statement items.

Case 12-5 224

Under the provisions of SFAS No. 109, the criteria for recognizing a deferred tax liability specify that a temporary difference has future tax consequences resulting in a liability when the reversal is a future taxable amount. If so, according to SFAS No. 109, the resulting deferred tax consequences meet the definition of liabilities found in SFAC No. 6. That is, the deferred taxes obligate the entity to pay future taxes in excess of the amount that would be paid if there were no reversal, and the obligation results from a prior transaction or event, the occurrence of the temporary difference. The criteria for recognizing a deferred tax asset specify that a temporary difference has future tax consequences resulting in an asset when the reversal is a future deductible amount. Also, a NOL carryforward and unused tax credits have future benefit and are considered assets. Recognition of the asset is constrained by the more likely than not criterion that may limit the amount of deferred tax assets in the balance sheet by a valuation allowance. According to SFAS No. 109, the resulting deferred tax assets meet the definition of assets found in SFAC No. 6. They embody future benefit to the entity resulting from prior transactions or events (the occurrence of the temporary difference or the presence of the NOL carryforward or unused tax credit).

The asset/liability method of interperiod tax allocation is balance sheet oriented. The intent is to accrue and report the total tax benefit or taxes payable that will actually be realized or assessed on temporary differences when they reverse. A temporary difference is viewed as giving rise to either a tax benefit that will result in a decrease in future payments, or a tax liability that will be paid in the future at the then-current tax rates. When using the asset/liability method, income tax expense is the sum (or difference between) the changes in deferred tax asset and liability balances, and the current provision for income taxes per the tax return. Under this approach, deferred taxes meet the conceptual definition of assets and liabilities established in SFAC No. 6. The deferred method of income tax allocation is an income statement approach. It is based on the concept that income tax expense is related to the period in which income is recognized. The tax effect of a temporary difference is the difference between income taxes computed with and without the inclusion of temporary differences. The resulting difference between income tax expense and income taxes currently payable is an increase or decrease to the deferred tax account.

Case 12-6 a.

Proponents of no allocation of income taxes believe that income tax expense should be equal to the current year provision for taxes. The following are arguments defending this position. 225

1. Income taxes result from taxable income, not accounting income. Thus, attempts to match taxes with accounting income are irrelevant. 2. Income taxes are not like other expenses; therefore, they should not be allocated in a manner similar to other expenses. Other expenses are costs of generating revenue. Income taxes generate no revenue. They are not incurred in anticipation of future benefit, nor are they expirations of cost incurred to provide facilities that generate revenue. 3. Income taxes are levied on total taxable income, not individual items of revenue or expense. Hence, there are no temporary differences between taxable income and accounting income. 4. Tax allocation hides economic differences between a company that employs tax savings strategies from one that does not. 5. Reporting tax expense equal to taxes paid provides a better predictor of future cash flows because many deferred taxes will never be paid. 6. Tax allocation presumes implicit forecasts of future profits, a practice which is inconsistent with conservatism. 7. Deferred tax liabilities do not meet the definition of a liability. There is no present obligation to the future taxes reported as deferred tax liabilities. There is no prior transaction because there is no legal liability until an actual tax return is filed. 8. The cost of doing interperiod tax allocation exceeds the benefits, if any, derived. b.

Proponents of partial allocation of income taxes propose that interperiod tax allocation is appropriate for items that will reverse, but not for others. They cite the following arguments to defend their position. 1. Many temporary differences are not like items such as accounts payable. Accounts payable “roll over” as the result of individual transactions each of which is individually paid. Because income tax is based on total taxable income, consideration of the effects of groups of items is appropriate. 2. Comprehensive income tax allocation distorts economic reality. For many items there is no “roll over” because the tax rules persist, and the company continues to repeat the same economic transactions (e.g., purchase fixed assets). Thus, consideration should be given to the impact of the future, as well as to historical transactions. 3. Partial allocation enhances assessments of future cash flows. The deferred taxes reported would be more reflective of expected cash flow. 4. Comprehensive allocation is a rigid mechanical approach, which inherently results in the distortion of economic reality.

Proponents of comprehensive allocation of income taxes argue that all temporary differences have future tax consequences and those tax consequences should be reported in the balance sheet as assets and liabilities. No allocation or partial allocation distorts the presenting of the economic facts because neither approach matches the 226

items reported in the income statement with their tax cash flow effects. The following arguments support this position. 1. Individual temporary differences do reverse. They are temporary, not permanent. Thus, the focus should be on individual items not on groups of items. 2. Accounting is historical. It is inappropriate to offset the income tax effects of possible future transactions against the tax effects of transactions that have already occurred. 3. Temporary differences result in future tax consequences. Hence, the expected tax effects should be reported in the same period as the related transactions and events in pretax financial accounting income. 4. Accounting should not be subjected to manipulation. Management should not be allowed to affect (bias) results by selecting which tax effects resulting from temporary differences should be recorded and which should not. Case 12-7 a. i. Gross Profit on Sales Operating Expenses Rent Expense Taxable Income Tax rate Taxes paid

2019 $350,000 210,000 60,000 $ 80,000 x30% $ 24,000

2020 $349,000 210,000 0 $139,000 x30% $ 41,700

2021 $351,000 210,000 0 $141,000 x30% $ 42,300

Net Income

$ 56,000

$ 97,300

$ 98,700

2019 $350,000 210,000 20,000 $120,000 36,000 $ 84,000

2020 $349,000 210,000 20,000 $119,000 35,700 $ 83,300

2021 $351,000 210,000 20,000 $121,000 36,300 $ 84,700

ii. Gross Profit on Sales Operating Expenses Rent Expense Income before taxes Tax Expense @ 30% Net Income

c. i.

The student may have his/her own opinion regarding this question. We believe that no allocation does distort net income. The company has performed essentially the same for all three years, yet no allocation gives the appearance, looking at net income, that the company performed significantly better the latter two years, almost twice as well. 2019 227

2020

2021

Gross Profit on Sales Operating Expenses Rent Expense Income before taxes Tax Expense Net Income

$350,000 210,000 20,000 $120,000 36,000 $ 84,000

$349,000 210,000 20,000 $119,000 39,870 $ 79,130

$351,000 210,000 20,000 $121,000 40,530 $ 84,700

2020 Tax expense: $139,000 x 33% = 20,000 x 30% =

$45,870 (6,000) $39,870

2021 Tax expense: $141,000 x 33% = 20,000 x 30% =

$46,530 ( 6,000) $40,530

ii. Gross Profit on Sales Operating Expenses Rent Expense Income before taxes Tax Expense Net Income

2019 $350,000 210,000 20,000 $120,000 36,000 $ 84,000

2020 $349,000 210,000 20,000 $119,000 40,470 $ 79,130

2021 $351,000 210,000 20,000 $121,000 39,930 $ 81,070

2019

Deferred Tax Liab. = 40,000 x 30%

$12,000

2020

Deferred Tax Liab. = 20,000 x 33% Decrease Taxes paid

2021

Deferred Tax Liab. = Decrease Taxes paid

6,600 $(5,400) 45,870 $40,470 0 ( 6,600) $46,530 $39,930

The asset/liability approach provides measures that are more useful. The asset/liability approach reports the deferred tax liability at the amount expected to be paid when the temporary difference reverses - i.e., when tax is paid on the taxable amount. The deferred method reports the deferred tax liability measured at the old tax rate. Hence, it does not reflect the expected cash outflow and the measurement is not consistent with the measurement implied in the definition of a liability as the probable future sacrifice. 228

Case 12-8 The answer depends on how and when a tax benefit or loss is expected. The tax rate would be 20% if the entity expects to realize a tax benefit for the deductible temporary differences by offsetting taxable income earned in future years. Alternatively, the tax rate would be 15% if the entity expects to realize a tax benefit for the deductible temporary differences via a losscarryback refund. Case 12-9 Yes. If the asset is sold at its book carrying amount of $114,000, the amount by which the book basis exceeds the tax basis ($2,000) will be taxable income. Alternatively, if the asset were to be held and used in operations, there is a difference at the end of 2020 between the book and tax basis (i.e., amount of future deductions for book and tax purposes). Recovery of the book basis through book depreciation Future tax depreciation (represents future tax deductions) Temporary difference

$114,000 (112,000) $ 2,000

FASB ASC 12-1 Tax Effect of Translation Adjustment Accounting for foreign currency translation adjustments is located at FASB ASC 830. It can be found by searching tax effect of translation adjustment. FASB ASC 12-2 Interpretations of SFAS No. 109 Found by accessing topic 740 through the cross reference function and using the Printer Friendly with Sources function. FASB ASC 12-3 Undistributed Earning of a Subsidiary Search income taxes and undistributed earnings of subsidiaries 740-30-25 FASB ASC 12-4 Deferred Tax Benefits for the Oil and Gas Industry Search oil and income taxes 932-740-30

229

In applying the comprehensive interperiod income tax allocation provision, the possibility that statutory depletion in future periods will reduce or eliminate taxable income in future years shall be considered in determining whether it is more likely than not that the tax benefits of deferred tax assets will not be realized FASB ASC 12-5 Special Temporary Difference for Steamship Companies Search industry-U. S. steamship and income taxes 995-740-25 FASB ASC 12-6 Temporary Differences for Entities Operating in Foreign Countries Search Temporary differences for foreign operations 740-10-55 FASB ASC 12-7 Deferred Taxes in the Casino Industry Use industry link-entertainment- casino- income tax 924-740 Room for Debate Debate 12-1 Deferred Method versus Asset–Liability Method Team 1 Defend the deferred method of accounting for income tax expense The deferred method of income tax expense is grounded on the assumption that income tax expense is related to the period in which income is recognized. Under the deferred method income tax expense is measured as though the current period pretax financial accounting income is reported in the current year’s income tax return. The tax effect of a temporary difference is measured as the difference between income taxes computed with and without the inclusion of the temporary difference. The resulting difference between income tax expense and income taxes currently payable is a debit or credit to the deferred income tax account. The deferred method is based on the matching concept. The tax effects of temporary differences are matched with the temporary differences when they originate and reverse. The matching concept is important to income reporting because of the going concern assumption. Since business entities are presumed to be going concerns, enterprise performance must be assessed at intervals. That is, accountants must report 230

periodically to investors, creditors and other users. Periodic reporting requires that accountants report on the performance of the entity during an accounting period so that users can assess enterprise how well the enterprise is utilizing resources to generate future cash flows for operations, reinvestment in operations, and dividends for investors. Some contend that the deferred tax balances resulting from application of the deferred method are meaningless because they result from the calculation of tax expense, i.e., they do not meet the definition of assets or liabilities. However, the income statement is the most important financial statement, and matching is a critical aspect of the accounting process. Thus, it is of little consequence whether deferred tax debits or credits meet the definition of assets or liabilities in the conceptual sense. Because the deferred method matches tax expense with all items reported in the income statement regardless of when they appear in the tax return, the resulting deferred taxes are the result of historical transactions or events that created the temporary differences. Since accounting reports most economic events on historical cost basis, deferred taxes should be reported in a similar manner. Historical cost is objective, verifiable, and neutral. It fulfills the stewardship function of accounting and is the cornerstone of the traditional accounting model. Accounting numbers should be reliable. The historical tax rates used to compute income tax expense and thus the deferred tax balances are historical rates and as such are objective, verifiable, and neutral. As a result, their use increases the reliability of accounting information. Team 2 Defend the asset/liability method of accounting for income tax expense The asset/liability method of accounting for income tax expense is balance sheet oriented. Under the asset/liability method, the tax benefits or liabilities that will be realized or assessed on temporary differences when they reverse. The result is the reporting of the future tax consequences of prior and present temporary differences between pretax financial accounting income and taxable income. Because the asset/liability approach reports future tax consequences, the measurement of the expected future assessment or benefit is based on tax rates that will be in effect (under currently enacted tax law) when the taxable or deductible amounts resulting from temporary differences occur. The resulting deferred tax assets and liabilities have predictive ability because the balance sheet amounts are measures of expected future resource flows. This approach is superior to the deferred method which measures deferred taxes at the originating rate, which does not measure expected tax benefits or assessments. 231

Because of the measurement approach used, the deferred tax assets and liabilities reported under the asset/liability approach meet the definitions of assets and liabilities found in SFAC No. 6. Deferred tax assets can be viewed as embodying probable future benefits because they represent amounts of tax that are recoverable when future taxable income is less than accounting income (deductible amounts). Deferred tax liabilities meet the definition of liabilities because they represent amounts that will be assessed when future taxable income is greater than financial accounting income (taxable amounts). As such this approach increases the predictive ability of items in the balance sheet, increases the ability to assess liquidity as well as financial flexibility. The asset/liability approach to measuring deferred taxes provides balance sheet measures that are relevant to assess future resource flows. The balance sheet is becoming more important. There is an increased tendency to rely upon changes in assets and liabilities to indicate income statement measures. Such measures are consistent with the definition of comprehensive income and as well the economic concept of income as well. Debate 12-2 Discounting Deferred Taxes Team 1. Arguments in favor SFAS No. 109 stated that the asset and liability approach to accounting for income taxes is consistent with the definitions in FASB Concepts Statement No. 6, Elements of Financial Statements. Liabilities are defined in paragraph 35 of Concepts Statement 6 as "probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events". Accordingly, liabilities comprise three characteristics. The FASB argued that deferred tax liabilities have all three characteristics. The first characteristic of a liability is that it "embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand". Taxes are a legal obligation imposed by a government, and an obligation for the deferred tax consequences of taxable temporary differences stems from the requirements of the tax law. A government levies taxes on net taxable income. Temporary differences will become taxable amounts in future years, thereby increasing taxable income and taxes payable, upon recovery or settlement of the recognized and reported amounts of an enterprise's assets or liabilities. The second characteristic of a liability is that "the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice”. An enterprise might be able to delay the future reversal of taxable temporary differences by delaying the events that give rise to those reversals, for example, by delaying the recovery of related assets or the settlement of related liabilities. A contention that those temporary differences will never result in taxable amounts, however, would contradict the 232

accounting assumption inherent in the statement of financial position that the reported amounts of assets and liabilities will be recovered and settled, respectively; thereby making that statement internally inconsistent. For that reason, the Board concluded that the only question is when, not whether; temporary differences will result in taxable amounts in future years. The third characteristic of a liability is that "the transaction or other event obligating the entity has already happened". Deferred tax liabilities result from the same past events that create taxable temporary differences. According to current GAAP, liabilities should be reported in the balance sheet at the present value of the future cash flows discounted at the market rate of interest. We argue that since deferred tax liabilities are considered “liabilities”, they should be given the same treatment as other liabilities. As such they should be measured and reported as the present value of the expected future tax outflows. Proponents of reporting deferred taxes at their discounted amounts argue that the company that reduces or postpones tax payments is economically better off. It is their belief that by discounting deferred taxes, a company best reflects the operational advantages of its tax strategies in its financial statements. Proponents also feel that discounting deferred taxes is consistent with the accounting principles established for such items as notes receivable and notes payable, pension costs, and leases. They argue that discounted amounts are considered to be the most appropriate indicators of future cash flows. In short, the time value of money is important to the well-being of companies, and because of this aspect, GAAP requires interest to be imputed for noninterest bearing financial instruments. It follows that the time value of money is enhanced by postponing tax payments, thus, consistency under GAAP would require imputing interest on deferred taxes. Team 2 Arguments in opposition FASB No. 109 omitted discounting from its scope. The result is that discounting deferred taxes is not allowed. Critics of discounting counter that discounting deferred taxes mismatches taxable transactions and their related tax effects. If companies discount deferred taxes, the amount of tax reported will be less than the amount of tax that will eventually be paid. The result would be that the future cash flows would be divided between interest and principal amounts. This would cause part of the deferred tax amount to be recognized in future periods as interest expense. So, the tax related to income statement items in one period would not be reported in the same period as the income statement items, rather some would be recognized over several periods as interest expense. As a result, discounting deferred taxes would conceal a company’s actual tax burden by reporting as interest expense the discount factor that would otherwise be reported as part of income tax expense. 233

Furthermore, deferred taxes may be considered as interest-free loans from the government that do not require discounting because the effective interest rate is zero. The government will not charge interest on income tax unless it is a past due amount resulting from filing a tax return. No tax return has been files for deferred taxes, thus, there is no interest expense. Debate 12-3 Income Tax Allocation The FASB requires comprehensive interperiod income tax allocation using the asset/liability approach. Some feel that there should be only partial interperiod income tax allocation. Others feel that there should not be any interperiod income tax allocation. Team 1: Present arguments favoring no allocation of income taxes We believe that it is inappropriate to give any accounting recognition to the tax effects of differences between accounting income and taxable income. A company should report the results of transactions and events. The difference between taxable income and accounting income is neither a transaction nor an event. Instead, the amount of income tax expense reported on a company’s income statement should be the same as the income taxes payable for the accounting period as determined by the income tax return. Thus, there should be no interperiod allocation of income taxes. Our position is buttressed by the following arguments. First, income taxes result only from taxable income. In so far as income tax is concerned, whether or not the company has accounting income is irrelevant. Hence, attempts to match income taxes with accounting income provide no relevant information for users of published financial statements. Moreover, income taxes are levied on total taxable income, not on individual items of revenue or expense. Therefore, there can be no temporary differences related to these individual items. Income taxes are different from other expenses; therefore, allocation in a manner similar to other expenses is irrelevant. Expenses are incurred to generate revenues; income taxes generate no revenues. They are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues. They are simply period costs that are incurred as obligations to the government as a result of operating the total business at a taxable profit for the tax year. In our opinion, interperiod tax allocation hides an economic difference between a company that employs tax strategies in order to reduce current tax payments (and as a result, is economically better off) and one that does not. According to SFAC No. 8, financial statements should provide information that is useful for the reader to evaluate 234

the performance of the company and thus to determine its value. Obscuring the economic benefits that result from effective tax strategies may mislead a potential investor and thus may result in suboptimal allocation of economic resources. SFAC No. 8 also states that financial information should help the user to predict future cash flows. Reporting a company’s income tax expense at the amount paid or currently payable is a better predictor of the company’s future cash outflows because many of the deferred taxes will never be paid, or will be paid only in the distant future. Another argument against income tax allocation is that it entails an implicit forecasting of future profits. For example, a deferred tax liability implies that there will be taxable income in the future on which income taxes will be paid. Also, a deferred tax asset implies that there will be future taxable income that can be offset or reduced by a future deductible amount, otherwise the deferred tax asset provides no future benefit. To incorporate such forecasting into the preparation of financial information is inconsistent with the long-standing principle of conservatism. It also violates the concept of representational faithfulness because a deferred tax liability may never be paid, or the deferred tax asset may never be realized. In these cases, they do not meet the definitions of liabilities or assets. We believe that the most powerful argument against any income tax allocation is that there is no present obligation for the potential or future tax consequences of present or prior transactions because there is no legal liability to pay taxes until an actual future tax return is prepared. If there is no obligation to pay taxes on any future taxable amounts, how can the deferred tax liabilities meet the definition of a liability. Since no tax return has been prepared that includes the future taxable amounts and no taxes are due until a tax return is prepared, there has been no event or transaction to cause a liability to have been incurred. Finally, although we believe that income tax allocation provides no benefits, even if it did, in our opinion, the accounting recordkeeping and procedures involving interperiod tax allocation are too costly for the purported benefits. Therefore, income tax allocation violates the cost constraint described in SFAC No. 8. We oppose any allocation of income tax – comprehensive or partial. With regards to partial income tax allocation, we believe that management may pick and choose those temporary differences to which they wish to apply income tax allocation. Accounting results should not be subject to manipulation by management. That is, a company’s management should not be able to alter the company’s results of operations and ending financial position by arbitrarily deciding which temporary differences will and will not reverse in the future. Team 2: Present arguments favoring partial allocation of income taxes 235

We believe that some temporary differences between accounting income and taxable income will reverse in the future. However, some temporary differences will never reverse because they are continuously replaced by others. Thus, the income tax expense reported in an accounting period should not be affected by those temporary differences that are not expected to reverse in the future. Stated differently, in certain cases, groups of similar transactions or events may continually create new temporary differences in the future that will offset the realization of any taxable or deductible amounts, resulting in an indefinite postponement of deferred tax consequences. In effect, we argue that these types of temporary differences are more like permanent differences. Examples of these types of differences include depreciation for manufacturing companies with large amounts of depreciable assets and installment sales for merchandising companies. We offer the following arguments to counter the arguments of our nonallocationist opponents. Firstly, income taxes result from the incurrence of transactions and events. If the company incurs taxable revenues, taxable income and thus taxes payable increase. If the company incurs tax deductible expenses, taxable income and thus taxes payable decrease. Without these transactions, there would be no taxable income and no taxes payable. Thus, the amount of income tax expense reported during an accounting period should take into consideration the results of those transactions and events that are included in financial accounting income. However, all groups of temporary differences are not similar to certain other groups of accounting items, such as accounts payable. Accounts payable “roll over” as a result of actual individual credit and payment transactions. Income taxes, however, are based on total taxable income and not on the individual items constituting that income. Therefore, consideration of the impact of the group of temporary differences on income taxes is the appropriate viewpoint. Applying income tax allocation to all temporary differences as is done for comprehensive income tax allocation is inappropriate. Comprehensive income tax allocation distorts economic reality. The income tax regulations that cause the temporary differences will continue to exist. For instance, Congress is not likely to reduce investment incentives with respect to depreciation. Consequently, future investments are virtually certain to result in originating depreciation differences of an amount to at least offset reversing differences. Thus, consideration should be given to the impact of future, as well as historical, transactions. Instead, we believe that only those temporary differences that will reverse will result in future cash flows and thus result in deferred tax amounts that meet the definitions of assets and liabilities. In these cases, there will be probable future benefits that are eventually realizable from deferred tax assets and probably future cash outflows that will eventually be incurred from deferred tax liabilities. Thus, the resulting deferred 236

tax assets and liabilities that are reported under partial income tax allocation will be assets and liabilities and will meet the qualitative characteristic of relevance. They will help the user to determine the financial position of the company and as well as its performance. Moreover, because they will result in eventual future cash flows, the assessment of a company’s future cash flows is enhanced by using the partial allocation approach. Since the deferred income taxes (if any) reported on a company’s balance sheet under partial allocation should actually reverse rather than continue to grow, partial allocation would better reflect future cash flows than either comprehensive tax allocation or no income tax allocation. Team 1’s arguments are flawed. Nonallocation of a company’s income tax expense hinders the determination of the company’s assets and liabilities as well as the prediction of its future cash flows. For those temporary differences that will reverse, nonalloction will distort the balance sheet and the income statement. Items that meet the definitions of liabilities and assets and are measurable will not be reported. Future cash flows that will result from the partial recognition of deferred tax assets and liabilities will not be readily determinable. The user will only see the current period obligation for income taxes that result from items reported in the income statement, not the impact on income taxes that will result from both present and future cash flows resulting from transactions and events that have already occurred. WWW Case 12-10 a. b. c.

The company’s deferred tax liability on December 2017 is $420,000 ($2.000.000 x 21%). As a result of applying the new 21% tax rate, the deferred tax liability would be reduced by $140,000 ($350,000 — $210,000) as of December 31, 2017. The $140,000 adjustment would be recorded as an income tax benefit in continuing operations in 2017. Note: If a portion of the temporary difference was expected to reverse in 2017, the company would first be required to estimate its temporary differences as of December 22, 2017 rather than using the beginning of the year balance.

Case 12-11 The effect of a decrease in the tax rate to 21% from 35% ($14 million) enacted in December 2017 would be reflected in Dunning Brothers’ income from continuing operations in 2017, despite the fact that the deferred tax asset was originally recorded in discontinued operations.

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This is consistent with FASB ASC 740’s general prohibition on backward tracing That is, an entity would not consider where the previous tax effects were allocated in the financial statements. Case 12-12 When income tax rates increase, the new rate is used to calculate deferred tax assets and liabilities. Hence, both deferred tax assets and liabilities would increase. An increase in deferred tax assets would decrease income tax expense. Hence, net income for a company with deferred tax assets would increase. Alternatively, an increase in deferred tax liabilities would increase income tax expense and result in a decrease in net income. Decreases in tax rates would have the opposite effects. Case 12-13 a.

The objectives in accounting for income taxes are: 1. To recognize the amount of taxes payable or refundable for the current year. 2. To recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns.

To implement the objectives, the following basic principles are applied in accounting for income taxes at the date of the financial statements: 1. A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for the current year. 2. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and loss carryforwards using the enacted marginal tax rate. 3. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. 4. The measurement of deferred tax assets is adjusted, if necessary, to not recognize tax benefits that, based on available evidence, are not expected to be realized.

The procedures for the annual computation of deferred income taxes are as follows: 1. Identify: the types and amounts of existing temporary differences and the nature and amount of each type of operating loss and tax credit carryforward and the remaining length of the carryforward period. 2. Measure the total deferred tax liability for taxable temporary differences using the enacted tax rate.

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3. Measure the total deferred tax asset for deductible temporary differences and operating loss carryforwards using the enacted tax rate. 4. Measure deferred tax assets for each type of tax credit carryforward. 5. Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. Case 12-14 a.

1. Temporary difference. The full estimated three years of warranty costs reduce the current year’s pretax financial income, but will reduce taxable income in varying amounts each respective year, as paid. Assuming the estimate as to each warranty is valid, the total amounts deducted for accounting and for tax purposes will be equal over the three-year period for a given warranty. This is an example of an expense that, in the first period, reduces pretax financial income more than taxable income and, in later years, reverses. This type of temporary difference will result in future deductible amounts which will give rise to the current recognition of a deferred tax asset. Another way to evaluate this situation is to compare the carrying value of the warranty liability with its tax basis (which is zero). When the liability is settled in a future year an expense will be recognized for tax purposes but none will be recognized for financial reporting purposes. Therefore, tax benefits for the tax deductions should result from the future settlement of the liability. 2. Temporary difference. The difference between the tax basis and the reported amount (book basis) of the depreciable property will result in taxable or deductible amounts in future years when the reported amount of the asset is recovered (through use or sale of the asset); hence, it is a temporary difference. 3. Temporary difference and permanent difference. The investor’s share of earnings of an investee (other than subsidiaries and corporate joint ventures) accounted for by the equity method is included in pretax financial income while only 20% of dividends received from some domestic corporations are included in taxable income. Of the amount included in pretax financial income, 80% is a permanent difference attributable to the dividends-received deduction permitted when computing taxable income. Twenty percent of the amount included in pretax financial income is potentially a temporary difference which will reverse as dividends are received. If the investee distributes 10% of its earnings, then onehalf of the potential temporary difference is eliminated and 10% of the amount included in pretax financial income is a temporary difference.

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4. Temporary difference. For financial reporting purposes, any gain experienced in an involuntary conversion of a nonmonetary asset to a monetary asset must be recognized in the period of conversion. For tax purposes, this gain may be deferred if the total proceeds are reinvested in replacement property within a certain period of time. When such a gain is deferred, the tax basis of the replacement property is less than its carrying value and this difference will result in future taxable amounts. Hence, this is a temporary difference. 5. Permanent difference. Life insurance premiums on employees are never deductible for income tax purposes 6. Permanent difference. Interest on municipal bonds is never taxable. 7. Temporary difference. The full amount of the sale is included in current income; whereas, only the annual amount of cash collected is reported as taxable income. This temporary difference will reverse in future years as the full sales priced is collected. b.

Deferred tax accounts are reported on the balance sheet as assets and liabilities. They should be classified in a net current and a net noncurrent amount. An individual deferred tax liability or asset is classified as current or noncurrent based on the classification of the related asset or liability for financial reporting. A deferred tax asset or liability is considered to be related to an asset or liability if reduction of the asset or liability will cause the temporary difference to reverse or turn around. A deferred tax liability or asset that is not related to an asset or liability for financial reporting, including deferred tax assets related to loss carryforwards, shall be classified according to the expected reversal date of the temporary difference. Thus, a deferred tax account may be reported as a current asset, a current liability, a noncurrent asset or a noncurrent liability. Generally, a noncurrent deferred tax asset appears in the “Other assets” section of the balance sheet while a noncurrent deferred tax liability appears in the “Long-term liabilities” section

Case 12-15 If the asset is to be held and used in operations, there is a difference at the end of year 1 of the book and tax basis (i.e., amount of future deductions for book and tax purposes) and a temporary difference of $1,000 should be recorded Recovery of the book basis through book depreciation Future tax depreciation (represents future tax deductions) Temporary difference Case 12-16 240

$57,000 (56,000) $ 1,000

Lenox Company can account for the ITC by using either the deferred or flow-through methods

Under the deferral method, the ITC ($300.000) is reflected as a reduction to income taxes payable and to the carrying value of the qualifying assets. Therefore, a deductible temporary difference arises since the recorded amount of the qualifying assets is $300,000 less than its tax basis. Under the flow-through method, the ITC received ($300,000) would be reflected as a current income tax benefit. Under this approach, the recognition of the ITC would not affect the book basis of the qualifying assets and, therefore, no temporary difference arises at initial acquisition (i.e., the book basis equals the tax basis). Case 12-17 A review of the compliance with the reporting requirement of Sarbanes-Oxley by the FASB discovered that many of the problems associated with compliance with its Section 404 were related to tax issues and as a result numerous financial statement restatements were required. Most specifically, the use of tax contingencies had become too flexible and was used to manipulate income and the reporting and disclosure of tax positions lacked transparency. The SEC was also concerned about the reporting of tax contingencies, and many SEC comment letters were issued on this issue In response to the above voiced concerns, the FASB undertook a project to determine how to account for uncertain tax positions. The result of this project was FIN No. 48 that establishes the proper accounting treatment for uncertain tax positions. The validity of a tax position is a matter of tax law, and it is not controversial to recognize the benefit of a tax position in an firm’s financial statements when there is a high degree of confidence that a particular tax position will be sustained after examination by the IRS. However, in some cases, tax law is subject to varied interpretations, and whether a tax position will ultimately be sustained may be uncertain. The evaluation of a tax position under FIN No 48 is a two-step process: 1.

Recognition: A firm determines whether it is more likely than not that a tax position will be sustained upon examination by the IRS based on the technical merits of the position. In evaluating whether a tax position has merit, a firm is to use a more-likelythan-not recognition threshold. This evaluation should presume that the IRS would have full knowledge of all relevant information.

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Measurement: A tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest cumulative amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

Case 12-18 Canning would recognize a $40,000 deferred tax asset. It is more likely than not that a tax benefit of at least that amount would be realized on settlement because the cumulative probability first exceeds 50% at the point of the $40,000 outcome (in this case, an 85% cumulative probability). Case 12-19 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution. Financial Analysis Case

Answers will vary depending on the companies selected.

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CHAPTER 13 Case 13-1 a.

Under SFAS No. 13 this transaction is considered an operating lease, as the PV of the payments is less than 90% of the fair value of the assets and therefore is not recorded on Noel’s bools Under FASB ASC 842, this lease must be capitalized and reported as a right-of-use asset and liability on the balance sheet. The present value of the rental payments is $56,557. This is the amount that is capitalized on the balance sheet. Noel’s initial balance sheet entries are: Right-to-Use Leased Asset = $56,557 Capitalized Lease Obligation = $56,557

Case 13-2 Baker Corp would calculate the right-of-use asset as follows: Initial measurement of lease liability Lease payments made to Baker Corp before the commencement date Lease incentives received from Baker Corp Initial direct costs Initial measurement of right-of-use asset

$1,100,000 15,000 (50,000) 2,000 $1,070,000

Case 13-3 Bank Data Center Contract Yes. Although the assets used to fulfill the contract are not explicitly specified, the assets are implicitly specified as a result of the contractual requirements and specifications mandated by 5th National Automobile Hood Ornament Contract Although the die is not explicitly specified in the arrangement, the contract is reliant on the die and therefore, it is implicitly specified. While Specialty Company is not contractually required to use a specific die, it is not feasible to utilize a different die. Therefore, the asset used to fulfill the contract would be the specialized die.

Case 13-4 243

a. • • •

•

Morgan Corp should assess the lease classification using the criteria outlined in ASC 842 as follows Transfer of ownership - Ownership of the asset does not transfer to Morgan Corp by the end of the lease term. Purchase option which Morgan is reasonably certain to exercise - The lease does not contain a purchase option. Lease term is for the major part of the remaining economic life of the asset - Morgan Corp is utilizing the asset for approximately 83% of the economic life of the asset (5year lease / 6-year economic life), which is deemed to be a major part. Sum of present value of lease payments and any residual value guarantee by the Morgan amounts to substantially all of the fair value of the underlying asset - The present value of the lease payments (discounted at Morgan Corp’s incremental borrowing rate of 7%) is $4,8250. Therefore, the present value of the lease payments amounts to approximately 97% of the fair value of the leased asset ($4,8250 / $50,000), which is substantially all of the fair value of the leased asset. Specialized nature -The equipment is nonspecialized and could be used by another party without major modifications. Therefore. Morgan Corp should classify the lease as a finance lease because the lease term is for the major part of the economic life of the equipment and the present value of the lease payments amounts to substantially all of the fair value of the underlying asset b. Morgan Corp would first calculate the lease liability as the present value of the fourremaining unpaid annual fixed lease payments of $11,000 discounted at Morgan Corp’s incremental borrowing rate of 7%; this amount is $37,250. The right-of-use asset is equal to the lease liability plus the $11,000 rent paid on the lease commencement date. Morgan Corp would record the following amounts on the lease commencement date. Right-of-use asset Lease liability Cash

48,250 7,250 11,000

Morgan Corp would amortize the right-of-use asset on a straight-line basis over the lease term because the economic life is greater than the lease term. Right-of-use asset Lease commencement Year 1 Year 2 Year 3 Year 4 Year 5

$9,650 9,650 9,650 9,650 9,650 244

Amortization $48,250 38,600 28,950 19,300 9,650 0

$48,250 Interest expense on the lease liability would be calculated using a rate of 7%, the same discount rate used to initially measure the lease liability. The lease liability would change as follows (assuming beginning of year payments): Lease liability Payment Principal Interest Interest end of paid paid expense year) Lease commencement $37,250 Year 1 * $2,610 39,860 Year 2 11,000 8,390 2,610 2,020 30,880 Year 3 11,000 8,980 2,020 1,390 21,270 Year 4 11,000 9,610 1,390 730 11,000 Year 5 11,000 1,0270 730 0 0 $44,000 $37,250 $6,750 $6,750 *No payment is reflected in Year 1 because the first payment was made at lease commencement and is not included in the lease liability. Case 13-5 Part 1 Lease Payments Tied to An Index The actual amount of the increases in lease payments that are tied to the percentage change in the CPI and movements in the CPI after lease commencement are unknown at the inception of the lease. Consequently, only the initial lease payments of $20,000 per month would be included in the calculation of lease payments when classifying the lease. Part 2 Real Estate Taxes The lease payments are $90,000. Although the terms of the lease require Queens Company to pay the real estate taxes, they are costs Staten Company would owe regardless of whether the underlying asset is leased; therefore, the payments represent a reimbursement of Staten Company’s costs, which are associated with the right to use the office building. However, since real estate taxes vary on an annual basis, they would be considered variable lease payments that are not dependent on an index or a rate. As a result, they should be excluded from lease payments for purposes of classification and measurement. Part 3 Lease Payments Tied to Fair Market Value Similar to variable lease payments that depend on an index or rate, lease payments during the renewal period should be included in lease payments when classifying and measuring the lease at lease commencement. The renewal period rents should be based on the market rental rate at the inception of the lease of $200,000 per year, not the estimated market rental rate at the beginning of the renewal period.

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Case 13-6 There are two units of account in this situation. The contract provides for surface land rights and conveys different rights between the site for the phone tower and the remainder of the acreage. Majewski Company has exclusive use of the parcel where the phone tower will be constructed and shared access to the remaining property. Therefore, the agreement contains two units of account. Majewski Company would need to evaluate both the subsection of the land where the phone tower will be built, and the remaining space not occupied by the phone tower to determine if either meets the definition of a lease. The agreement specifies the location of both units of account. As such, each is considered an identified asset. Majewski Company has exclusive use of the specified parcel where the phone tower will be built, and thus has the ability to both (1) direct how this identified asset is used and (2) obtain substantially all of the economic benefits from it. Consequently, Majewski Company has the right to control the use of that parcel of land, and the agreement contains a lease. The use of the remaining portion of the 10-acre land parcel is shared between Majewski Company and Burgess Inc. Therefore, Majewski Company would need to evaluate whether it has the right to control the use of that portion of the land. Majewski Company would determine the stand alone selling prices for each unit of account at inception and would allocate consideration based on those amounts. Majewski Company would recognize the consideration allocated to the phone tower site when the lease begins. Case 13-7 Part 1 No. While the contract explicitly specifies the location where Bryant Company’s inventory will be stored, the asset is not identified because Madigan Inc. has a substantive substitution right. Madigan Inc. has agreed to provide a specific amount of storage space within its warehouse at a specific location. However, Madigan Inc. has the unilateral right to relocate Manufacturing Corp’s inventory. It would benefit by relocating the customer’s inventory and can do so without significant cost. As such, Madigan Inc.’s substitution rights are considered substantive, and there is not an identified asset. Part 2 Yes. The asset is identified because Madigan Inc. does not have a substantive substitution right. Madigan Inc. has agreed to provide a specific level of capacity within its warehouse at a specific location within the warehouse and does not have the unilateral right to relocate Bryant Company’s inventory without significant cost of installing additional cooling systems or modifying its heating and cooling system. 246

Case 13-8 Part 1 Because Phoenix Company purchased the vehicle from the manufacturer, obtained legal title, accepted the asset, had physical possession of the asset, and had the significant risks and rewards of ownership, the transaction should be accounted for as a sale and leaseback. Part 2 Phoenix Company should account for the transaction as a lease arrangement with the bank and not a sale and leaseback. Phoenix Company obtained legal title to the asset prior to the lessor (the bank) and prior to the commencement of the lease but did not obtain control of the underlying asset. Although Phoenix Company had temporary title, it did not obtain the significant risks and rewards of ownership and none of the other indicators of control were present. Case 13-9 a.

Pierce Company should assess the lease classification using the criteria outlined in ASC 842 • •

•

Transfer of ownership - Ownership of the asset does not transfer to Pierce Company by the end of the lease term. Purchase option which the lessee is reasonably certain to exercise - At lease commencement, it is not reasonably certain that Pierce Company will exercise the purchase option. Pierce Company does not have a significant economic incentive to exercise the purchase option because the option is at fair value at the expiration of the lease. Lease term is for the major part of the remaining economic life of the asset - Pierce Company is utilizing the asset for 50% of the economic life of the asset (3-year lease / 6-year economic life), which is not deemed to be a major part. Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset - The present value of the lease payments (discounted at Pierce Company’s incremental borrowing rate of 6% because the rate charged in the lease is not readily determinable) is $16,518. Therefore, the present value of the lease payments amounts to approximately 55% of the fair value of the leased asset ($16,518 / $30,000), which is not deemed to be substantially all of the fair value of the leased asset. Specialized nature - The automobile is non-specialized and could be used by another party without major modifications.

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Consequently, Pierce Company should classify the lease as an operating lease because none of the criteria in ASC have been met. b.

Pierce Company would first calculate the lease liability as the present value of the remaining unpaid monthly fixed lease payments discounted at Pierce Company’s incremental borrowing rate of 6%; this amount is $16,018. The right-of-use asset is equal to the lease liability plus the $500 rent paid on the lease commencement date ($16,518). Pierce Company would record the following amounts on the lease commencement date. Right-of-use asset Cash Lease liability

$16,518 $500 $16,018

Pierce Company is required to pay $500 per month for three years, so the total lease payments are $18,000 ($500 × 36 months). Pierce Company would then calculate the straight-line lease expense to be recorded each period by dividing the total lease payments by the total number of periods. The monthly straight-line expense would be $500 ($18,000 ÷ 36 months). The rental payment and the straight-line expense are equal as the lease does not contain any escalation provisions or other required or optional payments. Pierce Company would calculate the amortization of the lease liability as shown in the following table. This table is shown on an annual basis for simplicity; the schedule would be calculated on a monthly basis to reflect the frequency of the lease payments.

Lease commencement Year 1 Year 2 Year 3

“Interest” on the Payment

lease liability*

$5,500** 6,000 6,000 $17,500

$820 500 162 $1,482

Lease liability $16,018 11,338 5,838 —

*Although these amounts are labelled as “interest,” there is no interest expense recorded in the income statement. These amounts are calculated on the lease liability on a monthly basis in order to determine the ending balance of the lease liability; however, there is only one straight-line lease expense recorded in the income statement. **This amount excludes the first month’s payment since it was made at lease commencement and is not included in the lease liability.

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The amortization of the right-of-use asset is calculated as the difference between the straight-line lease expense ($500 per month) and the interest calculated on the lease liability. The following table shows this calculation. This table is shown on an annual basis for simplicity; the schedule would be calculated on a monthly basis to reflect the frequency of the lease payment. Straight-line expense (A) Commencement Year 1 $6,000 Year 2 6,000 Year 3 6,000 $18,000

Interest on liability (B)

Amortization (A – B)

$820 500 162 $1,482

$5,180 5,500 5,838 $16,518

Right-ofuse asset $16,518 11,338 5,838 —

Case 13-10 a.

Image Maker Company would first determine the total net investment in the lease as the present value of the lease receivable and the unguaranteed residual asset. The present value of the lease receivable is equal to the present value of the remaining lease payments discounted at 7.04%; this amount is $3,722. The present value of the unguaranteed residual asset discounted at 7.04% is $178. Image Maker Company’s net investment in the lease is $3,900 (the sum of the lease receivable ($3,722) and the unguaranteed residual asset ($178)). To determine the selling profit or loss arising from the lease, Image Maker Company calculates the difference between the fair value of the underlying asset (or the lease receivable plus any proceeds received at or before lease commencement, if lower) and the carrying amount of the underlying asset net of any unguaranteed residual asset. Since the present value of the lease receivable plus the upfront proceeds ($4,822) is lower than the fair value of the underlying asset ($5,000), the selling profit is calculated as follows: Present value of the lease receivable Plus, the lease payment received at lease commencement Less, the carrying value of leased asset ($4,500) net of unguaranteed residual asset ($178) Selling profit

$3,722 1,100 (4,322) $ 500

Image Maker Company would record revenue at lease commencement equal to the lease receivable amount plus the lease payment received at lease commencement ($4,822). Cost of goods sold would be recorded as the difference between the carrying 249

value of the leased asset ($4,500) and the discounted value of the unguaranteed residual asset ($178). Image Maker Company would record the following amounts on the lease commencement date. Lease receivable Cash Unguaranteed residual asset Cost of goods sold Property, plant and equipment (leased asset) $ Revenue

$3,722 $1,100 $178 $4,322 4,500 $4,822

Image Maker Company would first schedule out the cash flows on the lease receivable as shown in the following table. Payment

Interest Income

Lease commencement Year 1 Year 2 Year 3 Year 4 Year 5

Lease receivable $3,722 3,984 3,087 2,127 1,100 —

* $262 1,100 203 1,100 140 1,100 73 1,100 — $4,400 $ 678 * In year 1, payment was made at lease commencement, so it is not included in the lease receivable. Interest paid to Image Maker Company at the beginning of year 2 would be accrued during year 1. Image Maker Company would also record accretion on the residual asset. Like the interest on the lease receivable, the accretion on the residual asset would be recorded during year 1. Accretion Lease commencement Year 1 Year 2 Year 3 Year 4 Year 5

$13 13 14 15 17 $72

Residual asset $178 191 204 218 233 250

Upon the expiration of the lease, Image Maker Company would reclassify the $250 net investment (which consists solely of the residual asset based on the Image Maker 250

Company’s business model) as PP&E or inventory. The $250 represents Image Maker Company’s best estimate of the value of the asset established at the beginning of the lease. Case 13-11 a.

Maywood Company should assess the lease classification using the criteria outlined in ASC 842 as follows: • Transfer of ownership - Ownership of the asset does not transfer to Maywood Company by the end of the lease term. • Purchase option which the lessee is reasonably certain to exercise - The lease contains an option to purchase the property for $3,000,000, which is below the fair value of the real estate asset at lease commencement and its expected value at the date of exercise. Options to purchase real estate at a price below commencement date fair value are generally considered to be reasonably certain of exercise since real estate generally appreciates in value; therefore, a significant economic incentive to exercise the purchase option exists. • Lease term is for the major part of the remaining economic life of the asset - The lease term is 10 years. The five 5-year renewal options available to Maywood Company are not reasonably certain of exercise (at lease commencement) because the renewal options require rent to be reset to market rates when exercised. Therefore, Maywood Company is utilizing the asset for 25% of the economic life of the asset (10-year lease / 40-year economic life), which is not deemed to be a major part. • Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset - The lease payments net of the incentive Oak Lawn Company pays Maywood Company are $5,531,940 The present value of the lease payments (discounted at the rate Oak Lawn Company charges in the lease of approximately 9.04%) is $3,737,510. Because the purchase option is reasonably certain of being exercised, it should be included as a lease payment at the end of the lease term. Using the 9.04% rate Oak Lawn Company charges Maywood Company, the present value of the purchase option is $1,262,490. Therefore, the present value of the lease payments represents 100% of the fair value of the leased asset (($3,737,510 + $1,262,490)/$5,000,000). • Specialized nature Although the property is in a specific location, it could be used by another party without major modifications. The following table shows the schedule of lease payments. Date Year 1

Amount 500,000 251

Year 2 (515,000 – 200,000 lease incentive) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total

315,000 530,450 546,364 562,754 579,637 597,026 614,937 633,385 652,387 $5,531,940

Maywood Company should classify the lease as a finance lease because, at lease commencement, the fixed price purchase option available to Maywood Company at the end of the initial lease term (i.e., after 10 years) is reasonably certain to be exercised by Maywood Company. As a result, Maywood Company has effectively obtained control of the underlying asset. The lease also has payments equal to substantially all of the fair value of the underlying asset. b.

Maywood Company would first calculate the lease liability as the present value of the remaining unpaid annual lease payments, less the lease incentive paid in year 2, plus the exercise price of the purchase option using a discount rate of 9.04%. PV of annual lease payments, less lease incentive PV of purchase option at end of lease term Total lease liability

$3,237,510 1,262,490 $4,500,000

The right-of-use asset is equal to the lease liability plus the $500,000 rent paid on the lease commencement date ($5,000,000). Maywood Company would record the following amounts on the lease commencement date. Right-of-use asset Lease liability Cash

$5,000,000 $4,500,000 $500,000

The lease is classified as a finance lease because it grants Maywood Company the option to purchase the asset underlying the lease and Maywood Company is reasonably certain to exercise that purchase option. The right-of-use asset is $5,000,000 and lease liability are $4,500,000.

252

Since the purchase option is reasonably certain to be exercised, Maywood Company would amortize the right-of-use asset over the economic life of the underlying asset (40 years). Annual amortization expense would be $125,000 ($5,000,000 / 40 years). Interest expense on the lease liability would be calculated as shown in the following table. This table includes all expected cash flows during the lease term, including the lease incentive paid by Oak Lawn Company and Maywood Company’s purchase option.

Payment

Lease liability Interest expense

(end of year) Lease commencement Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 101

$0* 315,000** 530,450 546,364 562,754 579,637 597,026 614,937 633,385 652,387 3,000,000 $8,031,940

$406,840 415,143 404,718 391,912 376,466 358,098 336,497 311,323 282,206 248,737 — $3,531,940

$4,500,000 4,906,840 5,006,983 4,881,251 4,726,800 4,540,511 4,318,972 4,058,443 3,754,829 3,403,650 3,000,000 —

* No payment is reflected in Year 1 because the Year 1 payment was made at lease commencement and is not included in the lease liability. ** In Year 2, a payment of $515,000 was made but the lease incentive of $200,000 was also received. 1 Exercise of purchase option at the end of term Although the lease was for 10 years, the asset had an economic life of 40 years. When Maywood Company exercises its purchase option at the end of the 10-year lease, it would have fully extinguished its lease liability but continue depreciating the asset over the remaining useful life.

CASE 13‐12 a.

Biltmore Company should first separate the contract into its lease and nonlease components. A lessee should allocate the consideration in a contract to the lease and nonlease components based on their relative standalone price, as shown here. Standalone Allocated lease 253

Annual copier lease payment Annual maintenance contract fee Total

Price (A)

Allocated % (A/$550) = B

Annual lease payment (C)

payment (B × C) = D

$ 475

86.36%

$ 500

$ 432

75 $ 550

13.64% 100.00%

500

68 $ 500

Biltmore Company should then assess the lease classification using the criteria outlined in FASB ASC • • •

•

Transfer of ownership - Ownership of the asset does not transfer to Biltmore Company by the end of the lease term. Purchase option which the lessee is reasonably certain to exercise - The lease does not contain a purchase option. Lease term is for the major part of the remaining economic life of the asset - Biltmore Company is utilizing the asset for 60% of the economic life of the asset (3-year lease / 5-year economic life), which is not deemed to be a major part. Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset - The present value of the lease payments allocated to the lease component (discounted at Biltmore Company’s incremental borrowing rate of 5.5%) is $1,229. Therefore, the present value of the lease payments amounts to approximately 61% of the fair value of the leased asset ($1,229 / $2,000), which is not deemed to be substantially all of the fair value of the leased asset. Specialized nature - The copier is non-specialized and could be used by another party without major modifications.

Consequently, Biltmore Company should classify the lease as an operating lease because none of the criteria in FASB ASC 842 have been met. b.

Biltmore Company would first calculate the lease liability as the present value of the remaining unpaid annual allocated lease payment amount of $432 discounted at Biltmore Company’s incremental borrowing rate of 5.5%; this amount is $798. The right-of-use asset is the sum of the lease liability, plus the $432 lease payment made on the lease commencement date and the initial direct costs paid by Biltmore Company ($100); this amount is $1,330 ($798 + $432+ $100). Biltmore Company would record the following amounts on the lease commencement date.

254

Right-of-use asset $1,330 Lease liability $798 Cash $532 FASB ASC 13-1 Initial Direct Cost Incurred by the Lessor Search Initial direct costs Topic 842-10-65-1

FASB ASC 13-2 Interpretations for Lease Accounting Access topic 842 and use the Printer Friendly with sources function.

FASB ASC 13-3 3 Profit on Time Sharing Transactions Search nonreversionary 978-10-15 FASB ASC 13-4 Sale and Leasebacks on Rate-Making Search ratemaking and leases 980-842

FASB ASC 13-5 Obligations to Return an Underlying Asset to its Original Condition Search Obligations to Return an Underlying Asset to its Original Condition 842-10-55 FASB ASC 13-6 Lease Fiscal Funding Clause Search Glossary: fiscal funding clause 842-10-25

FASB ASC 13-7 Terminal Space and Airport Facilities

255

Search Terminal Space and Airport Facilities 842-10-25 Room for Debate Debate 13-1 Operating versus Capital Leases Team 1 Argue for the capitalization of leases which do not meet the FASB ASC 840 criteria for capitalization SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. An asset embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net assets. A lease embodies the transfer of rights to the lessee to use the leased asset. The use of the asset singly, or in combination with other assets contributes directly or indirectly to generate future cash flows. A particular entity can obtain the benefit derived from an asset or control other’s access to it. The lease transfers rights to use the asset to the lessee who then obtains benefits derived from its use. The transaction or event giving rise to the entity’s right to or control of the asset has already occurred. That transaction is the initiation of the lease agreement. It is clear that a lease agreement has all three characteristics of an asset even when it does not meet the FASB ASC 840 criteria for capitalization as an asset. Similarly, the lease obligates the entity to make future cash payments and meets the definition of a liability. Liabilities are defined by SFAC No. 6 as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. They embody a present duty or responsibility to one or more other entities (in this case to the lessor) that entails settlement by probable future transfer or use of assets at a specified determinable date. The lease payments are set and will entail the payment of assets (cash) to the lessor at specified amounts and dates according to the lease contract. Finally, the transaction or event (the initiation of the lease contract) obligating the entity to make the lease payments has already happened. Team 2 Argue against the capitalization of leases which do not meet the FASB ASC 840 criteria for capitalization The lease criteria found in FASB ASC 840 are intended to be used to determine whether a lease should be capitalized or not. If they do not meet at least one of the four lease criteria, the transaction does not indicate that a purchase of an asset has occurred or that 256

a liability has been incurred. Instead the lease payments are considered a period expense. If none of the lease criteria are met, then the leased asset will revert to the lessee at the end of the lease term. Title to the asset will never have belonged to the lessee. Hence, the lessee has only temporary use, or control of the asset and does not meet the definition of an asset. Moreover, the lessee will not have acquired substantially all of the economic benefits to be derived from the leased asset because the lessee will not derive benefit for virtually all of its useful life (at least 75% thereof). Nor do the amount and timing of the lease payments imply that the lessee is essentially paying for the asset (present value of minimum lease payments at least 90%). The implication of the agreement is that the lessor owns and controls the asset but is allowing the lessee to use the asset temporarily for a fee, or rent. If the leased asset does not belong to the lessee, then payments for its use are merely periodic rent and as such should be treated as rent expense. As such they do not represent payments on a liability. Thus, it would be inappropriate to record a liability for a lease that is not in essence a purchase of an asset. Debate 13-2 Lease Accounting Symmetry Team 1 Arguments in support Accounting transparency and the Conceptual Framework requires that a company’s financial statements reflect its assets, liabilities, and owners’ equity as of the balance sheet date as well as its revenues, expenses, gains and losses that occurred over the accounting period. The lessee should classify a lease as an operating lease when it does not meet any of the four capital lease criteria, regardless of the accounting approach taken by the lessor. In other words, the accounting treatment of one company should not dictate the accounting treatment of another, even when accounting for the same transaction. Just because the lessor accounts for a lease as a sales-type lease does not imply that the lessee must report the lease as a capital lease. FASB ASC 840 does not require that both parties to the lease account for it in the same manner. Both parties may not measure items used to determine whether the lease meets any of the four lease criteria in the same way. For example the number of years to useful life from one company’s perspective may differ from that of the other. Just because the lease meets the useful life criterion for the lessor does not imply that it also must be met by the lessee. If not, then the lessee would not have leased the asset for substantially all of its useful life and thus from the lessee’s perspective the lease does not have the characteristics of asset ownership. Similarly, the estimate of the asset’s fair value is not required to be the same for both parties to the lease. Hence, the lessor may believe that the 90% test is met while the lessee may not. Team 2 Arguments against 257

Accountants should report the economic substance of economic events and transactions. The transaction or event, in this case, is the occurrence of a lease, should dictate its accounting treatment. It is logical that if one company sells an asset to another, the second party must have bought it. The asset in question must be owned by someone – if not the lessor, then it is owned by the lessee. If the lessor determines that the lease is a sales-type lease, then the lease must have met the four capital lease criteria. Those four criteria are intended to determine whether a lease transfers substantially the entire benefits and risks incident to the ownership of property from the lessor to the lessee. If so, it should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or financing by the lessor. All other leases should be accounted for as operating leases. In a lease that transfers substantially all of the benefits and risks of ownership, the economic effect on the parties is similar, in many respects, to that of an installment purchase. If the lease transfers substantially all of the risks and benefits of ownership from the lessor to the lessee, then when the lessor also meets the certainty criteria and recognizes a manufacturer or dealer’s profit, the lessor has a sales type lease. Similarly, the lessee would have received the risks and benefits of ownership and as a result, cannot have an operating lease. WWW Case 13-13 a.

Since Woodlawn Inc has already determined that the agreement is not a sales type lease, it must be recorded as either a direct financing or operating lease. To be categorized as direct financing the lease must satisfy the following criteria. i.

The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments and/or any other third party unrelated to Woodlawn Inc equals or exceeds substantially all of the fair value of the underlying asset. ii. It is probable that Woodlawn Inc will collect the lease payments plus any amount necessary to satisfy a residual value guarantee. Woodlawn Inc should classify the lease as an operating lease. When determining whether the present value of the lease payments and the residual value guarantee amount to substantially all the fair value of the underlying asset, Woodlawn Inc would consider the nominal amount of retained risk of $150,000, rather than the fair value of its retained risk. Assuming that the present value of the $150,000 unguaranteed residual value is great enough, the present value of the lease payments and the guaranteed residual will not amount to substantially all the fair value of the underlying asset. In that case, and considering that at lease commencement, the lease 258

did not meet any of the criteria to be classified as a sales-type lease, the lease would not meet the criteria to be classified as a direct finance lease. b.

The same conclusion would be reached if the residual value guarantee was provided by Kenwood Company as opposed to a third party.

Case 13-14 a.

Kofax should assess the lease classification using the criteria outlined in FASB ASC 842 • •

•

Transfer of ownership - Ownership of the asset does not transfer to Drysdale Company by the end of the lease term. Purchase option which the lessee is reasonably certain to exercise - At lease commencement, Drysdale Company is not reasonably certain to exercise the purchase option because it is at fair market value, which does not provide a significant economic incentive. Lease term is for the major part of the remaining economic life of the asset Drysdale Company is utilizing the asset for 50% of the economic life of the asset (3-year lease / 6-year economic life), which is not deemed to be a major part. Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset - The present value of the lease payments (discounted at the rate Kofax Corp charges in the lease of 8.0 %) is $17,400. Therefore, the present value of the lease payments amounts to approximately 58% of the fair value of the leased asset ($17,400 20/$30,000), which is not deemed to be substantially all of the fair value of the leased asset. Specialized nature - The automobile is non-specialized and could be used by another party without major modifications Consequently, Kofax should classify the lease as an operating lease because none of the criteria in FASB ASC 842 have been met.

Since the lease is classified as an operating lease, no asset or liability would be recorded at lease inception. Kofax Company would keep the automobile on its books as an asset and depreciate it in accordance with its normal depreciation policy.

Kofax Company would likely determine that the most appropriate income recognition pattern is straight-line over the economic useful life of the asset (as no other systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the use of the underlying asset). As such, Kofax Company would calculate the straight-line rental income per period by dividing the total rent payments to be made over the lease term by the total number of periods. In this example, the straight-line income Kofax Company would record is $550 per month calculated as follows:

Year 1 Year 2

Monthly rent $500 $ 550 259

Annual total 6,000 6,600

Year 3

600

7,200 $19,800 36 $550

Number of periods Straight-line rent per period

Kofax Company would record the excess between the $550 monthly rental income and the actual rental payments required by the lease agreement in year one as deferred rent receivable on the balance sheet. Subsequently, any difference between the actual rental payments and the $550 monthly rental would reduce the deferred rent receivable. The following table shows the calculation of the deferred rent receivable at the end of each year. For the sake of simplicity, this table is shown on an annual basis; the actual schedule would be calculated on a monthly basis to match the frequency of lease payments. Cash payments

Commencement Year 1 Year 2 Year 3

Straight-line

Increase (decrease)

(A)

(B)

(B – A)

$6,000 6,600 7,200 $19,800

$6,600 6,600 6,600 $19,800

$600 — (600)

Deferred rental receivable balance $— 600 600 — $—

Kofax Company would continue to depreciate the underlying asset over the economic useful life of the asset. Case 13-15 Canning Company would first calculate the lease liability as the present value of the remaining unpaid fixed lease payments plus the variable lease payment (based on the Prime rate at the lease commencement date) discounted at Canning Company’s incremental borrowing rate of 8%; this amount is $4,096. Even if the Prime rate is expected to increase each year, the lease payments must be calculated using the rate at lease commencement and the rate will only be updated upon certain lease remeasurement events. The right-of-use asset is equal to the lease liability plus the first lease payment made at lease commencement ($5,596). Canning Company would record the following amounts on the lease commencement date. Right-of-use asset - $5,596 Lease liability - $4,096 Cash - $1,500 Case 13-16 260

Part 1 The equipment lease and consulting services are separate lease and nonlease components, respectively. The variable payments do not depend on an index or rate. In addition, Kingman Inc believes that it will be entitled to at least part of the variable payments regardless of whether the consulting services are provided. Therefore, the variable payments relate, at least partially, to the lease component. Consequently, the variable consideration should be excluded from the allocation of consideration used for initial measurement and will be allocated to both the lease and nonlease components when the underlying event occurs. An allocation of the fixed payment over the term of the lease would be made as follows:

Medical equipment Consulting services (5 years) Total

Standalone Price (A)

Relative % (A / $2,130,000) (B)

Fixed Payments ($400,000 × 5 years) (C)

Allocated payment (B × C)

$2,000,000

93.9%

$2,000,000

$1,877,934

130,000 $2,130,000

6.1% 100%

$2,000,000

122,066 $2,000,000

Kingman Inc would record the following amounts on the lease commencement date, recognizing a net loss for the excess cost of the equipment over the fixed payments allocated to the lease component. Lease receivable Cost of sales Revenue Medical equipment asset

$1,877,934 $1,900,000 $1,877,934 $1,900,000

In the first year of the arrangement, Kingman Inc would allocate the fixed and variable payments of $500,000 ($400,000 fixed and $100,000 variable) based on the relative standalone selling price of the lease and nonlease components at lease commencement, as shown below.

Medical equipment Consulting services (5 years) Total

Relative % 93.9% 6.1%

Fixed payment Variable Payment Allocated Allocated $375,587 $93,897 24,413 $400,000

6,103 $100,000

Total Allocated Payment $469,484 30,516 $500,000

Fixed payments allocated to the medical equipment lease would be recognized using the guidance in ASC 842; fixed payments allocated to the consulting services would be recognized using the guidance in ASC 606. Variable payments would be recognized pursuant to the guidance in ASC 842. 261

During the first year of the arrangement, Kingman Inc would record the following amounts: Cash Lease receivable Lease revenue Service revenue

$500,000 $375,587 $93,897 $30,516

Part 2 In this case, the equipment lease and consulting services are separate lease and nonlease components, respectively. The variable payments relate specifically to the nonlease component. In this example, we assume that Kingman Inc allocates the variable payments to the lease and nonlease components based on relative standalone selling price, as the transaction price allocation objective is not met.

Medical equipment Consulting services (5 years) Total

Relative % (A)

Fixed Payments ($400,000 × 5 years) (B)

93.9%

$2,000,000

$500,000

$2,347,500

6.1% 100%

$2,000,000

$500,000

$152,500 $2,500,000

Variable Payments ($100,000 × 5 years) (C)

Total Allocated payment A × (B + C)

The total lease payments are approximately $2,347,500 (rounded) calculated as ($2,000,000 total fixed payments + $500,000 estimate of variable consideration) × ($2,000,000 selling price of equipment ÷ $2,130,000 combined selling price of equipment and consulting services). The annual payments attributable to the lease component are $469,500 ($2,347,500/5). For simplicity, it is presumed that all annual lease payments, including the expected variable consideration, are received at the beginning of each year of the lease. The rate implicit in the lease was determined to be 8.72% and the lease receivable is $2,000,000. Since the lease is a sales-type lease, Kingman Inc would remove the asset from its balance sheet and record a receivable equal to the present value of the lease payments calculated using the rate implicit in the lease. Kingman Inc would record the following amounts on the lease commencement date. Lease receivable Cost of sales Revenue Medical equipment asset

$2,000,000 $1,900,000 $2,000,000 $1,900,000

In the first year of the arrangement, Kingman Inc would allocate the total $500,000 payment based on the relative standalone selling price of the lease and nonlease components at lease commencement. 262

Payment (C)

Standalone lease payment (B × C)

93.9%

$500,000

$469,500

6.1% 100%

$500,000 $500,000

30,500

Allocated Price Relative % (A) (A / $2,130,000) (B) Medical equipment $2,000,000 Consulting services (5 years) 130,000 Total $2,130,000

At the beginning of the first year of the arrangement, Kingman Inc would record the following amounts to record receipt of the fixed medical equipment lease payment and variable incremental patient payment based on expected patient volume. Cash Lease receivable Deferred service revenue

$500,000 $469,500 $30,500

Interest paid to Kingman Inc at the beginning of year 2 would be accrued during year 1. At the beginning of the second year of the arrangement, Kingman Inc would record the receipt of the fixed medical equipment lease payment, variable incremental patient payment based on expected patient volume, and interest on the lease receivable as follows. Cash Lease receivable Lease receivable Deferred service revenue Interest income

$500,000 $133,460 $469,500 $30,500 $133,460

Part 3 The equipment lease and consulting services are separate lease and nonlease components, respectively. The variable payments relate specifically to the nonlease component (consulting services). Kingman Inc determined that it should allocate the variable payments entirely to the nonlease component (consulting services) because doing so would be consistent with the transaction price allocation objective in ASC The fixed payments of $2,000,000 ($400,000 × 5 years) would be allocated to the lease component. Since the lease is a sales-type lease, Kingman Inc would remove the asset from its balance sheet and record a receivable equal to the present value of those fixed lease payments. Kingman Inc would record the following amounts on the lease commencement date. Lease receivable Cost of sales Revenue Medical equipment asset

$2,000,000 $1,900,000 $2,000,000 $1,900,000 263

In the first year of the arrangement, Kingman Inc would allocate the $400,000 fixed lease payment entirely to the medical equipment lease and the $100,000 variable payment to the consulting services; the revenue from services provided would be recognized using the guidance in ASC 606. In the first year of the arrangement, Kingman Inc would record the following amounts to record receipt of the fixed medical equipment lease payment and variable incremental patient payment. Cash Lease receivable Service revenue

$500,000 $400,000 $100,000

This example depicts one case when the transaction price allocation objective under ASC 606 would be considered met (i.e., stand-alone selling price for the consulting services is equal to the expected variable payment for the services provided under the contract). There are other cases when the objective would also be met. For example, consider a circumstance when the fixed payments are $2,250,000 and the expected variable payments are $250,000. Allocating 100% of the variable payments and $250,000 of the fixed payments to the consulting services would also meet the allocation objective under ASC 606 because the payments allocated to the both components of the contract would be consistent with their stand-alone selling prices. Case 13-17 Part 1 The sale results in a gain on sale of $5 million ($20 million sales price - $15 million carrying amount of asset). Since the sale and leaseback transaction is at market value and the leaseback is classified as an operating lease, the presence of the leaseback does not impact the accounting for the sale; Bullock should recognize the gain on sale of $5 million in the period in which the sale is recognized. Part 2 The sale results in a loss on sale of $5 million ($20 million sales price - $25 million carrying amount of asset). Since the sale and leaseback transaction is at market value, the presence of the leaseback does not impact the accounting for the sale; the Bullock should recognize the loss on sale of $5 million in the period in which the sale is recognized. Case 13-18 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution. Financial Analysis Case 264

Answers will vary depending on companies selected. ___________________________________________________________________________

CHAPTER 14 Case 14-1 a.

i. In a defined contribution plan, the employer promises to contribute a certain sum into the plan each period. For example, the employer may promise to contribute 8 percent of the employee's salary each year. However, no promise is made concerning the ultimate benefits to be paid. Benefits are ultimately determined by the return on the invested pension funds. ii. In a defined benefit plan, the amount of pension benefits to be received in the future is defined by the terms of the plan. For example, the retirement plan of one company promises that an employee retiring at age 65 will receive 2 percent of the average of the highest 5 years' salary for every year of service. Therefore, an employee working for this company for 30 years would receive a pension for life equal to 60 percent of the average of his or her highest 5 salary years. In defined benefit plans, it is necessary for the employer to determine the annual contribution necessary to meet the benefit requirements in the future.

i. A cost approach estimates the total retirement benefits to be paid in the future and then determines the equal annual payment that will be necessary to fund those benefits. The annual payment necessary is adjusted for the amount of interest assumed to be earned by funds contributed to the plan. ii. A benefit approach determines the amount of pension benefits earned by employee service to date and then estimates the present value of those benefits. Two benefit approaches may be used: (1) the accumulated benefit approach and (2) the benefits/years of service approach. The major difference between these two methods is that under the accumulated benefits approach, the annual funding and liability are based on existing salary levels; whereas under the benefits/years of service approach (also called the projected unit credit method) the annual funding and liability are based upon the estimated final pay at retirement. The liability for pension benefits under the accumulated benefits approach is termed the accumulated benefits obligation, whereas the liability computed under the benefits/years of service approach is termed the projected benefit obligation.

Case 14-2 a.

The service cost component is determined as the actuarial present value of the benefits attributed by the pension formula to employee service for that period. This 265

requirement means that one of the benefit approaches discussed earlier must be used as the basis for assigning pension cost to an accounting period. It also means that the benefits/years of service approach should be used to calculate pension cost for all plans that use this benefit approach in calculating earned pension benefits. The FASB's position is that the terms of the agreement should form the basis for recording the expense and obligation, and the plan's benefit formula is the best measure of the amount of cost incurred each period. The discount rate to be used in the calculation of service cost is the rate at which the pension benefits could be settled, such as by purchasing annuity contracts from an insurance company. This rate is termed the settlement-basis discount rate. ii. The interest cost component is determined as the increase in the projected benefit obligation due to the passage of time. Recall that the pension liability is recorded on a discounted basis and accrues interest each year. The interest cost component is determined by accruing interest on the previous year's pension liability at the settlement-basis discount rate. iii. The actual return on plan assets component is the difference between the fair value of these assets from the beginning to the end of the period, adjusted for contributions, benefits and payments. That is, the interest and dividends earned on the funds actually contributed to the pension fund will reduce the amount of net Pension cost for the period. iv. Prior service cost is the total cost of retroactive benefits at the date the pension plan is initiated or amended. Prior service cost is assigned to the expected remaining service period of each employee expected to receive benefits. (As a practical matter, the FASB allows for a simplified method of assigning this cost to future periods; the company may assign this cost on a straight-line basis over the average remaining service life of its active employees.) v. SFAS No. 87 requires significant changes in pension accounting from what was previously required in APB Opinion No. 8. As a result, the board decided to allow for a relatively long transition period. Since these changes are so significant, an unrecognized net obligation or unrecognized net asset will frequently result when changing to the new reporting requirements. Therefore, the provisions of SFAS No. 87 require companies to determine, on the date the provisions of this statement are first applied, the amount of (1) the projected benefit obligation and (2) the amount of the fair value of the plan assets. This will result in either an unrecognized net obligation or unrecognized net asset. This amount, termed the transition amount should be amortized on a straight-line basis over the average remaining service period of employees expecting to receive benefits.

266

When a plan is initiated or amended, the increase in prior service cost to be amortized in future periods is not recorded. Recall that the FASB's original position on this issue, expressed in "Preliminary Views," was that a liability existed when the projected benefit obligation exceeded the plan assets or that an asset existed if the reverse was true. Since agreement on this issue could not be reached, the board developed a compromise position which requires recognition of a liability, termed the minimum liability, when the accumulated benefit obligation exceeds the fair value of the plan assets. It is important to note that the minimum liability is based upon the accumulated benefit obligation and not the projected benefit obligation. As a result, future salary levels are not taken into consideration in computing the minimum liability. The debit to offset any recognized minimum liability is not recorded as a component of annual pension cost. This amount is generally recognized as an intangible asset because unfunded accumulated benefits usually result from plan amendments that are expected to benefit future periods. However, in the event the amount of minimum liability exceeds the amount of the existing prior service cost, this excess is not considered to have future economic benefit and must be classified as a reduction of equity instead of an intangible asset. The intangible asset or reduction of equity is not amortized. The required amount of minimum liability is reassessed annually, and any necessary adjustment is made directly to either the intangible asset or stockholders' equity.

Case 14-3 a.

The two accounting problems resulting from the nature of the defined benefit pension plan are as follows: *

Estimates or assumptions must be made concerning future events that will determine the amount and timing of the benefit payments.

Some approach to attributing the cost of pension benefits to individual years of service must be selected. The two problems arise because a company must recognize pension costs before it pays pension benefits.

Carson should determine the service cost component of the net pension cost as the actuarial present value of pension benefits attributable to employee services during a particular period based on the application of the pension benefit formula.

Carson should determine the interest cost component of the net pension cost as the increase in the projected benefit obligation due to the passage of time. Measuring the 267

projected benefit obligation requires accrual of an interest cost at an assumed discount rate. d.

Carson should determine the actual return on plan assets component of the net pension cost as the change in the fair value of plan assets during the period, adjusted for (1) contributions and (2) benefit payments.

Case 14-4 a.

The following characteristics of OPRBs make them different from defined benefit pension plans: 1.

Defined benefit pension payments are determined by formula. Once the employee retires, the amount of future cash outlays per year of retirement is generally fixed. Although actuarial assumptions are made, the measurement of the projected pension obligation is fairly objective. On the other hand, future cash flows for OPRBs is a function of the future costs of services, such as healthcare. Obviously, the present obligation to provide these services is difficult to predict and measure.

Employees accumulate future defined pension benefits with years of service. Employees do not accumulate OPRBs with years of service.

Defined pension benefits vest. This means that employees who have vested benefits may keep the benefits if they leave or seek employment elsewhere. These rights are protected by ERISA. OPRBs do not vest. Employees who leave have no further claim to OPRBs. OPRBs are explicitly excluded from ERISA.

The accounting for OPRBs differs from the accounting for defined benefit pension plans in the following respects: 1. Accounting for defined benefit pension plans requires recognition of a minimum liability equal to the funded status of the plan wherein the employer's obligation for future benefits earned to date is measured by using the accumulated benefit obligation. Due to measurement problems associated with OPRBs, no minimum liability is required. 2. The pension service cost component is that portion of the PBO attributable to employee service during the current year. The service cost for OPRB is ratably apportioned to employee service lives. 3. OPRB prior service cost is amortized over the life expectancy of employees when most employees are fully eligible to receive benefits, else they are amortized to the 268

date of full eligibility. Defined benefit pension plan prior service cost is amortized over the service lives of employees. 4. Defined benefit pension plan gains and losses are amortized using the corridor approach at a minimum over the service lives of employees as an adjustment to pension expense. OPRB gains are treated as offsets to unrecognized prior service costs and transition obligations. 5. The transition amount for defined benefit pension plans is amortized over the average remaining service lives of employees or the company may elect a longer 15-year period. The OPRB transition amount may be recognized immediately, amortized over the average remaining service lives of employees or over 20 years, if longer. In addition, the cumulative expense recognized as a result of electing to defer recognition of the transition amount may not exceed the cumulative expense that would occur on a pay-as-you-go basis. c.

OPRBs are similar to defined benefit pension plans in the following respects: Management promises OPRBs and defined pension benefits to employees in exchange for current services. The notion that OPRBs and defined pension benefits are both forms of deferred compensation is consistent with theories of labor economics wherein management and labor contract for wages equal to their marginal revenue product. Under this concept employee bargain for total wages and agree to defer wages to retirement years.

The accounting for OPRBs is similar to the accounting for defined benefit pension plans in the following respects: 1. The accounting for both requires that the cost of the future benefits be accrued over the working lives of the employees who will receive them. 2. The interest component for pension expense and OPRBs is calculated based on the value of the beginning employer obligation.

Case 14-5 a.

Projected Benefit Obligation Fair Value of Plan Assets Funded Status

$205 (175) $ 30 underfunded

Penny Pincher’s unsatisfied obligation is $30. This amount is consistent with the definition of liabilities found in SFAC No. 6. SFAC No. 6 defines liabilities as the probable future sacrifice of economic benefits arising from present obligations of a 269

particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. The obligation is contractual. It accrues as the employees perform services. The measurement of the obligation is consistent with the notion that the employees have already earned the future benefits to be paid to them during retirement. The measured amounts of the projected payments take into consideration the benefit formula and projected salaries that will actually be used to determine the amounts to be paid. The result is a measurement of the expected future cash outflows resulting from prior transactions or events, employees working and earning future benefits. Part of the obligation has already been satisfied (paid for) by placing assets into a fund and foregoing the return on those assets. The remaining obligation is a liability to the company. c.

The FASB ASC 715 guidelines require recognition of the overfunded or underfunded status of a DBPP or OPBP as an asset or liability in a company's statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Therefore, Penny Pincher should report the funded status, underfunded $30, on its balance sheet.

Case 14-6 a.

According to SFAS No. 87, the discount rate used to calculate the projected benefit obligation, the accumulated benefit obligation, vested benefits, service cost, and the interest component on pension expense shall reflect the rates at which the pension benefits could be effectively settled, i.e., the settlement rate. To determine the discount rate, employers are encouraged to look at rates implicit in current annuity contracts that could be used to effectively settle the obligation. They may also look at rates on high-quality fixed income investments.

The FASB chose the settlement rate to discount projected benefits because this rate is consistent with the measurement of the liability owed at the balance sheet date. The resulting present value reflects the amount that it would take to effectively settle the debt (for example by purchasing an annuity contract or a fixed income security) and provide the projected benefits to the employees at retirement.

Other possible discount rates would be the alternative borrowing rate of the employer or the rate of return expected on plan assets. Other liabilities incurred by the corporation are measured using the market rate on the debt when it was incurred. This rate is the rate of interest that the borrower could and did borrow at. Since, the pension obligation is also a liability of the employer corporation, the incremental borrowing rate of that corporation would be a logical selection. 270

The rate of return expected on plan assets is another logical choice. The rates implicit in other liabilities of the corporation is the effective rate, that rate which equates payments to the amount borrowed. Since the pension obligation is being taken care of by payments to a pension fund, the rate earned on funded assets provides payments toward the obligation and is therefore similar to interest payments on a debt. The rate of return is the rate by which the obligation is being settled currently, not the rate by which it could be effectively settled. d.

Companies believe that investors, creditors and other users use accounting information to make projections of expected future economic performance. These projections include evaluation of the amount, timing and uncertainty of expected future cash flows. Increased volatility would be interpreted an increased uncertainty regarding the amount and timing of future cash flows. Increased uncertainty is associated with increased riskiness. Increased riskiness is associated with lower market values of firm shares. Finance literature teaches us that the higher the risk taken on by the investor, the greater must be the expected return. Greater returns, given expected levels of future cash flows imply smaller investments, i.e., a lower value for the firm.

Case 14-7

Item

Pensions

Post-retirement Benefits

Service Cost

Present value of increased benefits coming from one additional year of service

Interest Cost

Interest on beginning-ofyear projected benefit obligation at settlement rate of interest.

Total Obligation

Projected benefit obligation or accumulated benefit obligation depending on component being measured. Must be reported if accumulated benefit obligation exceeds the fair value of plan assets adjusted for prepaid and accrued pension costs. Description of plan, detail of pension expense, rate assumptions, and

Present value of equal attribution of postretirement benefit costs for period from hiring date to full eligibility date. Interest on beginning-ofyear accumulated postretirement benefit obligation at assumed discount rate. Accumulated postretirement benefit obligation.

Minimum Liability

Disclosure Requirements

271

No provisions for minimum liability.

Same as pensions with additional information about the health cost trend rate

reconciliation of funded status of the plan with amounts reported on the balance sheet.

used and sensitivity information about effect of rate change.

Case 14-8 1. e 2. c 3. d 4. b 5. a

Case 14-9 a.

Service cost Interest cost Actual (and expected) return on plan assets Pension expense for 2021

Projected Benefit Obligation PBO, December 31, 2020 Service cost Interest cost Benefits paid PBO, December 31, 2021

$30,000 27,000 (25,000) $32,000

$270,000 30,000 27,000 (21000) $396,000

Fair value of plan assets Fair value of plan assets December 31, 2020 Add: Actual return Contributions Subtract: Benefits paid Fair value of plan assets December 31, 2021

$270,000 25,000 18,000 (21,000) $292,000

Case 14-10 a. An actuary's role in calculating the components of pension expense is to ensure that the company has established an appropriate funding pattern to meet its pension obligations, to make predictions and assumptions about future events and conditions that affect pension costs, and to assist the accountant in measuring facets of the pension plan that must be reported (costs, liabilities and assets). 272

In order to determine the company's pension obligation, the actuary must first determine the expected benefits that will be paid in the future. To accomplish this requires the actuary to make actuarial assumptions, which are estimates of the occurrence of future events affecting pension costs, such as mortality, withdrawals, disablement and retirement, changes in compensation, and changes in discount rates to reflect the time value of money. In measuring the amount of pension benefits under a defined-benefit pension plan, an actuary must consider such factors as mortality rates, employee turnover, interest and earnings rates, early retirement frequency, and future salaries.

Case 14-11 a.

• • •

The following assumptions are made to determine pension expense the associated pension benefit obligation (PBO). Note that a company is required to disclose this information in the pension footnote: Expected long-term rate of return on plan assets Discount rate Rate of compensation increases

In addition, an actuary will also be required to make assumptions about the average life expectancy, service periods, and retirement age of the plan participants. These items are not required to be disclosed as they are not company specific. b.

Prior service cost arises when a defined benefit pension plan is amended to include employees in the plan on a retroactive basis that were not previously included as pension beneficiaries and also if the pension plan is amended to provide additional pension benefits on a retroactive to current plan participants. When these amendments are made, the cost of the additional benefits is included in Other Comprehensive Income as Prior Service Cost and carried on the balance sheet in Accumulated Other Comprehensive Income. In subsequent periods, Pension Expense is increased to amortize this amount into current earnings and out of AOCI using the average service life of the employees who receive the retroactive benefits.

Actuarial Gains and Losses arise from a variety of sources. The general source is differences between amounts that have been estimated and what actually occurs. For example, an actuarial gain would arise if the actual return on plan assets exceed to expected return on plan assets. Actuarial gains and losses also occur when the assumptions used in the calculation of pension expense and the PBO. For example, if a company has been using an assumed rate of salary increases of 2.6%, increases the assumed rate to 3.1% due to changes in the labor market of their industry, an actuarial loss would occur.

273

As long as the balance in the Actuarial Gain/Loss account (in AOCI) remains small there is no requirement to adjust pension expense. However, if the balance in the account grows too large, there may be a need to make an adjustment. The accounting guidance requires that each period the balance in the AOCI account for actuarial gain/loss be tested using a “corridor approach”. The beginning balance in the AOCI account is compared to 10% of the larger of the beginning PBO or the beginning plan assets. If the amount in AOCI is below 10%, no amortization would be required. If, on the other hand, the balance was in excess of 10% then the excess amount would be subject to amortization over the average service life of the employees covered by the plan. Note that since this account could be either a net gain or a net loss, the amount amortized could increase or decrease pension expense. FASB ASC 14-1 Settlement and Curtailment of a Defined Benefit Pension Plan Search pension plan curtailment 715-30-55 The definitions are found in the glossary 715-30-20 FASB ASC 14-2 EITF Interpretations for Pension Accounting Access Defined benefit pension plans. 715-30. Use Printer Friendly with sources to find EITF pronouncements

FASB ASC 14-3 EITF Interpretations for Postretirement Benefits Accounting Search “pensions.” Defined benefit plans-other postretirement 715-60. Use Printer Friendly with sources to find EITF pronouncements FASB ASC 14-4 Discount Rate on Retirement Benefits Search disclosure of assumed discount rate 715-20-55

FASB ASC 14-5 Excess Pension Plan Assets for Contractors 274

Search Excess Pension Plan Assets for Contractors \ 912-715-50

FASB ASC 14-6 Postretirement Health Benefits for Entities in the Coal Industry Use industry link-extractive industries-mining-compensation-retirement benefits 930-715 FASB ASC 14-7 Pension Cost in Regulated Industries Use industry link-regulated industries-compensation-retirement benefits FASB ASC 14-8 Postretirement Benefit Cost in Regulated Industries Use industry link-regulated industries-compensation-retirement benefits Room for Debate Debate 14-1 Articulation of Financial Statements SFAS No. 87 (FASB ASC 715) required that projected benefits be used to measure pension expense, but allowed companies to report a minimum liability on the balance sheet using accumulated benefits. The result was that financial statements were not articulated. For the following debate, relate your arguments to the conceptual framework, where appropriate. The articulation of financial statements refers to how they are linked together. That is, in this case the same information is presented regarding pension costs on the income statement and the balance sheet. Team1: Argue in favor of articulation The goal of articulation is to present a cohesive financial picture of an entity such that the relationships between items on the different financial statements are clear. To achieve that goal, assets liabilities, equity revenue, expense, gains and losses should be classified in a consistent manner. Phase B of the joint FASB IASB financial statement project illustrates the current thinking on this issue. Under this proposal, changes in the financial statement elements would be classified consistently in the balance sheet, 275

statement of comprehensive income and the statement of cash flows. These changes are recommended because previously transactions or events recognized in financial statements were not described or classified in the same way in each of the statements. That made it difficult for users to understand how the information in one statement relates to information in the other statements. Team 2 Argue against articulation Although financial statement articulation may be a worthy goal in some situations, in other cases the disclosure of useful information outweighs the advantages of articulation. The disclosure of the minimum pension liability is such a case. This amount is disclosed when the accumulated benefit obligation exceeds the fair value of the plan assets. Thus, even though future salary levels are used to calculate pension expense, the liability reported on the balance sheet need take into consideration only present salary levels. This lack of articulation is due to the contention that the projected benefit obligation overstates the pension liability because it does not represent the legal liability or the most likely settlement amount. Debate 14-2 Measurement of the Pension Obligation SFAS No. 158 no longer allows companies to report the SFAS No. 87 minimum liability in the balance sheet. Instead the amount reported in the balance sheet is measured using projected benefits rather than accumulated benefits. For the following debate, relate your arguments to appropriate accounting theory, including the conceptual framework and capital maintenance theories. Team Debate: Team 1. Argue for the use of projected benefits for pension expense and liability purposes. According to the Conceptual Framework, a company’s financial statements should be articulated. This implies that the measurement of an expense should be based on the same measurement criteria as is the measurement of a related balance sheet item. For example, if a company uses LIFO to value its inventory, then LIFO determines the amount of the company’s cost of goods sold. If a company reports its liability for a defined benefit pension plan measured using accumulated benefits, rather than projected benefits, but reports pension expense measured using projected benefits, its financial statements are no longer articulated. If not, the balance sheet amount cannot be relied upon to help users project the company’s future cash flows (a primary objective of financial reporting). The result of allowing companies to report the minimum liability for defined benefit pension plans was a meaningless amount that was reported as the company’s unamortized prior service cost or a meaningless amount that was reported as an adjustment to accumulated other comprehensive income because companies simply plugged numbers into the balance 276

sheet to make reporting of the minimum liability result in a balance sheet that was in balance. Representational faithfulness, reliability, and relevance require companies to report items in their balance sheet that reflect the items that they purport to represent. A balance sheet plug simply cannot do this. Projected benefits provide a measure of the company’s obligation that employees have earned during the accounting period, but will be paid out in the future. If so, projected benefits provides an appropriate measure of the cost of a pension plan that was incurred during the accounting period and reflected in the income statement as pension expense. By the same token projected benefits provide an appropriate measure of the company’s obligation of those employees. It represents the present value of amounts that will be paid to employees who have already earned those benefits. Since the benefit formula utilizes future salaries to determine what those amounts will be, it follows that it should be used to determine the future cash flows whose present values are reported in today’s financial statements. The current year salaries have been earned, but will not be used to determine what will actually be paid. So they are irrelevant for both income statement and balance sheet measurement purposes. Team 2 Argue for the use of accumulated benefits for pension expense and liability purposes Articulation may provide financial statements whose numbers are interrelated and thus internally consistent, but at the same time, the resulting financial statements may be irrelevant for user decision-making. For example, the use of LIFO to value cost of goods sold may provide an income statement that measures current cost against revenue and thus gives users a good measure of income, but, at the same time the resulting balance sheet inventory amount is totally meaningless because it may include cost that is many years old, and thus in no way reflects its value to the company as an asset. By the same token, use of projected benefits for reporting pension expense may provide relevant amounts for determining income, while the present value of projected benefits may not result in a relevant measure of the company’s liability to employees for a defined benefit pension plan. We argue that the projected benefit obligation overstates a company’s liability for defined benefit pension plans. It includes not only the present value of benefits that will actually be paid, but also the present value of benefits that may never be paid. This is so because it includes estimated benefits for employees who are not yet vested and may leave the company before they are. In these cases the benefits will never be paid. Also, employees may retire at a time that differs from that estimated by the actuary. If so, the measurement of projected benefits is inaccurate. In addition, we believe that accumulated benefits should be used to measure the balance sheet obligation because the accumulated benefit obligation measures the amount that would have to be rolled over today if the company should terminate the 277

defined benefit plan in favor of one that is a type of defined contribution plan or perhaps will no longer offer pension benefits to its employees. Finally, we argue that an economist would say that pension benefits must be related to an employee’s marginal revenue product. The marginal revenue product for this year is not related to future years and so measurement of obligations resulting from its incurrence should not be based on future labor prices. WWW Case 14-12 a.

A private pension plan is an arrangement whereby a company undertakes to provide its retired employees with benefits that can be determined or estimated in advance from the provisions of a document or from the company’s practices. In a contributory pension plan the employees bear part of the cost of the stated benefits whereas in a noncontributory plan the employer bears the entire cost.

The employer is the organization sponsoring the pension plan. The employer incurs the costs and makes contributions to the pension fund. Accounting for the employer involves: (1) allocating the cost of the pension plan to the proper accounting periods, (2) measuring the amount of pension obligation resulting from the plan, and (3) disclosing the status and effects of the plan in the financial statements. The pension fund or plan is the entity which receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the pension recipients. Accounting for the fund involves identifying receipts as contributions from the employer sponsor and as income from fund investments and computing the amounts due to individual pension recipients.

1. Relative to the pension fund the term “funded” refers to the relationship between pension fund assets and the present value of expected future pension benefit payments; thus, the pension fund may be fully funded or underfunded. Relative to the employer, the term “funded” refers to the relationship of the contributions made by the employer to the pension fund and the pension expense accrued by the employer; if the employer contributes annually to the pension fund an amount equal to the pension expense, the employer is fully funded. 2. Relative to the pension fund, the pension liability is an actuarial concept representing an economic liability under the pension plan for future cash payments to retirees. From the viewpoint of the employer, the pension liability is an accounting credit that results from an excess of amounts expensed over amounts contributed (funded) to the pension fund. 278

1. The theoretical justification for accrual recognition of pension costs is based on the matching concept. Pension costs are incurred during the period over which an employee renders services to the enterprise; these costs may be paid upon the employee’s retirement, over a period of time after retirement, as incurred through funding or insurance plans, or through some combination of any or all of these methods. 7. Although cash (pay-as-you-go) accounting is highly objective for the final determination of actual pension costs, it provides no measurement of annual pension costs as they are incurred. Accrual accounting provides greater objectivity in the annual measurement of pension costs than does cash accounting if actuarial funding methods are applied to actuarial valuations to determine the provision for pension costs. While cash accounting provides a more precise determination of the final cost, accrual accounting provides a more objective measure of the annual cost.

Case 14-13 a.

1. The theoretical justification for accrual recognition of pension costs is based on the matching concept. Pension costs are incurred during the period over which an employee renders services to the enterprise; these costs may be paid upon the employee’s retirement, over a period of time after retirement, as incurred through funding or insurance plans, or through some combination of any or all of these methods. 2. Although cash (pay-as-you-go) accounting is highly objective for the final determination of actual pension costs, it provides no measurement of annual pension costs as they are incurred. Accrual accounting provides greater objectivity in the annual measurement of pension costs than does cash accounting.

Terms and their definitions as they apply to accounting for pensions follow: 1. Market-related asset value, when based on a calculated value, is a moving average of pension plan asset values over a period of time. Considerable flexibility is permitted in computing this amount. In many cases, companies will undoubtedly use the actuarial asset value employed by the actuary as their market-related asset value for purposes of applying this concept to pension reporting. 2.

The projected benefit obligation is the present value of vested and nonvested employee benefits accrued to date based on employees’ future salary levels. This is the pension liability required by GAAP.

3. The corridor approach was developed by the FASB as the method for determining when to amortize the balance in the Accumulated OCI (G/L) account. The net gain 279

or loss balance is amortized when it exceeds the arbitrarily selected FASB criterion of 10% of the larger of the beginning-of-the-year balances of the projected benefit obligation or the market-related value of the plan assets. c.

The following disclosures about a company’s pension plans should be made in financial statements or their notes: 1. A description of the plan including employee groups covered, type of benefit formula, funding policy, types of assets held, and the nature and effect of significant matters affecting comparability of information for all periods presented. 2. The components of net periodic pension expense for the period. 3. A reconciliation showing how the projected benefit obligation and the fair value of the plan assets changed from the beginning to the end of the period. 4. Pension-related amounts recorded In Accumulated Other Comprehensive Income and the impact of amortization of these items on pension expense in the current and next year. 5. A table indicating the allocation of the pension plan assets by category (equity securities, debt securities, real estate, and other assets), and showing the percentage of the fair value to total plan assets. In addition, a narrative description of investment policies and strategies, including the target allocation percentages (if used by the company), must be disclosed. 6. The company must disclose the expected benefit payments to be paid to current plan participants for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter, based on the same assumptions used to measure the company’s benefit obligation at the end of the year. Also required is disclosure of a company’s best estimate of expected contributions to be paid to the plan during the next year.

Case 14-14 a.

Pension benefits are part of the compensation received by employees for their services. The actual payment of these benefits is deferred until after retirement. The net periodic pension expense measures this compensation and consists of the following five elements: 1. The service cost component is the present value of the benefits earned by the employees during the current period. 2. Since a pension represents a deferred compensation agreement, a liability is created when the plan is adopted. The interest cost component is the increase in that liability, the projected benefit obligation, due to the passage of time. 3. In order to discharge the pension liability, an employer contributes to a pension fund. The return on the fund assets serves to reduce the interest element of the pension expense. Specifically, the expected return reduces pension expense. 280

Expected return is the expected rate of return times the market-related value of plan assets. 4. When a pension plan is adopted or amended, credit is often given for employee service rendered in prior years. This retroactive credit, or prior service cost, is charged to other comprehensive income (PSC) in the year the plan is adopted or amended, and then is recognized as pension expense over the time that the employees who benefited from this credit worked. 5. The gains and losses component arises from a change in the amount of either the projected benefit obligation or the plan assets. This component is amortized via corridor amortization. b.

The major similarity between the accumulated benefit obligation and the projected benefit obligation is that they both represent the present value of the benefit attributed by the pension benefit formula to employee service rendered prior to a specific date. All things being equal, when an employee is about to retire, the accumulated benefit obligation and the projected benefit obligation would be the same. The major difference between the accumulated benefit obligation and the projected benefit obligation is that the former is based on present salary levels and the latter is based on estimated future salary levels. Assuming salary increases over time, the projected benefit obligation should be higher than the accumulated benefit obligation.

1. Pension gains and losses, sometimes called actuarial gains and losses, result from changes in the value of the projected benefit obligation or the fair value of the plan assets. These changes arise from the deviations between the estimated conditions and the actual experience, and from changes in assumptions. The volatility of these gains and losses may reflect an unavoidable inability to predict compensation levels, length of employee service, mortality, retirement ages, and other relevant events accurately for a period, or several periods. Therefore, fully recognizing the gains or losses on the income statement may result in volatility that does not reflect actual changes in the funded status of the plan in that period. 2. In order to decrease the volatility of the reporting of the pension gains or losses, the FASB had adopted what is referred to as the “corridor approach.” This approach achieves the objective by amortization of the accumulated OCI (G/L) in excess of 10% of the greater of the projected benefit obligation or the marketrelated asset value of the plan assets.

Case 14-15 Boston’s plan is a defined benefit plan because it entitles employees to a defined amount in future (which is based on future salary). Worchester has a defined contribution plan because 281

the employees only receive an amount equal to their salaries today and there is no guarantee of future amounts. Case 14-16 Service Cost Interest Cost Actual return on plan assets Amortization of Prior service cost Pension expense for 2020

60,000 50,000 -12,000 8,000

$106,000

Case 14-17 Financial Analysis The solution to this case is dependent upon the companies selected by the students. A recommended method of checking the students’ solutions is to require them to turn in their downloaded financial statements with their solutions. Financial Analysis Case Solution will vary depending on the company selected

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CHAPTER 15

Case 15-1 a.

Under FASB ASC 717-10-25-2, an entity shall recognize the services received in a share-based payment transaction with an employee as services are received. Employee services themselves are not recognized before they are received. The entity shall recognize either a corresponding increase in equity or a liability, depending on whether the instruments granted satisfy the equity or liability classification criteria. As the services are consumed, the entity shall recognize the related cost. For example, as services are consumed, the cost usually is recognized in determining net income of that period, for example, as expenses incurred for employee services. In some circumstances, the cost of services may be initially capitalized as part of the cost to acquire or construct another asset, such as inventory, and later recognized in the income statement when that asset is disposed of or consumed. This Topic refers to recognizing compensation cost rather than compensation expense because any compensation cost that is capitalized as part of the cost to acquire or construct an asset would not be recognized as compensation expense in the income statement. The amount of compensation for compensatory ESOPs is determined on the Grant date. The grant date is the date at which an employer and an employee reach a mutual understanding of the key terms and conditions of a share-based payment award. The employer becomes contingently obligated on the grant date to issue equity instruments or transfer assets to an employee who renders the requisite service. Awards made under an arrangement that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality (or perfunctory), for example, if management and the members of the board of directors control enough votes to approve the arrangement. Similarly, individual awards that are subject to approval by the board of directors, management, or both are not deemed to be granted until all such approvals are obtained. The grant date for an award of equity instruments is the date that an employee begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer’s equity shares.

John believes that employee stock options are equity securities. His opinion is consistent with prior practice. This position implies that options are nonreciprocal transfers wherein the corporation receives something of value but gives up nothing in return. Because the option contracts do not obligate the corporation to give up assets or perform future services, they do not meet the definition of liabilities. In addition, their value is derived solely from the underlying market value of the company's stock - i.e., their existence and worth are derived from the value of 283

equity. Because the options exist only to allow the holder to acquire stock, their issue price is similar to a down payment toward the eventual purchase of stock, implying further that the options are equity securities. ii.

Marcy believes that preexisting stockholders are hurt by the exercise of stock options. If so, the option holder is not acting as an owner in the role of owner. Hence, it can be argued that options do not fit the definition of an equity security. Proponents of this view hold that options are debt or quasi-equity. Those who argue that options are liabilities consider the obligation to issue the shares, particularly to the detriment of preexisting shareholders, is a liability. It is argued that the liability could be settled at any time prior to exercise by purchasing the options from the option holder at the then current market price. If so, an appropriate measure of the option's value at the balance sheet date is fair value. If the options are not equity, then changes in fair value would fit the definition of earnings and should be recognized in the income statement.

Case 15-2 a.

Entity theory income statement:

Revenues Cost of goods sold Gross profit Operating expenses Net income

$450,000 220,000 $230,000 64,000 $166,000

Entity theory balance sheet: ASSETS Current assets Noncurrent assets

a. Total assets

EQUITIES $ 87,000 186,000

_______ $273,000

Current liabilities Bonds payable Preferred stock Common stock PIC in excess of par Retained earnings Total equities

ii. Proprietary theory income statement: Revenues Cost of goods sold

$450,000 220,000 284

$ 19,000 100,000 20,000 50,000 48,000 36,000 $273,000

Gross profit Operating expenses Operating income Interest expense Net income

$230,000 64,000 166,000 10,000 $156,000

Proprietary theory balance sheet: ASSETS

LIABILITIES

Current assets $ 87,000 Noncurrent assets 186,000

TOTAL ASSETS

$273,000

Current liabilities Bonds payable Total liabilities Stockholder Equity Preferred stock Common stock

$ 19,000 100,000 $119,000

PIC in excess of par Retained earnings Total SE TOTAL LIAB. & SE

48,000 36,000 $154,000 $273,000

$ 20,000 50,000

iii. Residual Equity theory income statement: Revenues Cost of goods sold Gross profit Operating expenses Operating income Interest expense Preferred dividends Net income

$450,000 220,000 $230,000 64,000 166,000 10,000 1,000 $155,000

Residual Equity theory balance sheet: ASSETS Current assets Noncurrent assets

LIABILITIES $ 87,000 186,000

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Current liabilities Bonds payable Total liabilities Preferred stock Residual equity Common stock PIC in excess of par

$ 19,000 100,000 $119,000 $ 20,000 50,000 48,000

TOTAL ASSETS b.

_______ $273,000

Retained earnings Total SE TOTAL LIAB. & SE

36,000 $134,000 $273,000

Entity theory. There would be no entity theory debt to equity ratio. Entity theory views all equities as contributors of capital. The theory makes no distinction between debt and equity securities. Proprietary theory debt to equity ratio = 119/154 = 0.77 Residual equity theory debt to equity ratio = 121/154 = 0.79

Case 15-3 a.

Under the cost method, treasury stock is debited for the purchase price of the shares even though the purchase price is less than par value. Under the par method, treasury stock is debited for the par value of the shares, and a separate paid-in capital account is credited for the excess of the purchase price over the par value.

Under the cost method, treasury stock is debited for the purchase price of the shares. Under the par value method, treasury stock is debited for the par value of the shares, and the debit for the excess of the purchase price over the par value is assigned to additional paid-in capital arising from past transactions in the same class of stock and/or retained earnings.

Under the cost method, treasury stock is credited for the original cost (purchase price) of the shares, and the excess of the original cost (purchase price) over the sales price first is debited to additional paid-in capital from earlier sales or retirements of treasury stock, and any remainder then is debited to retained earnings. Under the par value method, treasury stock is credited for the par value of the shares, and the excess of the sales price over the par value is credited to additional paid-in capital from sale of treasury stock.

Under the cost method, treasury stock is credited for the original cost (purchase price) of the shares and the excess of the sales price over the original cost (purchase price) is credited to additional paid-in capital from sales of treasury stock.

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Under the par value method, treasury stock is credited for the par value of the shares and the excess of the sales price over the par value is credited to additional Paid-in capital from sale of treasury stock. e.

There is no effect on net income as a result of treasury stock transactions.

Case 15-4 The steps involved in a quasi-reorganization are: 1. Assets are written down to their fair market value against retained earnings or additional paid-in capital. 2. The retained earnings deficit is eliminated against additional paid-in capital or legal capital. 2. The zero retained earnings balance is dated, and this date is retained until it loses its significance (typically 5 to 10 years). 3. Carrol Inc. should prepare the following journal entries to accomplish the quasi-reorganization. Additional paid-in capital Retained Earnings Equipment

$ 100,000 1,100,000

Common Stock Retained Earnings

2,000,000

$1,200,000

2,000,000

Carrol, Inc. should also date the retained earnings balance December 31, 2019 until the date loses its significance. Case 15-5 a.

The five methods that were proposed to determine the value of a stock option prior to the release of SFAS No. 123R involved determining the excess of the fair value of the stock over the option price at one of the following dates: i. The date of the option grant. ii. The date the option becomes the property of the employee. iii. The date the option is first exercisable. iv. The date the option is exercised. 287

v. The date of exercise adjusted for the income tax effect to the corporation. b.

The conceptual merits of the methods are: i.

The excess of the fair value of the stock over the option price at the date of the option grant is the generally accepted method of valuation. The lack of a ready market value for the options does not negate the existence of their value. The excess of the fair value of the stock over the option price is usually easily measurable (the more closely held the stock, the more difficult the measurement). The value at the grant date is appropriate because this is the point at which the corporation forgoes the alternative uses of the optioned shares, and any difference between option price and market price of the shares or the value of the option after that date only benefits the option holder in his role as a potential investor, not in his role as an employee contracting for services.

ii. The date the option becomes the property of the employee (i.e., the date the employee fulfills any conditions included in the option plan) is appropriate because it is at this time that the corporation has an unqualified obligation. iii. The date the option is first exercisable is appropriate because it is at this date that the employee first has control over the option and only from this date that he can be considered as an investor. iv. The date the option is exercised is appropriate because it is only at this date that it is certain that exercise will occur; prior to exercise, the corporation has only a contingent obligation. v. Adjustment for the income tax effect to the corporation is justifiable in the case of nondeductible stock options. Had the firm chosen to compensate the employee with an additional (deductible) cash payment, the firm's income tax would have been less. Thus, the total cost of the option to the firm includes the difference in tax. Case 15-6 a.

i. ii. Under FASB ASC 718-10-50, the required financial statement disclosures at December 31, 2019 and December 31, 2020 include sufficient information that enables users of the financial statements to understand all of the following: 1. The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders 2. The effect of compensation cost arising from share-based payment arrangements on the income statement 288

3. The method of estimating the fair value of the goods or services received, or the fair value of the equity instruments granted (or offered to grant), during the period 4. The cash flow effects resulting from share-based payment arrangements. This disclosure is not required for interim reporting. The following list indicates the minimum information needed to achieve the objectives in the preceding paragraph and illustrates how the disclosure requirements might be satisfied. In some circumstances, an entity may need to disclose information beyond the following to achieve the disclosure objectives: a. A description of the share-based payment arrangement(s), including the general terms of awards under the arrangement(s), such as: 1. The requisite service period(s) and any other substantive conditions (including those related to vesting) 2. The maximum contractual term of equity (or liability) share options or similar instruments 3. The number of shares authorized for awards of equity share options or other equity instruments. b.

The method it uses for measuring compensation cost from share-based payment arrangements with employees.

For the most recent year for which an income statement is provided, both of the following: 1. The number and weighted-average exercise prices (or conversion ratios) for each of the following groups of share options (or share units): i. Those outstanding at the beginning of the year ii. Those outstanding at the end of the year iii. Those exercisable or convertible at the end of the year iv. Those that during the year were: 01. Granted 02. Exercised or converted 03. Forfeited 04. Expired.

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2. The number and weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses that method or intrinsic value for awards measured pursuant to paragraph 718-10-30-21) of equity instruments not specified in (c)(1), for all of the following groups of equity instruments: i. Those nonvested at the beginning of the year ii. Those nonvested at the end of the year iii. Those that during the year were: 01. Granted 02. Vested 03. Forfeited. d.

For each year for which an income statement is provided, both of the following: 1. The weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses that method or intrinsic value for awards measured at that value pursuant to paragraphs 718-10-30-21 through 3022) of equity options or other equity instruments granted during the year 2. The total intrinsic value of options exercised (or share units converted), share-based liabilities paid, and the total fair value of shares vested during the year.

For fully vested share options (or share units) and share options expected to vest at the date of the latest statement of financial position, both of the following: 1.

The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value (except for nonpublic entities), and weightedaverage remaining contractual term of options (or share units) outstanding

3. At December 31, 2019 and December 31.2020, a footnote to the financial statements should also describe the status of the plan and state that all options have been exercised at the option price given.

290

A dilution of the existing stockholders' equity could occur when the optioned shares are issued only if it could be demonstrated that there was no value in the option holder’s' incentive services exchanged for the option grant. The dilution could occur also if the optionee left the corporation after exercise of the option but prior to the termination of the contract period. If the value of the incentive services was to cover the five years of this contract and an optionee left at the end of four years, the compensation cost for the fifth year of this contract should be shown as a loss arising from the option grant. Dilution, as typically determined by the financial analyst, would be considered to have occurred if per-share earnings and/or book value decreased.

ii.. To the extent that the optionee's incentive services invested under the option grant are equal to the implicit value of the option contract, there has been a fair exchange of values and there would be no dilution of the stockholders' equity. Case 15-7 a.

Under the proprietary theory, the accounting concepts are defined from the viewpoint of the proprietor. Assets are looked upon as the property of the proprietor and liabilities the debts of the proprietor. Under the entity theory, the firm is looked upon as separate and distinct from its owners. The creditors and owners alike are interested in the welfare and success of the firm. Income and expenses are defined from the point of view of the firm. In the funds theory, the balance sheet is comprised of assets on the one side and restrictions of assets on the other side. The area of interest may be limited to a group of assets or a specific set of activities or it may be applied to an entire organization. The fund theory does not have at its center the concept of income but rather the flow of assets and the changes in the restrictions of their use.

The applications of any one of these theories to specific situations depend upon the emphasis desired. However, the usual emphasis suggests the following: i.

The position of the owner in a single proprietorship with respect to income and personal liability for creditors suggests the emphasis of the proprietary theory even though the business is considered separate from the owner's personal affairs.

ii. The partnership equities may be defined in terms of either the proprietary or entity concept depending upon the emphasis desired. As opposed to the single proprietorship, the partnership is considered more of a separate entity. The partnership property is owned by the partnership not by the partners. The 291

partnership creditors must look first to the assets of the partnership. Only if partnership assets are insufficient, may they claim the personal assets of the partners and then only after personal creditors have been completely satisfied. iii. The financial corporation has responsibilities far beyond those to the owners. Very often, depositors and creditors have a greater interest than do the legal owners. Therefore, the emphasis should be in favor of the entity theory. iv. The proprietary theory is often present in consolidated statements because the assets and liabilities of subsidiaries are combined with those of the parent. Consolidated statements can be considered from the point of view of the entity because of the separate concept of the economic unit. It is also possible, but rather remote, to look at the consolidation from the viewpoint of the funds concept as there is no legal relationship between the creditors, parent stockholders, and minority interest and the consolidated assets. The funds concept is reasonable from the economic activity approach to consolidations. v. Estate accounting is usually viewed definitely from the funds approach. The objective of reporting is generally for accountability and information regarding restrictions against assets. Case 15-8 a.

Contributed (or "paid-in") capital is the total amount designated as the permanent capital of a corporation, including amounts paid in for shares, contributed, or capitalized by order of the Board of Directors.

ii. Retained earnings represent the cumulative amount of undistributed income that has not been designated as permanent capital by the Board of Directors. a. Appropriated retained earnings are the amounts of retained earnings that have been restricted by contract and/or by the Board of Directors and are therefore not available as a basis for dividends. b. Unappropriated retained earnings in the amount of undistributed earnings that is available for distribution to stockholders upon appropriate action of the Board of Directors. iii. Unrealized appraisal increments are amounts of upward revaluations of net assets that have not been realized, in accordance with the accounting concept of realization.

292

iv. Cost of treasury shares (contra-amount) is the cost to the corporation of acquiring shares of its own capital stock that are being held in the treasury and have not been legally canceled or reissued. This amount is subtracted from Stockholders’ equity. v. Minority interest in subsidiaries consolidated. Consolidated statements prepared in accordance with the "entity" theory would include the minority interest in subsidiaries consolidated as a part of the stockholders' equity section. vi. Some companies consider the excess of the book value of the net assets of a subsidiary over the cost thereof to be a part of "capital" surplus. b.

The stockholders' equity section is subdivided in order to give useful information about the source and ownership of corporate net capital, and to indicate any restrictions on its withdrawal. Distinctions between contributed (paid-in) capital and retained earnings indicate the extent to which a company has financed its growth internally. Further distinction in the contributed capital section indicate the relative interests of various classes of owners (e.g., preferred and common). Other classifications are pertinent in determining the unavailability, for reasons of law or management action, of capital for dividend purposes. These include the distinction between legal or stated capital and amounts in excess thereof, treasury stock restrictions, and sometimes appraisal increments, as well as contractual or voluntary appropriations of retained earnings.

Four sources of capital in excess of par or stated value of shares:

Issuance of shares for a consideration in excess of par or stated value per share.

Issuance of shares as a stock dividend, where the amount to be capitalized per share exceeds its par or stated value.

Re-issuance of treasury shares for an amount in excess of the cost incurred in re-acquiring them.

In ordinary usage the term surplus is used to designate the amount of anything that is in excess of use or need. The amount of capital paid in, in excess of par or stated value, and the income retained in a business are in no sense in excess of amounts that are needed or used by the corporation. Therefore, the terms "capital surplus" and "earned surplus" are likely to be misinterpreted by many users of financial information, and should be avoided whenever possible. Suggested substitutes are "Contributed capital in excess of par or stated value" and "Accumulated earnings retained in the business" or "Retained earnings."

Case 15-9 293

A stock dividend is the issuance by a corporation of its own stock to its stockholders on a pro-rated basis without receiving payment thereof. The stock dividend results in an increase in the amount of the legal or stated capital of the enterprise. The dividend may be charged to retained earnings or to any other capital account that is not a part of legal capital. 1.

From the legal standpoint a stock split-up is distinguished from a stock dividend in that a split-up results in an increase in the number of shares outstanding and a corresponding decrease in the par or stated value per share whereas a stock dividend, though it results in an increase in the number of shares outstanding, does not result in a decrease in the par value of the shares.

From the accounting standpoint the distinction between a stock dividend and a stock split-up is dependent upon the intent of the board of directors in making the declaration. If the intent is to give to stockholders some separate evidence of a part of their prorated interests in accumulated corporate earnings, the action results in a stock split-up, regardless of the form it may take. In other words, if the action takes the form of a stock dividend but reduces the market price markedly, it should be considered a stock split-up. Such reduction will seldom occur unless the number of shares issued is at least 20% or 25% of the number previously outstanding.

The usual reason for issuing a stock dividend is to give the stockholders something on a dividend date and yet conserve working capital. A stock dividend that is charged to retained earnings reduces the total accumulated earnings, and all stock dividends reduce the per share earnings. Issuing a stock dividend to achieve these ends would be a public relations gesture in that the public would be less likely to criticize the corporation for high profits or undue retention of earnings. A stock dividend also may be issued for the purpose of obtaining a wider distribution of the stock. Although this is the main consideration in a stock split-up, it may be a secondary consideration in the issuance of a stock dividend. The issuance of a series of stock dividends will accomplish the same objective as a stock split-up. A stock split-up is intended to obtain wider distribution and improved marketability of shares by means of a reduction in the market value of the company's shares.

The amount of retained earnings to be capitalized in connection with a stock dividend (in the accounting sense) might be (1) the legal minimum (usually par or stated value), (2) the average paid-in capital per outstanding share, or (3) the market value of the shares. The third basis is generally recommended on the grounds that recipients tend 294

to regard the market value of the stock received as a dividend as the amount of earnings distributed to them. If the corporation in such cases does not capitalize an amount equal to the fair value of the shares distributed as a dividend, there is left in the corporation's retained earnings account an amount of earnings that the stockholders believe has been distributed to them. This amount would be subject to further stock dividends or to cash dividends. The recipients might thus be misled into believing that the company's distribution-and earnings-are greater than they actually are. If the per share market value of the stock is materially reduced as a result of a distribution, no matter what form the distribution takes, the action is a stock split-up and should be so designated and treated to the extent permitted by legal requirements. Case 15-10 a.

A stock split effected in the form of a dividend is a distribution of corporate stock to present stockholders in proportion to each stockholder's current holdings and can be expected to cause a material decrease in the market value per share of the stock. Account Research Bulletin No. 43 specifies that a distribution in excess of 20% to 25% of the number of shares previously outstanding would cause a material decrease in the market value. This is a characteristic of a stock split as opposed to a stock dividend, but, for legal reasons, the term "dividends" must be used for this distribution. From an accounting viewpoint, it should be disclosed as a stock split effected in the form of a dividend because it meets the accounting definition of a stock split as explained above.

The stock split effected in the form of a dividend differs from an ordinary stock dividend in the amount of other paid-in capital or retained earnings to be capitalized. An ordinary stock dividend involves capitalizing (charging) retained earnings equal to the market value of the stock distributed. A stock split effected in the form of a dividend involves no charge to retained earnings or other paid-in capital if the par (stated) value of the stock is reduced in inverse proportion to the distribution of stock, other paid-in capital or retained earnings would be charged for the par (stated) value of the additional shares issued. Another distinction between a stock dividend and a stock split is that a stock dividend usually involves distributing additional shares of the same class of stock with the same par or stated value. A stock split usually involves distributing additional shares of the same class of stock but with a proportionate reduction in par or stated value. The aggregate par or stated value would then be the same before and after the stock split.

A declared but unissued stock dividend should be classified as part of corporate capital rather than as a liability in a statement of financial position. A stock dividend affects only capital accounts; that is, retained earnings are decreased and contributed capital is increased. Thus, there is no debt to be paid, and consequently, there is no severance 295

of corporate assets when a stock dividend is issued. Furthermore, stock dividends declared can be revoked by a corporation's board of directors any time prior to issuance. Finally, the corporation usually will formally announce its intent to issue a specific number of additional shares, and these shares must be reserved for this purpose. Case 15-11 a.

Under the provisions of APB Opinion No. 25, Growth company would first calculate the amount of total compensation and then allocate it over the service period. Total compensation = (market price – option price) x number of options. Since the market price and the option price are the same, there would be no compensation. Therefore, no expense would be recognized in the income statement for these options.

In this example, the consequence is that the plan is considered compensatory because it is not available to all employees, but no compensation expense is recognized. i.

ii.

iii.

According to the conceptual framework, an expense is the outflow of resources or incurrence of a liability for performing activities that constitute the company’s major or central operations. Those favoring reporting no expense under APB Opinion No. 25 could argue that the company has not given up any resources to incur an expense. Nor, has the company incurred an obligation to expend resources or to perform future services A potential ethical consideration is that use of the fair value approach rather than APB Opinion No. 25 would cause companies to limit or no longer offer stock option plans to its employees. If so, employees might leave the company. Thus, opponents of fair value could argue that recoding no compensation expense would not reduce reported earnings and thus not induce companies to limit participation n ESOPs. Because the option price is equal to the market price on the grant date, we can argue that the company hasn’t given the employees anything. The employee will only gain something from the options if the market price rises above the option price. This is speculative in nature and as such could be construed as a violation of the historical cost principle Since under APB Opinion No. 25 the company would report no compensation expense, no consequent decrease in retained earnings or increase in paid in capital, there is no direct impact on the company’s financial statements. Nothing is reported in the balance sheet or the income statement for these options even though they clearly have a market value.

296

iv.

Since nothing is reported in the financial statements, the granting of these options has no impact on the financial ratios either. Thus, any financial ratios that use net income in the numerator would be overstated. For example, proponents of fair value reporting for ESOPs may argue that return on assets and return on owners’ equity are understate when fair value measurement is not used to record compensation expense. Because assets and liabilities are unaffected by recording ESOPs under either APB Opinion No. 25 or under the fair value method, there would be no impact on liquidity or solvency ratios.

Under FASB ASC 718-10. The fair value of the options would be used to determine total compensation expense. Total compensation expense would be $3,000 ($3 x 1,000 options). The $3,000 would be spread over the service period – normally from the grant date until the first date that the employees can exercise their options. Each year, paid-in-capital in increased for the amount of the expense that is recognized.

Since the employee compensation plan is compensatory, the fair value method appropriately recognizes compensation, measured at fair value. i.

ii.

iii.

iv.

Proponents of fair value accounting for employee stock options would argue that it is consistent with the conceptual framework’s definition of expense because we are giving the employee something of value – the fair value of the options. Although we are not giving the employees an asset, nor are we incurring an obligation that meets the definition of a liability, we are in essence paying for the expense by giving the employees the potential to increase their ownership in the company at potentially a bargain price. We argue that the reduction in price is a cost the company because the stock could be sold to someone on the outside at a higher price. Thus, a potential ethical consideration is that use of the fair value approach rather than APB Opinion No. 25 would be that companies are transparent in their reporting of the expense resulting from granting stock options to its employees. Moreover, the financial statements are not biased because the selection of the option price does not affect whether an expense is recognized or not. Thus, fair value accounting for ESOPs should be considered ethical. Fair value accounting for employee stock options would fairly present the value of the options given to employees and thus would not overstate a company’s earnings and as a consequence its retained earnings. It would also fairly present the impact of those options on paid-in capital because the company is giving their employees the value of the options which are thus appropriately accounted for as equity securities. Since the fair value of the expense would be reported in the income statement, net income would be less that it would be under APB Opinion No. 25 (which would report no expense). As a result, ratios that use net income would be lower. For 297

example, return on assets and return on equity would be lower under fair value accounting for ESOPs. Since the expense decreases net income and retained earnings by the same amount as the increase in paid-in-capital, there is no impact on assets or liabilities and thus no impact on measures of liquidity or solvency. Case 15-12 a.

The entity theory was proposed in 1922 by Paton who stated that the accounting equation is properly depicted as Assets = Equities. According to Paton, creditors and stockholders provide capital for which they are compensated (with interest or dividends). The source of capital has no effect on how the moneys are spent. That is, whether debt or equity is used as a source of financing, the investment of the capital so derived does not depend on the where the financing came from. If debt is substituted for equity, or vice versa, the cost of the factors of production remains unchanged. Thus, the source of capital has no effect upon and is independent of investment and operations, and the question of debt versus equity is irrelevant. Under entity theory, the debt and equity securities of the company would be arrayed on the right-hand side of the balance sheet. Since there is no need for a distinction between debt and equity, none would be made, and there would be no subtotal for debt or equity.

Entity theory is consistent with early theories of finance, e.g., Modigliani and Miller, 1958, however, it is inconsistent with the more recent literature. Debt versus equity was shown to be relevant because the tax deductibility of interest made debt more attractive than equity. Also, there is evidence that when equity related tax shields, such as the investment credit, are removed, debt tax shields are substituted and vice versa, causing changes in the debt-to-equity ratio. In addition, there is empirical support for the notion that companies have target debt-to-equity ratios and that risk as perceived by the ratio of debt-to-equity makes a difference in the pricing of securities. Finally, it has been demonstrated that complex financial instruments affect firm value and that a complex capital structure has value. To summarize, recent studies in the finance literature indicate that debt versus equity does make a difference and hence the distinction between debt and equity in the balance sheet should continue.

Case 15-13 a.

Convertible debt is a complex hybrid security because it bears an option for the holder to either convert the debt to common stock or redeem it for cash. That is, the holder must either convert the debt to common stock and thus forgo the right to redemption or redeem the debt for cash and thus forgo the right to convert the debt to common shares. 298

Other complexities occur when the debt instrument has a contingently adjustable conversion ratio or detachable call options. The response to this case will not address these types of complications. The entity may issue convertible debt with a beneficial conversion feature. This occurs when the debt is convertible into common stock at the lower of a conversion that is fixed at the commitment date or a fixed discount to the market price of the common stock at the date of conversion. Thus a beneficial conversion feature exists when the debt instrument is issued at a price such that is below the fair value of the stock into which it is convertible. Stated differently, the conversion price is “in the money” and the holder benefits to the extent of the price difference. Thus, the convertible has what is known as an embedded beneficial conversion feature. ASC 470-20-25-5 requires that when an embedded beneficial conversion feature is present in convertible debt, at issuance the issue shall first allocate a portion of the proceeds that is equal to the n intrinsic value of the conversion feature to additional paid-in-capital. The remainder of the proceeds shall be considered the issue price of the debt itself. \ To illustrate, assume that $1,000,000, 8%, 30 year bonds are issued at 98. Each $1,000 bond is convertible into 40 shares of common stock that has a current fair value of $30 per share. The number of shares that holders could receive upon conversion = 40 x $1,000,000/$1,000 = 40,000 shares. The current market value of the 40,000 shares is $30 x 40,000 = 1,200,000. If we divide the $1,000,000 bon by 40,000 shares, we get only $35 per share. Thus, the intrinsic value of the option is $5 per share. Thus, when recording the issuance of the bond, the company would credit additional paid-in capital for $5 x 40,000 = $200,000. The result would be a $200,000 increase in the discount recorded for the bond. The journal entry would appear as follows: Cash 980,000 Discount on Bond s 220,000 Bond Payable Additional Paid-In-Capital

1,000,000 200,000

The more typical case for issuances of convertible debt is to issue debt that has no beneficial conversion feature. Thus, there is no immediate advantage to the holder because the bond is not “in-the-money”. This case is often referred to instead as “plain vanilla”, and there is no intrinsic value to take into consideration. As a result, the debt is recorded as a straight issuance of debt.

299

If the market value of the stock at the date of issuance in the above example was at least $35, there would be no beneficial conversion feature and the issuance would be recorded as follows. Cash Discount on Bond S Bonds Payable

980,000 20,000 1,000,000

FASB ASC 15-1 Cost to Issue Equity Securities to Effect a Business Combination Search business combinations and acquisition costs. 805-10-25 FASB ASC 15-2 Treasury Stock Search treasury stock 505-30-45 FASB ASC 15-3 Quasi-Reorganizations Search quasi-reorganizations 855-20 FASB ASC 15-4 Dividends in Arrears Search cumulative preferred dividends 440-10-50

FASB ASC 15-5 Stock Dividends and Splits Search stock dividends and splits 505-20 . 300

FASB ASC 15-6 Treasury Stock Search treasury stock 505-30 FASB ASC 15-7 Mandatorily Redeemable Preferred Stock Search mandatorily redeemable preferred stock 480-10 Definition in glossary 480-10-20 Room for Debate Debate 15-1 The Nature of Stock Options Team 1

Argue for current GAAP treatment for the issuance and subsequent reporting of options and warrants Stock options and warrants give the holder the right to purchase a share of stock at a predetermined price within a given time period. Current accounting practice (GAAP) is to report the cash inflow received from these securities as equity. The value reported in subsequent periods is historical and does not change in response to changes in the market value of these securities. To defend this position, we must address two issues: measurement and the appropriateness of displaying the security in the balance sheet as the financial statement element, equity. SFAC No. 6 defines equity as the residual interest in the assets of an entity that remains after deducting its liabilities. If options and warrants do not meet the definition of liabilities, then in the current accounting model (and consistent with this definition of equity) they must meet the definition of equity. A liability is an obligation that embodies a future sacrifice of assets. The company owes no assets to option or warrant holders. There is no present obligation to surrender assets or perform services. Hence, stock options and warrants do not meet the definition of liabilities, and they must be equities. Treating stock options and warrants as equity implies that the holder is acting as an owner. Owner transactions involve nonreciprocal transfers of assets to and from the company where one party the investor gives up something and receives nothing in 301

return; investments by owners and distributions to owners are nonreciprocal transfers. They do not involve revenue or expense. The definition of equity implies that the exercise of an option or warrant involves a nonreciprocal transfer wherein the issuing company receives something of value (e.g., employee services or the fair value of a warrant on the date it was issued) but gives up nothing of value in return. Therefore, financial option contracts that do not result in the eventual payment of assets or the performance of services do not qualify as liabilities, rather they are consistent with the definition of equities. The measurement of equity is historical in nature. Equity purports to represent the amount of moneys that have been contributed to the entity from owners plus the accumulated changes in net assets that have not been distributed to owners. The practice is consistent with the historical cost principal and the stewardship role of accounting. As such, it is consistent with the financial capital maintenance concept of measuring net assets and income. Although the holders of options and warrants are not owners until they exercise their rights, they are not creditors. Moreover, the price paid to acquire stock warrants is a function of the market price of shares of stock. Hence, the value recorded is related to and derived from equity in the company. Team 2

Argue for reporting options and warrants as liabilities measured at fair value Stock options and warrants are acquired and held because of their potential to be exercised so that the holder can acquire shares of stock at a price more favorable than buying the stock in the market. Although the market value of these securities is a function of the market price of shares, the holders are not owners and do not act as owners. They have no residual claim to the net assets of the company. If the company were to liquidate, they would receive no distribution of assets. They have no voting rights. They have no rights to share in the profits of the company, and they have no preemptive right. Moreover, if and when their rights are finally exercised, there is an opportunity loss to existing shareholders because not only is their share of the company and company profits diluted, but also their net assets per share decrease because the option price is less than what the company would have receive had the shares been sold in the market instead. That is, option holders profit at the expense of preexisting stockholders, and thus are not acting in the role of owners. The resulting opportunity loss is financed by diluting preexisting stockholders’ wealth. The foregoing arguments imply that stock options and warrants are not equity. Rather, they are more like liabilities. They represent present obligations to issue stock contingent upon exercise by the holder. Exercise results in a loss to preexisting shareholders. The options and warrants give the holder the right to exchange financial instruments on specified terms. The shares issued represent compensation for the cash 302

received. Because the shares could have been sold at market value, they are issued to the option holder in lieu of cash. Hence, the receipt of cash upon exercise is not a nonreciprocal transfer as would be the case for transactions with owners acting as owners. The obligation to make the exchange embodied in a stock option or warrant may be satisfied at any time prior to exercise by purchasing them in the market at fair value. Because financial option contracts entail contractual obligations of the issuing corporation to deliver financial instruments upon exercise on potentially unfavorable terms to preexisting stockholders, they are more like debt than equity. According to economic theory, income is the change in wealth from one period to the next, excluding investments and distributions to owners. Hence, wealth at a point in time provides a relevant measure of the value of the firm. Fair value is what an asset is worth today in the market. It measures what could be realized from its sale or what it would take to replace the operating assets it has. The fair value of net assets comprises value the stockholder’s claim to the enterprise. This implies that if the fair value of net assets equals stockholder wealth, and as such assets are measured at fair value, then liabilities should also be measured at fair value. Since, as stated above the obligation to issue shares upon exercise of stock warrants can be satisfied by purchasing the warrants in the market, the appropriate measure for predictive purposes is fair value. Debate 15-2 The Nature of Cumulative Preferred Dividends Under GAAP, cumulative preferred dividends are reported as liabilities only after they have been declared by the corporation’s board of directors. For the following debate, support your arguments by referring to the SFAC No. 6 definition of liabilities and the consequent characteristics of liabilities. Team Debate: Team 1: Argue that cumulative preferred dividends are liabilities, even if not declared. The conceptual framework defines liabilities as probable future sacrifices of economic benefits of an entity that result from prior transactions or events. Cumulative preferred dividends meet this definition because they meet the three characteristics of a liability. The first characteristic of a liability is that a liability obligates the entity to give up resources or perform services. Cumulative preferred dividends that have not been paid, will be paid even though they have not yet been declared. The only exception is bankruptcy and dissolution where the company is insolvent. Since we assume a going concern, it makes no sense to presume bankruptcy or dissolution. In other words, unless there is evidence to the contrary, we should presume a probable future outflow regardless of when it will occur. Even if a company liquidates, it must pay the current 303

dividend and any arrearage to preferred stockholders before common stockholders can receive anything. If the company were to buy preferred shares from stockholders, it would be required to pay current and dividend arrearages to the preferred stockholders in addition to paying the investors for the stock itself. The second characteristic of a liability is that it obligates a particular entity. The company is that particular entity. The contract between it and the investor obligates it to pay the dividend, eventually, if not today. The third characteristic of a liability is that it results from a transaction or event. In this case the sale of the preferred stock to investors can be seen as the transaction or event that results in the obligation to pay the dividend. Even though the company may not declare a dividend this year, it will still have to pay the dividend to the preferred stockholder in the event of stock repurchase or liquidation of the company (assuming solvency). Consistent with the accounting rules for contingent liabilities, when an obligation is probable and we can reasonably estimate its amount, it should be reported in a company’s balance sheet. For cumulative preferred dividends, we have made a strong case for probability and no one can dispute the certainty regarding the amount. We know by the contract between the company and its preferred stockholders what the amount is. Team 2: Argue that cumulative preferred dividends are not liabilities, unless they are declared. We agree that the company will eventually have to pay a dividend to a preferred stockholder, provided that it repurchases the stock or terminates business and is solvent. However, the typical underlying accounting assumption is that the company is considered a going concern and is not likely to terminate. In this case, it may be able to put off paying a dividend for a very long time or perhaps even an indefinite period. So, accountants correctly do not report dividends in arrears as liabilities unless they have been declared. A company does not have a legal obligation to pay a dividend unless declared (or in the case of cumulative preferred dividends, when they are declared or when a company terminates or reacquires the preferred shares). Declaration constitutes the critical event that triggers the incurrence of the liability for cumulative preferred dividends or any other dividends. Without declaration there is no liability. Debate 15-3 Distinguishing Between Debt and Equity In its 1990 discussion memorandum on distinguishing between liabilities and equity, the FASB posed the question, “Should the sharp distinction between liabilities and equity be effectively eliminated?” To do so would be consistent with the entity theory 304

of equity and with the notion that the capital structure (debt vs. equity) of a firm is irrelevant to users of financial information. Team 1:

Argue for elimination of the distinction between debt and equity. Support your argument by citing the entity theory of equity as well as finance theory that asserts that capital structure is irrelevant.

We believe that the current distinction between debt and equity in corporate balance sheets should be eliminated. Our position is supported by entity theory which provides a better basis to account for the financial position and operations of the corporation than does the proprietary theory. A corporation is characterized by the separation of ownership and management. Its legal definition treats the corporation as though it were a person – a separate legal entity, separate from its owners, the stockholders. We argue that entity theory provides the appropriate foundation to represent the financial position of the corporate form. From an accounting standpoint, the entity theory can be expressed as assets = equities The entity theory is a point of view toward the firm and the people concerned with its operation. This viewpoint places the firm, and not the owners, at the center of interest for accounting and financial reporting purposes. The essence of the entity theory is that creditors as well as stockholders contribute resources to the firm, and the firm exists as a separate and distinct entity apart from these groups. Unlike a partnership or a sole proprietorship, the owners’ risk of loss is limited to their investment in the firm. If the company goes bankrupt, they are not obligated for debts of the firm. Thus, the corporate concept of limited liability makes the proprietary unsuitable for the corporate form of business. Limited liability enables stockholders to have the same sort of risk that is associated with debt. Even though the creditor has priority over the stockholder in the case of corporate liquidations, like the stockholder, the creditor can lose his investment and the interest income stream from the investment. But like the stockholder, the creditor is not responsible for the debts of the firm. Therefore, there is no fundamental difference between debt and equity capital. In a corporation, the assets and liabilities belong to the firm, not to its owners. As revenue is received, it becomes the property of the entity, and as expenses are incurred, they become obligations of the entity. Any profits belong to the entity and are paid out to the stockholders only when a dividend is declared. Under entity theory, all the items on the right-hand side of the balance sheet are viewed as claims against the assets of the firm, and individual items are distinguished by the nature of their claims. Some items are identified as creditor claims and others are identified as owner claims; nevertheless, they are all claims against the firm as a separate entity. 305

Entity theorists take a broad view of the nature of the beneficiaries of income – both debt-holders and equity-holders are compensated for investing in the firm. In essence, entity theory makes no distinction between debt and equity. Both are considered sources of capital, and the operations of the firm are not affected by the amount of debt relative to equity. Thus, under entity theory debt-to-equity ratios would not provide relevant information for investor decision making. The entity theory concept that there is no distinction between a company’s debt and equity is supported by the finance indifference theorem. Modigliani and Miller showed that, in theory, if we ignore taxes the company is indifferent between using debt and equity financing. This theory relies on the assumption that the sources of capital are unaffected by how the capital is invested. It also assumes that the income streams to debt and equity are equal and perpetual. Modigliani and Miller than added taxes to the equation and showed that the tax deductibility of interest would cause debt to be preferred to equity financing. However, Miller later showed that with arbitrage, that the tax deductibility of interest is irrelevant and thus, reestablished a theoretical basis for the finance indifference theorem. Team 2:

Argue against elimination of the distinction between debt and equity. Support your argument by citing the proprietary theory of equity as well as finance theory that asserts that capital structure is relevant

We believe that the current distinction between debt and equity in corporate balance sheets should continue. Our position is supported by proprietary theory which provides a better basis to account for the financial position and operations of businesses than does the entity theory. Under the proprietary theory, the interests of owners are seen as the guiding force in the preparation of financial statements because according to proprietary theory, the firm is owned by some specified person or group. Stockholders are owners. Creditors are not. Equity capital is different from capital raised by issuing debt. And, even though the stockholders are protected by limited liability, they do own the business. Stockholders have a right to participate in the business management of the corporation by casting their vote. In this way they are owners, acting as owners. Creditors do not participate in management. They simply provide capital. From a potential investor’s viewpoint, debt and its potential effect on the company is an important factor. The investor will weigh the risk of loss associated with corporate debt against the potential for high profits from financial leverage. When we calculate the return to common equity, the financial leverage and ROE vary directly. This the distinction between debt and is an important factor when evaluating firm performance. 306

We reiterate. Equity is not like debt. Equity is the basic risk capital of an enterprise. Unlike debt, equity capital has no guaranteed return and no timetable for the repayment of the capital investment. From the standpoint of enterprise stability and exposure to risk of insolvency, a basic characteristic of equity capital is that it is permanent and can be counted on to remain invested in good times as well as bad. Consequently, equity funds can be most confidently invested in long-term assets and it is generally thought that equity funds can be exposed to the greatest potential risks. Consistent with proprietary theory, the business belongs to the owners. The assets of the firm belong to these owners, and any liabilities of the firm are also the owners’ liabilities. Revenues received by the firm immediately increase the owner’s net interest in the firm. Likewise, all expenses incurred by the firm immediately decrease the net proprietary interest in the firm. Proprietary theory holds that all profits or losses immediately become the property of the owners, and not the firm, whether or not they are distributed. Therefore, the firm exists simply to provide the means to carry on transactions for the owners, and the net worth or equity section of the balance sheet should be viewed as assets – liabilities = proprietorship Under the proprietary theory, financial reporting is based on the premise that the owner is the primary focus of a company’s financial statements. This premise is consistent with the manner in which balance sheets are constructed and performance is measured. GAAP does distinguish liabilities from equity capital. GAAP does presume that the income earned by the company does belong to its owners. For example, the construction of consolidated statements separates income according to the type of stock owned by stockholders. Parent company stockholders are assigned their share of income while noncontrolling stockholders are assigned theirs. None of the corporate income is assigned to debt. In addition, we find other significant accounting policies that can be justified only through acceptance of the proprietary theory. For example, the calculation and presentation of earnings per share figures are relevant only if we assume that those earnings belong to the shareholders prior to the declaration of dividends. Current accounting practice continues to make a sharp distinction between debt and equity. Moreover, as pointed out above, the amount of debt relative to equity is generally considered an important indicator of risk. Such a distinction implies that accountants must separately identify and classify liabilities from equities. The Conceptual Framework defines debt and equity as two separate and very different financial statement elements. Given the Conceptual Framework objective that financial statements should report each element in a representationally faithful manner, from a theoretical standpoint, a company should distinguish debt from equity. In addition, we should strive to separate a complex financial instrument into its various 307

parts and report each part in accordance with the financial statement element it meets the definition of. The FASB not only favors the position that balance sheets should distinguish between debt and equity, but also intends to make determinations on how to accomplish such distinctions between the components of complex financial instrument. WWW Case 15-14 a. b. c. d. e.

Authorized capital stock—the total number of shares authorized by the state of incorporation for issuance. Unissued capital stock—the total number of shares authorized but not issued. Issued capital stock—the total number of shares issued (distributed to stockholders). Outstanding capital stock—the total number of shares issued and still in the hands of stockholders (issued less treasury stock). Treasury stock—shares of stock issued and repurchased by the issuing corporation but not retired.

Case 15-15 1. 2. 3. 4. 5. 6. 7. 8. 9.

b, j a, e, i e, h, i b, j j e a, e, i b, e, j d, j

Case 15-16 Issue 1 The key to this problem is to recognize that the cash a company receives when it issues stock is based on the number of shares issued and the market price per share. The company would receive $9,000 when it issues the 1,000 shares. (1,000 shares x $9 market price per share = $9,000 cash). Issue 2 308

The key to this problem is to recognize that the cash a company receives when it issues stock is based on the number of shares issued and the market price per share. Since the company wants to receive $80,000 when it issues the 10,000 shares, it must receive $8 per share for the shares. (10,000 shares x market price per share = $80,000 cash. Market price per share = $80,000 cash / 10,000 shares = $8 per share). Issue 3 The key to this problem is to recognize that when a company retires its stock, assets and stockholders' equity decrease. In this case, since the company was able to acquire its stock at its par value ($.50 per share), cash and common stock both decrease by $20,000. As a result, the company's assets decrease to $600,000 and its contributed capital decreases to $180,000. So, immediately after the stock is retired, 30% of the corporation's assets were obtained from owners. Before Retirement After Retirement Assets $620,000 $600,000 Contributed capital $200,000 $180,000 $180,000 contributed capital / $600,000 assets = .3 or 30%. Issue 4 The key to this problem is to recognize that corporate ownership is based on the number of shares owned. Since the Fourth Corporation owns 20,000 shares out of a total of 2,000,000 shares, the Fourth Corporation owns 1% of the Cape Cod Corporation. 20,000 shares owned by the Fourth Corporation / 2,000,000 Cape Cod Corporation shares outstanding = .01 or 1%. Issue 5 The key to this problem is to recognize that cash dividends paid are based on the number of shares outstanding and the dividends paid per share. Since the company paid dividends of $.80 per share and had 1,000,000 shares outstanding, it would pay total cash dividends of $800,000. ($.80 cash dividends per share x 1,000,000 shares outstanding = $800,000 cash dividends). Case 15-17 a. December 31, 2020 210,000 ($420,000 x ½) December 31, 2021 210,000 ($420,000 x ½) b. December 31, 2020 $725,000 (14,500 x $50) December 31, 2021 $775,000 (15,500 x $50) c. $145,000 (14,500 x $10) $155,000 (15,500 x $10) 309

Case 15-18 The solution to this case is dependent upon the companies selected by the students. A recommended method of checking the students’ solutions is to require them to turn in their downloaded financial statements with their solutions. Financial Analysis Case Answers will vary depending on the company selected.

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______________________________________________ CHAPTER 16 Case 16-1

The cost of property, plant and equipment includes all expenditures to acquire the property, plant and equipment and to put it into position and condition for use. Among the expenditures which might be applicable to a purchase are the following: 1. Purchase price, less all discounts and applicable interest, plus the fair value of any other obligations assumed therewith--or an apportionment of the total if bought in a lump-sum purchase. 2. Title costs for items such as surveys, searches, registrations, unpaid taxes and accrued interest, action to obtain clear title and legal services. 3. Positioning costs such as freight, insurance in transit, duties, drayage and reinstallation. 4. Conditioning costs prior to normal use such as repairs, remodeling, reconditioning, test runs, renovation, insurance and taxes, draining, clearing, landscaping, grading, materials, direct and indirect labor and depreciation of equipment used in the conditioning effort. 5. Improvement or betterment costs to increase the value or extend the normal service life of the property, plant and equipment. even after putting it to normal operating use.

Majority ownership and administrative control are the two most important criteria for determining whether to consolidate the financial statements of Bevo Corporation and Casco, Inc. Other criteria include the extent to which Casco contributes directly to the activities of Bevo, existence of a large proportion of intercompany transactions, absence of restrictions by outsiders upon assets and earnings of the subsidiary, expectation of continued financial control, general coincidence of accounting periods and the general homogeneity of the assets and operations of the affiliate.

ii. Casco appears to be a captive of Bevo, financially and administratively. Casco is controlled through Bevo's board of directors and it is not unusual for a captive 311

subsidiary to be liquidated when its usefulness has ended. Consolidated financial statements for Bevo and Casco therefore seem more appropriate and informative than separate financial statements. c.

Treating the $75,000 advance to Casco as an account receivable does not seem appropriate even though the nature of the advance suggests that the transaction was a loan to an affiliate. Bevo's advance was not an operating loan to an affiliate in need of working capital or temporary liquidity. It served only to clear Bevo's title to the property, plant and equipment of Algo's division. Also, the fact that Casco was formed for this purpose implies that the advance would not be paid back except perhaps through an exchange of the Algo shares purchased from the minority stockholder, an exchange which could be made at will by Bevo and therefore has little substance. Finally, accounts receivable generally are related to receivables from normal trade with customers.

ii. Treating the entire $75,000 advance as an investment in Casco is not appropriate even though stock of Algo was purchased by Casco with the $75,000 because the underlying value of the related assets was only about one half of this cost. In addition, Bevo's board would not invest in Algo as a purchase agreement with Algo and had nothing to gain in the way of control of the majority. It also would not be likely to invest more in an entity managed by a management with divergent views. Therefore, one half of the $75,000 should be treated as an investment in Casco (the value of the Algo stock purchased by Casco) with the remainder treated as a cost of property, plant and equipment. iii. Treating the entire $75,000 advance to Casco as a cost of property, plant and equipment purchased from Algo does not seem appropriate although in substance the transaction was an attempt to obtain clear title to the property, plant and equipment. It is of course true that had the minority stockholder not intended to exercise his right to prevent the purchase, Casco would not have been formed and the advance would not have been made. To the extent that a portion of the $75,000 cost of the Algo stock can be attributed to the market value of the Algo stock, Bevo should treat that amount as an investment in Casco. After this allocation all that remains of the $75,00 advance should be treated as a part of the cost of property, plant and equipment of the manufacturing division purchased from Algo. If it is assumed that the original negotiated price reflected the fair market value of the property, plant and equipment purchased, that part of the $75,000 which is in excess of the fair market value should be treated as an intangible asset and classified as goodwill. iv. Treating the $75,000 advance as a loss does not seem appropriate because a loss is a reduction of equity, other than withdrawals of capital, for which no compensating value had been or is expected to be received. It was not an expired cost, one without 312

benefits to the revenue producing activities of the enterprise. The $75,000 advance served a useful purpose: removing probable future actions to prevent the purchase or, failing that, to seek equity. This treatment might be appropriate if the $75,000 raised the cost of the property, plant and equipment far beyond its economic usefulness. However, this condition is unlikely in this situation because Bevo's board would not have pursued the agreement or taken the action it did unless the additional costs of obtaining clear title were economically justifiable. Case 16-2 a.

Whit Company should allocate the purchase price to the assets acquired and liabilities assumed. First, all identifiable assets acquired, either individually or by type, and liabilities assumed in the business combination, whether or not shown in the financial statements of Berry Company, should be assigned a portion of the cost of Berry Company, normally equal to their fair values at the date of acquisition. Goodwill is determined as the excess of the purchase price over the sum of the amounts assigned to identifiable assets acquired less liabilities assumed.

In deciding upon consolidation policy, the aim should be to make the financial presentation that is most meaningful in the circumstances. Berry Company should be included in the entity's consolidated financial statements from the date of the purchase. The usual condition for consolidation is control as evidenced by ownership of a majority voting interest. Therefore, as a general rule, ownership by one company, directly or indirectly, of over fifty percent of the outstanding voting shares of another company is a condition pointing toward consolidation.

Case 16-3 a.

The additional value for the building would cause an increase in the amount allocated to the building cost by $40,000 and a consequent reduction in goodwill from $100,000 by $40,000 to $60,000.

Additional Depreciation for 20x1 would have been 2/12 x 40,000 /20 = $333. But, since none was taken in 20x1 and the new information is to be treated retrospectively, the company will need to adjust accumulated depreciation by this amount. The tax effect of the additional depreciation would have been $333 x 40% = $133 The net effect of the additional depreciation on the company’s 20x2 income statement would be $200 ($333 - $133). 313

Retrospective treatment would require the following working paper journal entry, assuming that the company reports a consolidated tax return and did not take the additional depreciation on its 20x1 tax return. Retained Earnings Income Tax Refund Receivable Building Goodwill Accumulated Depreciation

200 133 40,000 40,000 333

Consolidated depreciation expense on the additional 40,000 would be 40,000 / 20 years = 2,000. c. The proposed treatment is prospective. Thus, there would be no prior period adjustment to retained earnings. Instead, the following working paper entry would be made.

Building Goodwill

40,000 40,000

Case 16-4 a.

Under FASB ASC 280, there are three basic tests to be applied to segments of an industry to see if they are significant enough to be separately reportable. If a segment meets any one of the tests it is deemed significant and reportable. The first test is based upon revenue. If a segment's revenue from sales to unaffiliated customers and intersegment sales and transfers is equal to 10 percent or more of the enterprise's combined revenues, the segment is reportable. The second test is based upon operating profits or losses. There are two subtests in this category based upon absolute amounts of operating profits or losses. A segment is deemed reportable if the operating profit or loss shown by the segment is equal to or greater than 10 percent of the higher of the following two absolute amounts: (a) Sum of all operating profits for all segments reporting operating profits. (b) Sum of all operating losses for all segments reporting operating losses.

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Third, a segment is significant and reportable if the identifiable assets of the segment equal or exceed 10 percent of the combined identifiable assets of all of the industry segments within the enterprise. Finally, all segments, whether deemed reportable or not, must be reviewed from the standpoint of interperiod comparability, because the primary purpose of presenting segment information is to aid the financial statement reader. b.

Statement of Financial Accounting Standards No. 14 stated that enough industry segments must be separately reported so that the total of revenues from sales to unaffiliated customers for the reportable segments equals or exceeds 75 percent of the combined revenues from sales to unaffiliated customers for the entire enterprise. If applying the prescribed tests does not yield the required percentage of revenues described above, additional segments must be reported on until the 75 percent test is met. The Financial Accounting Standards Board has stated that if an enterprise has many reportable segments, benefit to the reader may be lost if more than 10 segments are reported. In such a situation, the board suggests combining related reportable segments until the total is ten or fewer

Under FASB ASC 280-10-50, the following segmental information is required to be disclosed:

Factors used to identify the public entity's reportable segments, including the basis of organization (for example, whether management has chosen to organize the public entity around differences in products and services, geographic areas, regulatory environments, or a combination of factors and whether operating segments have been aggregated). Types of products and services from which each reportable segment derives its revenues. Additionally, information about profit or loss and assets each reportable segments should be disclosed, including all of the following about each reportable segment if the specified amounts are included in the measure of segment profit or loss reviewed by the chief operating decision maker or are otherwise regularly provided to the chief operating decision maker, even if not included in that measure of segment profit or loss: Revenues from external customers Revenues from transactions with other operating segments of the same public entity Interest revenue Interest expense Depreciation, depletion, and amortization expense 315

Unusual items as described in paragraph 225-20-45-16 Equity in the net income of investees accounted for by the equity method Income tax expense or benefit Significant noncash items other than depreciation, depletion, and amortization expense. Case 16-5 The term measure, as used by the Financial Accounting Standards Board, refers to the quantification of an attribute of an item in a unit of currency other than the reporting currency. In this respect, transactions or balance reflected on a foreign financial statement are expressed in terms of U.S. dollars by applying the appropriate exchange rate to the foreign amount. This process is referred to as translation. It is possible to measure a given transaction or balance in terms of any other currency if the appropriate exchange rate is known. An asset or liability is denominated in a foreign currency if the liability or right to receive is fixed in terms of the foreign currency, regardless of the exchange rate. When an account receivable (or payable) is created and stated in fixed amounts of the foreign currency, the entity has the right (obligation) to receive (pay) the originally stated number of units of foreign currency. A change in the exchange rate between the date of the right to receive (obligation to pay) and the date the asset (liability) is received (paid) gives rise to an exchange gain or loss. An asset or liability may only be denominated in one currency. Any given transaction may be measured in one currency and denominated in another currency. An example of such a transaction would be the purchase of goods for sale by a German subsidiary of a U.S company (measuring the transaction in German marks) from a British company payable (denominated) in pounds sterling. A transaction may also be measured and denominated in the same foreign (with respect to a parent company) currency. An example of this type of transaction would be a British subsidiary of a U.S. company purchasing an asset from another British company. In this example the British subsidiary would measure the transaction in pounds sterling and would subsequently satisfy the debt in pounds sterling. In the first example, a change in the exchange rate between the date of the purchase of the goods and the settlement of the debt would cause the debt to be paid at an amount different from the original balance measured in U.S. dollars at the date of the transaction. This difference arises because a fixed amount of pounds sterling must be paid in order to settle the debt regardless of the cost to obtain the pounds sterling. In the second example, the subsidiary measures its transactions in the currency in which the debt is denominated, and so a subsequent change in the exchange rate of pounds sterling to U.S. dollars would have no effect on the amount of debt owed. 316

Case 16-6 The temporal method generally translates assets and liabilities, expressed in foreign currency in a manner that retains the accounting principles used to measure them in foreign statements, and is characterized by the following: a.

Cash or amounts receivable or payable that are denominated in a local foreign currency are to be translated using current rates. All other assets and liabilities that are not classified as above are to be translated in a manner that retains their original measurement bases. The historical rate is to be used for accounts that are carried at prices in past exchanges, and the current rate is to be used in translating accounts that are priced in current or future exchanges. The balances in long-term accounts receivable and long-term accounts payable represent amounts receivable or payable denominated in local foreign currency and as such must be translated at the current rate of exchange.

Revenues and expense accounts are to be translated at the average exchange rate in effect during the period being reported upon. However, revenue and expense balances related to assets and liabilities translated at historical rates are translated at the rate in existence at the time the asset or liability was attained. Examples of revenue and expense accounts to be translated at historical rates are depreciation, amortization, inventory changes in cost of goods sold, and recognition of deferred income.

Inventory valued at cost and deferred income each represent accounts measured in past exchanges and must be translated at historical rates.

Long-term debt is translated at the current rate.

Case 16-7 a.

For a derivative designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item. The effect of that accounting is to adjust the basis of the hedged item by the amount of the gain or loss on the hedging derivative to the extent that the gain or loss offsets the loss or gain experienced on the hedged item.

A derivative instrument that is designated as hedging changes in the fair value of an unrecognized firm commitment qualifies for the accounting treatment of a fair value 317

hedge if all of the specified criteria for hedge accounting under SFAS No. 133 are met. A derivative instrument that is designated as hedging the changes in the fair value of an available-for-sale security also qualifies for the accounting treatment of a fair value hedge if all of the same specified criteria are met. c.

Derivative instruments designated as hedging the foreign currency exposure to the variability in the functional-currency-equivalent cash flows associated with either a forecasted foreign-currency-denominated transaction (a forecasted export sale to an unaffiliated entity with the price to be denominated in a foreign currency) or a forecasted intercompany foreign-currency-denominated transaction (a forecasted sale to a foreign subsidiary) qualify for hedge accounting under the following conditions: i.

The company with the foreign currency exposure is a party to the hedging instrument ii.. The hedged transaction is denominated in a currency other than that unit's functional currency iii. All of the qualifying criteria for hedge accounting contained in SFAS No. 133 are Case 16-8 a.

The guidelines contained at FASB ASC 830 adopt the functional currency approach to translation. An entity's functional currency is defined as the currency of the primary economic environment in which it operates, which will normally be the environment in which it expends cash. Most frequently the functional currency will be the local currency, and four general procedures are involved in the translation process when the local currency is defined as the functional currency. 1. The financial statements of each individual foreign entity are initially recorded in that entity's functional currency. For example, a Japanese subsidiary would initially prepare its financial statements in terms of yen, as that would be the currency it generally uses to carry out cash transactions. 2. The foreign entity's statements must be adjusted (if necessary) to comply with generally accepted accounting principles in the United States. 3. The financial statements of the foreign entity are translated into the reporting currency of the parent company (usually the U.S. dollar). Assets and liabilities are translated at the current exchange rate at the balance sheet date. Revenues, expenses, gains, and losses are translated at the rate in effect at the date they were first recognized. 4. Exchange gains and losses are accumulated and reported as a separate component of stockholders' equity in the unrealized capital section. 318

FASB ASC 830 defines two situations in which the local currency would not be the functional currency. 1. The foreign country's economic environment is highly inflationary (over 100 percent cumulative inflation over the past three years such as recently experienced by Argentina and Brazil). 2. The company's investment is not considered long-term. In these cases, the foreign company's functional currency is defined by the U.S. dollar and the financial statements are translated using the FASB Statement No. 8 approach. That is: 1.

Each transaction was recorded at the historical exchange rate (the exchange rate in effect at the transaction date).

2. All cash, receivables, and payables denominated in foreign currencies were adjusted using the current rate at the balance sheet date. 3. All assets carried at market price were adjusted to equivalent dollar prices on the balance sheet date. 4. For all other assets, the particular measurement basis was used to determine the translation rate. 5. Revenues and expenses were translated in a manner that produced approximately the same dollar amount that would have resulted had the underlying transactions been translated into dollars on the dates they occurred. An average rate could be used in most cases. 6. All exchange gains and losses were included in the determination of net income. 7. Gains and losses on forward exchange contracts (agreements to exchange currencies at a predetermined rate) entered into to hedge a foreign currency– exposed net asset or liability position or to speculate were included in net income, while gains and losses on forward exchange contracts intended to hedge an identifiable foreign currency commitment were typically deferred. 8. All exchange gains and losses are reported as a component of income. b.

Under the guidelines contained at FASB ASC 830, translation is the purpose of expressing financial statements measured in one unit of currency (the reporting currency). The translation process is performed for the purpose of preparing financial statements and assumes that the foreign accounts will not be liquidated into U.S. dollars. Therefore, translation adjustments are disclosed as a part of stockholder's equity rather than as adjustments to income. 319

Remeasurement is significantly different from translation and is the process of measuring transactions originally denominated in a different unit of currency (e.g., purchases of a German subsidiary of a U.S. company payable in French francs). Remeasurement is required when: 1. A foreign entity operates in a highly inflationary economy. 2. The accounts of an entity are maintained in a currency other than its functional currency. 3. A foreign entity is a party to a transaction that produces a monetary asset or liability denominated in a currency other than its functional currency. Remeasurement is virtually the same process as described under the temporal method. That is, the financial-statement elements are restated according to their original measurement bases. It assumes that an exchange of currencies will occur at the exchange rate prevailing on the date of remeasurement. This produces a foreign exchange gain or loss if the exchange rate fluctuates between the date of the original transaction and the date of the assumed exchange. Therefore, any exchange gain or loss is included in the period in which it occurs. Case 16-9 a.

Entity theory views the assets and liabilities of the consolidated entity as belonging to the entity, not to its owners. Thus, the entity theory acquisition value for goodwill would be based on acquiring 100% of the subsidiary’s goodwill, no matter what the percentage ownership interest the parent company acquires. The typical entity theorist would infer the 100% value of goodwill from the amount pays by the parent company for its interest in the subsidiary. If, for example, the parent company pays $108,000 for a 90% interest in the subsidiary, and the fair value of the subsidiary’s net assets is $100,000. The parent is presumed to have purchased 90% x $100,000 = $90,000 of the identifiable net assets of the subsidiary. The other $18,000 ($108,000 - $90,000) is considered payment for 90% of the subsidiary’s goodwill. If $18,000 = 90% x goodwill, then the value of goodwill is presumed to be $18,000 / 90% = $20,000.

Because entity theory views the assets and liabilities of the consolidated entity as belonging to the entity, not to its owners, when a parent company acquires less than a 100% ownership interest in a subsidiary, the assets and liabilities are valued at 100% of their respective fair values, including goodwill. Thus, the noncontrolling interest must be valued at their percentage ownership in the subsidiary multiplied times the fair value of those net assets. 320

The typical entity theorist would infer the value of the total subsidiary from the purchase price the parent company pays for the ownership interest the parent company purchases. For example, if the parent company pays $108,000 for a 90% interest in the subsidiary, the fair value of the net assets of the subsidiary (including goodwill) are presumed to be $108,000 / 90% = $120,000. Noncontrolling interest would be valued at $120,000 x 10% = $12,000. c.

Because the net assets of the consolidated entity are viewed as belonging to the consolidated entity, any income generated by them belongs to the consolidated entity, not to any particular equity holder. The bottom line of an entity theorist’s consolidated income statement would be consolidated net income. Consolidated net income would include the revenues, expenses, gains and losses of the entity. In the entity theorist’s income statement, consolidated net income would not be allocated between the parent company and the noncontrolling interest. An allocation of the consolidated net income between the parent company and the noncontrolling interest could be separately shown so that the user could see how the parent company’s share of the consolidated net income impacts the parent company’s retained earnings and how the noncontrolling interest‘s share of the subsidiary income (that is included in consolidated net income) impacts the balance of the noncontrolling interest that is reported in the consolidated balance sheet.

Because entity theory views the assets of the consolidated entity as belonging to the entity, rather than to its owners, both creditors and stockholders of the consolidated group are seen as providers of capital. A strict entity theorist, such as William Paton, would say that all capital providers should be listed on the right side of the balance sheet with no distinction being made for debt versus equity. However, the typical entity theorist would say that noncontrolling interest in the subsidiary is an equity interest and should be reported in stockholders’ equity along with the parent company’s equity in the consolidated entity. He/she would argue that noncontrolling interest does not meet the definition of a liability; rather, noncontrolling interest has all the characteristics of an equity interest just like the parent company’s interest in the consolidated entity has. The only difference is that the noncontrolling interest has an interest in only a part of the consolidated entity (the subsidiary), but nevertheless it is still an equity interest

Case 16-10 a.

Parent company theory views the assets and liabilities of the consolidated entity as belonging to the owners, not to the entity. In addition, parent company theorists believe that consolidated financial statements are constructed primarily for the parent company stockholders and that a noncontrolling interest is an outside interest. Thus, the parent company theory acquisition value for goodwill would be based only on the goodwill presumed to have been purchased by the parent company. 321

If, for example, the parent company pays $108,000 for a 90% interest in the subsidiary, and the fair value of the subsidiary’s net assets is $100,000. The parent is presumed to have purchased 90% x $100,000 = $90,000 of the identifiable net assets of the subsidiary. The additional amount paid to purchase the parent’s company’s interest is deemed to be goodwill. Goodwill = $108,000 - $90,000 = $18,000. b.

Because parent company theory views the assets and liabilities of the consolidated entity as belonging to the owners of parent company shares, when a parent company acquires less than a 100% ownership interest in a subsidiary, the assets and liabilities are valued at historical cost from the perspective of the parent company. Thus, the value of the net assets of an acquired subsidiary are initially valued at 100% of their respective book values plus the parent company’s share of the adjustment of those assets and liabilities to fair value. In addition, purchased goodwill is added to the subsidiary’s assets. The result is that the value of noncontrolling interest is not affected by the consolidation process. It will be equal to the noncontrolling interest’s ownership percentage multiplied times the book value of the subsidiary’s equity. In the above example, if the book value of the identifiable net assets of the subsidiary on the acquisition date is equal to $94,000, the difference between their fair value and book value would be ($100,000 - $94,000) = $6,000. On the acquisition date, the balance sheet of the consolidated entity would include subsidiary net assets valued at $94,000 + 90% x 6,000 plus goodwill of $18,000. It would also report noncontrolling interest equal to 10% x $94,000 = $9,400.

Because the parent company theorist views the financial statements of the consolidated entity as being provided solely for the parent company shareholders and thus views the noncontrolling interest as an outside interest, the noncontrolling interest’s share of the subsidiary’s net income is subtracted from the consolidated entity’s net income to arrive at parent company net income. Some parent company theorists would show the noncontrolling interest income as an expense, others would show it as a subtraction to arrive at parent company net income.

Because the parent company theorist views the financial statements of the consolidated entity as being provided solely for the parent company shareholders and thus views the noncontrolling interest as an outside interest, only the parent company shareholders are viewed as an equity interest. Even though the noncontrolling interest represents a shareholder interest in the subsidiary, the parent company theorist would not place noncontrolling interest in stockholders’ equity. It would be reported either in the liability section of the balance sheet or between liabilities and stockholders’ equity.

Case 16-11 322

Current practice values the net assets of a consolidated entity at 100% of their fair value, regardless of the percentage ownership that the parent company has in its subsidiary. Because entity theory views the assets and liabilities of the consolidated entity as belonging to the entity, not to its owners, when a parent company acquires less than a 100% ownership interest in a subsidiary, the assets and liabilities are valued at 100% of their respective fair values. Current practice requires companies to value noncontrolling interest at fair value. Consequently, goodwill is also valued at fair value. The result is that all assets and liabilities are valued at their respective fair values. The entity theory result would be identical with one possible exception. The entity theorist would use the value of goodwill purchased by the parent to infer the 100% fair value of goodwill and thus the fair value of the noncontrolling interest. Current practice will allow parent companies to do the same but seems to prefer a separate determination of the fair value of noncontrolling interest based on share price or some other method, and thus the valuation of noncontrolling interest in concert with the valuation of identifiable net assets determines the fair value of goodwill. Current practice requires companies to determine consolidated net income (which is called net income) and then subtract noncontrolling interest income to arrive at parent company net income. This is consistent with entity theory to the extent that both approaches call net income the amount that would otherwise be called total consolidated net income. However, an entity theorist would not then show an allocation in the income statement. Current practice requires that noncontrolling interest be included in the stockholders’ equity section of the balance sheet, but clearly separated from parent company equity. Total equity would include both. Entity theorists consider the net assets as belonging to the entity. Strict entity theorists would not have an equity section of the balance sheet because they see both debt holders and shareholders simply as capital providers. However, many entity theorists would argue that because noncontrolling interest is an ownership interest in the subsidiary it is an ownership interest in at least part of the consolidated entity. Thus, it is an equity interest. FASB ASC 16-1 Cost Allocation for a Patent a.

Internally developed patents fall under the accounting for research and development costs section of the FASB ASC and the provisions of FASB ASC 730-25-1 and 7305-2&3 consequently the patent should be recorded as an expense and should not be recorded as an asset.

Yes, the asset’s value on the acquired company’s books is irrelevant under FASB ASC 805-20-30-1

FASB ASC 16-2 Consolidations and the EITF Search “new basis.” 323

Found at 805-50. Then select the Printer Friendly with Sources function FASB ASC 16-3 Definition of Business Search business combinations and definition of a business 3 805-10-55-4

FASB ASC 16-4 Noncontrolling Interests Cross reference FAS 160 810-10-65 FASB ASC 16-5 Proportionate Consolidation Search proportionate consolidation 932-810-45

FASB ASC 16-6 Value beyond Proven and Probable Reserves Search value beyond proven and probable reserves 930-805-30 Definition found in glossary 930-805-20 FASB ASC 16-7 Demutualization of Life Insurance Companies Search Demutualization 944-805-05 FASB ASC 16-8 Affiliated Sales in the Consolidation of Regulated Industries Search consolidation and regulated operations and affiliated sales 980-810-45 324

Room for Debate Debate 16-1 Noncontrolling Interest Team 1 Argue in favor of presenting the noncontrolling interest as an element of stockholders’ equity The reporting of noncontrolling interest as an element of stockholders’ equity is consistent with the entity theory. According to entity theory, the consolidated group (parent company and subsidiaries) is an entity, separate from its owners. Thus, the emphasis is on control of the group of legal entities operating as a single unit. Consolidated net assets and the change in them (income) belongs to and is controlled by the consolidated entity. Consolidated assets belong to the consolidated entity, consolidated liabilities are obligations of the consolidated entity, and the income generated by investing in the consolidated assets is income to the consolidated entity rather than to the parent company stockholders. Consequently, the purpose of consolidated financial statements is to provide information to all shareholders - parent company stockholders and outside noncontrolling stockholders of the subsidiary companies. Entity theory implies that all stockholders are stockholders in the consolidated group i.e., that noncontrolling interest is an equity interest. The consolidated entity is considered as one economic unit, and noncontrolling stockholders contribute resources to the unit in the same manner as parent company stockholders. Noncontrolling stockholders have the same characteristics as parent company stockholders. Their interest is enhanced or burdened by changes in net assets from nonowner sources - a prerequisite for equities as defined and described in SFAC No. 6. For noncontrolling interest which owns common stock, they have the four basic rights of common stock inherent in the common stock of the parent company. They have the right to vote, to share in profits, to share in liquidation, and the preemptive right. The FASB defined minority interest (here termed noncontrolling interest) as meeting the definition of equity. Recently the FASB issued an exposure draft in which they reiterated this position. Noncontrolling interest does not meet the definition of a liability. It embodies no obligation for the future transfer of assets unless a dividend is declared (no different from parent company shares). If noncontrolling interest does not meet the definition of a liability and it is not an asset, under the present accounting model, it must be equity. Team 2 Argue in favor of presenting the noncontrolling interest outside of stockholders’ equity 325

Presenting noncontrolling interest as an outside interest is consistent with parent company theory and IAS No. 27. According to parent company theory, only parent company stockholders have a proprietary interest in the net assets of the consolidated group. Under this theory, the purpose of consolidated statements is to provide information primarily for parent company stockholders, a view that is supported by ARB No. 51. As a result, consolidated financial statements reflect the parent company perspective in which the net assets of the subsidiary are substituted for the parent’s equity interest investment in the subsidiary resulting from the application of the equity method of accounting. As a result, consolidated net income equals parent company net income and consolidated equity is equal to parent company equity. Because only parent company stockholders play a proprietary role, noncontrolling shares are an outside interest and should not be included in consolidated stockholder’s equity. The consolidation process has no impact on the reporting entity and is of no benefit to noncontrolling shareholders. Noncontrolling shareholders have no interest in the parent company or any other subsidiaries of the parent company. Their interest is limited to a segment of the consolidated group, the subsidiary. They cannot exercise control over the consolidated entity, hence, they do not act as owners in the usual sense. Hence, they are not equity to the consolidated group. They represent an outside interest. Debate 16-2 Measurement Team 1 According to the guidance contained at FASB ASC 805, a company should measure the plant assets of an acquired company that it plans to use in its operations using replacement cost. This makes sense because, replacement cost measures the amount that a company would have to pay to acquire the assets that it will use. In other words, we believe that an entry value is appropriate to measure the current value of assets in use. If the plant assets of an acquired company were measured in accordance with SFAS No. 157, the parent company would have to value assets acquired based on exit values. These exit values would be the values that the parent company could get from selling the assets in an orderly sale. If the parent company plans to use these assets, the value they could get from selling them is not relevant. Instead, the only relevant cost is the cost that it would take to acquire them in their current condition. Team 2 Fair value under the guidance contained at FASB ASC 820 is based on exit value. It is the amount that a company would receive from selling an asset in an orderly sale. 326

The company always makes a choice to sell and replace an asset or to keep it. The exit value measures the opportunity to sell. Once owned, the opportunity to sell is the only relevant current value. Since the company already owns the asset, the opportunity to purchase another one just like it is not relevant. Since companies are always making replace or keep decisions, they are reinvesting in the asset by keeping rather than selling it. This is in effect a capital budgeting decision-making process. If you were trying to decide whether to sell or keep, you would compare the future cash flows for each alternative. The future cash flows to sell would be what you would get by selling the assets combined with the cost of acquiring a new one along with financing decisions, tax effects and potential effects on cash flow resulting from increased efficiency of a replacement asset. You would not be acquiring another asset in the same condition as the old one. The future cash flows to keep would be similar, but would not include the cost of replacement, since keeping the asset would negate its replacement. Debate 16-3 Goodwill of an acquired company SFAS No. 160 requires that Goodwill be measured at 100% of its fair value. Team 1: Argue that Goodwill reported in balance sheets should only be measured at the value purchased by the parent company. Your arguments should refer to parent company theory. According to parent company theory, consolidated statements are prepared only for the benefit of parent company stockholders. The parent company and its subsidiary companies are controlled by the parent company and thus by the owners of the parent company (the parent company stockholders). Parent company theorists argue that the parent and subsidiary businesses operate for the benefit of parent company shareholders, rather than for the benefit of noncontrolling subsidiary stockholders. From the parent company’s perspective, the parent company has purchased an interest in each subsidiary that it controls. The parent company paid to obtain subsidiary shares. If less than 100% of the shares of any subsidiary are owned by the parent company, the amount paid to acquire control of the net assets of a subsidiary is less than 100% of the value of those net assets on the acquisition date. Any additional amount paid to purchase subsidiary shares is assumed to have been spent to purchase the parent company’s share of the subsidiary’s goodwill. From the parent company’s perspective, reporting only the amount of goodwill that is purchased by the parent company is consistent with the historical cost principle. The remaining amount of goodwill was not purchased. Since the historical cost principle implies that the initial cost of an asset is equal to the price paid for it plus all costs 327

necessary to acquire it and get it ready for its intended use, the amount of goodwill purchased by the parent company is its historical cost. An additional argument for reporting only the portion of goodwill that is purchased by the parent company is the argument that the parent may have paid more to acquire subsidiary shares in order to obtain control of the subsidiary. This extra amount is called a control premium. If a control premium was paid, the amount of the purchase price assigned to goodwill is equal to the value of purchased goodwill plus the control premium. Thus, by assigning all of the excess amount paid to purchase subsidiary shares to goodwill, means that the value reported as the purchase price of goodwill is overstated. So, if the parent company would then use the price paid to purchase subsidiary shares as a basis to infer the amount of the subsidiary’s total goodwill would result in an additional overstatement of goodwill. Team 2: Argue that Goodwill reported in balance sheets should be the amount of goodwill for the total company acquired. Your arguments should refer to entity theory. According to the entity theory, the parent company and its subsidiaries are a single entity. The consolidated group is an entity, separate from its owners. Thus, the emphasis is on control of the group of legal entities operating as a single unit. All of the assets belong to the entity. All of the debts are debts of the entity. And the income earned by investing in those assets is income to the consolidated entity rather than to either the parent company stockholders or to the subsidiary’s noncontrolling stockholders. Consequently, the purpose of consolidated statements is to provide information to all shareholders—parent company stockholders and outside noncontrolling stockholders of the subsidiaries. Stockholders (both parent company stockholders and stockholders that comprise the noncontrolling interest in subsidiaries of the parent company provide capital to the entity. The earnings accrue to the entity and are distributed to providers of capital – debt holders and stockholders. The revision of SFAS No. 141 and the FASB’s requirements outlined in SFAS No. 160 are consistent with entity theory. Companies are now required to report 100% of the fair value of both the assets and liabilities of an acquired company even when there is a noncontrolling interest remaining in the acquired company or subsidiary. The noncontrolling interest must be measured initially at its fair value which means that its initial value is no longer unaffected by the consolidation process. The result is that goodwill is now reported at the amount purchased by the parent company plus the noncontrolling interest’s share as measured by its fair value. This treatment is consistent with the initial measurement of an asset at its fair value. At acquisition, an asset’s fair value is equal to what it could be sold for in an ordinary 328

exchange transaction. The parent company’s purchase of a controlling interest in the subsidiary is an arm’s length transaction and thus the fair value of the share of the subsidiary that was purchased. The fair value of the noncontrolling interest’s share of goodwill is determined by first measuring the fair value of the noncontrolling interest itself. The resulting fair value of goodwill is relevant to users of the financial statements. From their perspective the partial fair value adjustment that would occur under the parent company theory represents neither historical cost nor fair value. As such it provides a less meaningful measure of goodwill. Since we are reporting a consolidated entity, why not report the total value of its assets rather than adding together the fair value acquired by the parent company plus the noncontrolling interest’s share of the historical cost of those assets? WWW Case 16-12 Juarez SA is a direct and integral extension of Brady Company’s operations; Juarez SA performs assembly that could just as easily be performed by Brady Company directly, and Juarez SA cannot operate without financing from Brady Company. Furthermore, Juarez SA’s expenses have a direct impact on Brady Company’s cash flows through the cost-plus reimbursement arrangement. As a result, the functional currency of Juarez SA is the U.S. dollar, the functional currency of its parent, Brady Company. Case 16-13 Because the transaction is denominated in a currency other than the Brady Company’s functional currency, the purchase of the copy machines is considered a foreign currency transaction. Accordingly, Brady Company should measure and record the copy machines and corresponding account payable in its functional currency, the U.S. dollar, using the exchange rate on the purchase date. GBP 2,000 × (1.6/ 1) = USD 3,200 To record its purchase of office printers, Brady Company would record the following entry in U.S. dollars: Office equipment Accounts payable

3,200 3,200

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Case 16-14 a.

Financial reporting for segments of a business enterprise involves reporting financial information on a less-than-total enterprise basis. These segments may be defined along organizational lines, such as divisions, branches, or subsidiaries. Segmentation could be based on areas of economic activity, such as industries in which the enterprise operates, product lines, types of services rendered, markets, types of customers, or geographical areas. In addition to these possible individual definitions of an enterprise’s segments, a company may use more than one of the above-cited bases of segmentation.

The reasons for requiring financial data to be reported by segments include the following: 1. They would provide more detailed disclosure of information needed by investors, creditors, and other users of financial statements. 2. Appraisers can evaluate major segments of a business enterprise before considering the business in its entirety. 3. In addition to being useful and desirable, such information is practical to compute. 4. The growth potential of an enterprise can be evaluated by reviewing the growth potential of its major segments. 5. Users can better assess management decisions to drop or add a segment. 6. Projection of future earning power is made more effective when approached on a segment basis because different segments may have differing rates of growth, profitability, and degrees of risk. 7. Managerial ability is better assessed with segment data because managerial responsibility within the enterprise is frequently decentralized.

The possible disadvantages of requiring financial data to be reported by segments include the following: 1. They could be misinterpreted due to the public’s general lack of appreciation of the limitations of the somewhat arbitrary bases for most allocations of common costs. 2. They may disguise the interdependence of all the segments. 3. They might result in misleading comparisons of segments of different enterprises. 4. Confidential information would be revealed to competitors about profitable or unprofitable products, plans for new products or entries into new markets, apparent weaknesses that might induce competitors to increase their own efforts to take advantage of the weakness, and the existence of advantages not otherwise indicated. 5. Information thus made available might cause customers to challenge prices to the disadvantage of the company. 6. Operating data reported by segments might be misleading to those who read them. Segment data prepared for internal management purposes often include arbitrary 330

judgments that are known to those using the data and taken into account in making evaluations. The difficulty of making such background information available and understandable to outside users is considered by many to be insurmountable. d.

The accounting difficulties inherent in segment reporting include the following: 1.

The transfer prices must be determined. Transfer prices are those charged when one segment deals with another segment of the same enterprise. Various possible transfer prices exist, and the company must select one. 2. The computation of segment net income must be defined. The net income may be merely a contribution margin, that is, sales less variable costs, or a more conventional measure of net income. If a contribution-margin approach is used, the variable costs must be identified. If a more conventional measure of net income is used, the treatment of various items for each segment’s net income must be established. Such items include the following: i. ii. iii.

Determining whether common costs should be allocated to segments. Selecting allocation bases if common costs are to be allocated. Determining which costs of capital (interest, preferred dividends, etc.) should be attributed to segments.

Case 16-15 Because the transaction is denominated in a currency other than the Eagle Company’s functional currency, the purchase of the office computers is considered a foreign currency transaction. Accordingly, Eagle Company should measure and record the office computers and corresponding account payable in its functional currency, the U.S. dollar, using the exchange rate on the purchase date.

GBP 10,000 × (1.4/ 1) = USD 14,000. Accordingly, Eagle Company would record the following entry in to record the purchase of office computers in U.S. dollars: Office computers Accounts payable

14,000 14,000

Case 16-16 Foreign currency denominated monetary assets and liabilities should be measured at

331

the end of each reporting period using the exchange rate at that date. Any change in value should be reported in the income statement as a foreign currency transaction gain or loss. Eagle Company’s GBP denominated account payable is a monetary liability. To prepare its September 30, 2020 financial statements, Eagle Company must first measure the foreign currency account payable using the exchange rate on that date as follows: GBP 10,000 × (1.3/ 1) = USD 13,000 a.

Eagle Company would then record an entry to recognize the difference between the U.S. dollar balance on September 30, 2020, and the U.S. dollar balance on July 1, 2020 (USD), the date the initial account payable was recognized. Any gain or lossis recorded in the income statement. Eagle company has a gain because the amount owed has decreased from $14,000 to $13,000. Therefore, the following entry will be recorded: Accounts payable Foreign currency transaction gain

1,000 1,000

To record the settlement of its account payable with John Bull Company on October 15, 2020, Eagle Company would first measure its foreign currency account payable using the exchange rate on that date. GBP 10,000 × (1.2/ 1) = USD 12,000 Eagle Company would then record an entry to recognize the difference between the U.S. dollar balance on September 30, 2020 (USD 13,000), the most recent reporting date, and the U.S. dollar balance on October 15, 2020. The gain or loss is recorded in the income statement. This amount is again a $1,000 gain ($13,000 - 12,000) and is recorded as follows: Accounts payable Foreign currency transaction gain

1,000 1,000

Finally, to record the payment of GBP 10,000 and satisfy the account payable, Eagle Company would record the following entry: Accounts payable Cash

12,000 12,000

No changes are recorded to Eagle Company’s nonmonetary office computer asset balance,

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which was initially measured and recorded in U.S. dollars and is not adjusted for subsequent changes in foreign currency exchange rates. Case 16-17 Companies should apply the guidance contained in ASC 830 at the beginning of the quarter following the date the economy was deemed highly inflationary. This assessment is generally made by following the guidance provided by the International Practices Task Force (IPTF) of the SEC Regulations Committee of the Center for Audit Quality. Case 16-18 The solution to this case is dependent upon the companies selected by the students. A recommended method of checking the students’ solutions is to require them to turn in their downloaded financial statements with their solutions. Financial Analysis Case Answers will vary depending on company selected

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CHAPTER 17 Case 17-1 The position that mandatory accounting and auditing standards inhibit contracting arrangements and the ability to report on company operations is an agency theory argument. This argument holds that regulators will be affected by external pressures and will act to maximize their own utilities. This position was first advanced by Watts and Zimmerman in "Toward a Positive Theory of the Determination of Accounting Standards" the Accounting Review, January 1978, pp. 113-134). They concluded that management will lobby on accounting standards based on its own self-interest. To the extent that management can increase either its level of incentive compensation, or its firm's share price via accounting standards, they are better off. Other factors affecting management wealth are taxes, regulation, political costs, information production and management compensation plans. A management position on a particular accounting standard depends on the size of the firm (which affects political costs) and whether or not the standard will affect earnings. They concluded that as long as financial accounting standards have potential effects on future cash flows, standard setting bodies will be influenced by corporate lobbying. The opposing view that market forces cannot be relied on to produce information is a critical perspective viewpoint. Individuals taking this position point to various failures in our system such as the saving and loan crisis, the housing crisis and audit failures as evidence that the system is not working. They maintain that various individuals and groups have the ability to influence standard setting. They maintain that large corporations have pressured standard setters to protect their own interests. It should be noted that both viewpoints come to the same conclusion but differ in their approaches to solving what they see as the problem. The marginalists favor a completely free market with no rules; whereas, the critical perspectivists favor government intervention into the standard setting process. Case 17-2 The following is one solution. Students may find other issues. a.

It is not ethical for Barbara to work hours and not charge them to the client. This is a violation of the firm's employment policy that could cause her to be dismissed. This practice could also cause problems is subsequent years when the number of hours necessary to complete the Lakes Brothers audit in compared to the current year. 334

1. Obtain the relevant facts. - Barbara Montgomery is being pressured to work hours on the Lakes Brothers audit "off-the-clock." 2. Identify the ethical issues. She is being asked to work “off-the-clock.” This practice is against her auditing firm’s employment policy, a violation that could cause her to be dismissed. This practice could also cause problems in subsequent years when the number of hours necessary to complete the Lakes Brothers audit is compared to the current year. 3. Determine the individuals or groups affected by the dilemma. The individuals affected by this decision are Barbara, Robert Cooley her supervisor, the partner in charge of the job, the accounting firm Coopers and Rose, subsequent years' audit teams and the client Lakes Brothers. 4. Possible alternative solutions: a. b. c. d.

Work "off-the-clock" Refuse to work "off-the-clock" Report the situation to the partner in charge of the audit Report the situation to a mentor or an ombudsman within the firm and ask for advice.

5. Possible outcomes of alternative solutions: i.

Barbara will be seen as a team player by her immediate colleague. Robert Cooley will be assisted in bringing the job in at or under Budgeted hours. The partner in charge will be misled about the hours necessary to actually complete the job. The firm and the client will also be misled as to the actual hours necessary to complete the job

ii.

Barbara will not be viewed as a team player. Cooley will probably give her an unfavorable review; and he will be less likely to buy the job in under budget. The partner in charge will be informed about the hours necessary to complete the job but may be faulted by others in the firm for failing to buy the job at budget. However, the original situation may not be exposed. The firm and the client will be unhappy because the job has not been completed within budged hours; however, they will be informed of the time necessary to actually complete the job.

iii.

This alternative depends upon whether or not the partner is also pressuring Cooley to have staff members work “off-the-clock." Assuming the situation is all Cooley's idea, Barbara will be bringing a violation of company policy 335

to the partner's attention. Cooley faces discipline. The firm and the client will be more knowledgeable concerning the actual hours necessary to complete the job. iv.

This is a possible solution that may not directly affect Barbara Montgomery. An internal investigator will probably cause Cooley to be disciplined. However, the other partners will be affected in a manner similar to C. The most appropriate action is D if it is available. This alternative does not cause Barbara to directly confront a superior in the firm and ensure that the violation will be exposed at the highest levels of the firm.

Case 17-3 Item 1 a.

Unless cumulative preferred dividends are involved, no recommendations by the CPA are required. Common stock dividend policy is understood by readers of financial statements to be discretionary on the part of the board of directors. The company need not commit itself to a prospective common stock dividend policy or explain its historical policy in the financial statements, particularly since dividend policy is to be discussed in the president's letter. If cumulative preferred dividends are omitted, this should he disclosed in the financial statements or a footnote.

No comment or opinion modification is required in the auditor's report on the financial statements unless an omission of cumulative preferred dividends is not properly disclosed.

Item 2 a.

The staff auditor reviewing the loan agreement misinterpreted its requirement. Retained earnings are restricted in the amount of $298,000, which was the balance of retained earnings at the date of the agreement. The nature and amount of the restriction should be disclosed in the balance sheet or in a footnote to the financial statements.

Assuming Lancaster does not make the recommended disclosure, the nature of an amount of the restriction should be disclosed in the auditor's report, and the opinion should be appropriately modified.

Item 3 a.

The lease agreement with the Sixth National Bank meets the criteria for an installment purchase of property: (1) it is noncancellable; (2) the company may 336

purchase the property at the expiration date at a nominal price, substantially less than probable fair value: (3) the property meets special needs of the lessee; (4) the lessee is obligated to pay property taxes, insurance and maintenance. Accordingly, Mr. Olds should recommend that the property and the related obligation be stated in the balance sheet at the appropriate discounted amount of future payments under the lease agreement. The income statement should include annual financing charges applicable to the unpaid obligation and amortization of the cost of the property based upon its useful life. Additional footnote disclosure may be desirable b.

If Lancaster does not capitalize the installment purchase as recommended, Mr. Olds should explain the circumstances in his report and qualify his opinion as to conformity with generally accepted accounting principles (or express an adverse opinion, if the amounts involved are so material that in his judgment a qualified opinion is not justified).

Item 4 a.

A competitive development of this nature normally is considered to be the second type of subsequent event, one that provides evidence with respect to a condition that did not exist at the date of the balance sheet, but in some circumstances the auditor might conclude that Lancaster's poor competitive situation was evident at year-end. In any event, this development should be disclosed to users of the financial statements because the economic recoverability of the new plant is in doubt and Lancaster may incur substantial expenditures to modify its facilities. Because the economic effects probably cannot be determined, the usual disclosure will be in a footnote to the financial statements. If the present recoverable value of the plant can be determined, Lancaster should consider disclosure of the Company's revised financial position in a pro forma balance sheet, assuming that this event is concluded to be evidence of a condition that did not exist at year-end. (Only if circumstances were such that it was concluded that this condition did exist at year-end should financial statements for the year ended December 31, 2020 be adjusted for the ascertainable economic effects of this development.)

If Lancaster does not disclose this event as the auditor recommends, the financial statements are misleading. Mr. Olds should take exception to the adequacy of disclosure and depending upon the degree of materiality, he may express an adverse opinion. A qualified or disclaimer of opinion (neither of which is proper under the given assumption) might be justified if the development was adequately disclosed and the economic effects could not be determined. The occurrence of this event after the completion of field work does not affect the need for disclosure. The auditor generally is responsible for inquiry as to subsequent events 337

only to the end of field work and dates his report accordingly, but he has the responsibility to evaluate subsequent information if it comes to his attention. Case 17-4 a&b

l. The auditor might recommend the following footnote be appended to the financial statements in regard to item 1. Note A. The federal income tax return filed by the Corporation for the year 2020 is being examined by the Internal Revenue Service. The Internal Revenue Service has questioned the amount of a deduction claimed by the Company's domestic subsidiary for a loss sustained in 2020. The examination by the Internal Revenue Service has not progressed to the point that would indicate the extent of the Company's liability. The Company's tax counsel believes that the Company will not be subject to any substantial income tax liability with respect to this matter. 2. Item 2. Nonaccounting matters such as management changes and pending proxy fights are not disclosed unless such information is needed for the proper interpretation of the financial statements. The president should be informed that footnotes are an integral part of the financial statements and as such should be limited to information that relates to the financial statements. Furthermore, there is no certainty that a proxy fight will materialize and, hence, in view of the uncertainty no reason for footnote disclosure. Disclosure of events that have no relevance to those matters essential to proper interpretation of the financial statements frequently creates doubt as to the reasons for disclosure and inferences drawn could be misleading. Information about the pending proxy fight might be included in the president's letter to the stockholders which is usually included in a company's annual report.

Case 17-5 According to the clarity project, the steps an auditor should take to form an opinion on a company’s financial statements are: 1. 2.

Form an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. In order to form that opinion, conclude whether he or she has obtained reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. Evaluate whether the financial statements are prepared, in all material respects, in accordance with the requirements of the applicable financial reporting framework. This evaluation should include consideration of the qualitative aspects of the entity’s accounting practices, including indicators of possible bias in management’s judgments. 338

Evaluate whether, in view of the requirements of the applicable financial reporting framework the financial statements adequately disclose the significant accounting policies selected and applied. The evaluation about whether the financial statements achieve fair presentation should also include consideration of the following: a. The overall presentation, structure, and content of the financial statements b. Whether the financial statements, including the related notes, represent the underlying transactions and events in a manner that achieves fair presentation c. Evaluate whether the financial statements adequately refer to or describe

the applicable financial reporting framework Case 17-6 a.

In its December 31, 2020 financial statements, Lansing Company should apply the going-concern basis of accounting as liquidation is not considered “imminent” at that date. Under FASB ASC 205 liquidation is considered “imminent” when:

A plan for liquidation has been approved by the person or persons with the authority to make such a plan effective, and the likelihood is remote that the execution of the plan will be blocked by other parties. A plan for liquidation is being imposed by other forces (for example, involuntary bankruptcy), and the likelihood is remote that the entity will subsequently return from liquidation

Furthermore, the liquidation basis is applied prospectively only from the day that liquidation becomes imminent, and so a reporting entity adopting the liquidation basis for the first time would not retrospectively adjust its historical financial statements. In this situation, Lansing Company’s liquidation does not meet the imminent threshold until the required shareholder approval is obtained. Although goingconcern accounting is utilized as of December 31, 2020, given the significance of the subsequent event and the pending change in the basis of accounting, it may be necessary to provide a pro forma statement of net assets in liquidation giving effect to the change to liquidation basis of accounting as if it had occurred on the date of the balance sheet. b.

Assuming Lansing Company reports annually on December 31, 2021, it would prepare its “going concern” financial statements for the January 1 through October 28, 2021 period and its liquidation basis financial statements for the October 29 to December 31, 2021 period.

Case 17-7 a.

If a corporation's activity could be expected to be the same in all quarters, there would be no problems in using quarterly statements to predict annual results, providing one 339

recognized that the normal activities of any corporation could be disrupted by unforeseen events such as strikes, fires, floods, actions of governmental authorities, and unusual changes in demand for goods or supply of raw materials. Most businesses, however, can be expected to have variations in activity among quarters. Any user of the financial statements who is not a member of management would probably have great difficulty in making accurate predictions. A basic cause of fluctuating quarterly activity is seasonality. Sales often show a seasonal pattern. Expenses also may show a seasonal pattern, but the pattern for any expense may differ from the patterns for sales or for the other expenses. Production, expressed in physical units, may show still another pattern. The more product lines a business has, the greater the number of varying seasonal patterns that may be present. b.

Repairs and Maintenance of Factory Machinery is an example of an item which may show substantial variations which are not proportionate to either sales or production. In fact, it would not be unusual for many repair and maintenance projects to be performed during the time when production is lowest, thus causing high unit costs (high costs divided by few units) for the quarter. The effect on income would be spread between the quarter of incurrence and later quarters depending on inventory levels and costing methods. Use of predetermined overhead rates would have the same effect (if variances were allocated between inventories and cost of goods sold) or else would confine the effect of the high costs to the current quarter (if variances were included in cost of goods sold). Low costs in periods of high production would result in low unit costs, the effects of which would be spread among quarters as described above.

Such quarterly statements do give management opportunities to manipulate the results of operations for quarter--for instance, through the timing of expenses. Management can defer some expenses in an attempt to make the results of earlier quarters look very profitable, thus delaying discovery of conditions which could reflect on management's performance. On the other hand, management can incur heavy expenses in the earlier quarters in an attempt to show a favorable trend in the later quarters. For example, the time at which maintenance work is undertaken is somewhat discretionary.

Case 17-8 a.

A variety of disclosure techniques are available in published financial statements. Among the most common are: 1. 2. 3. 4.

The financial statements. Footnotes to the financial statements. Supplementary statements and schedules. The auditor's report. 340

The financial statements should contain the most relevant and significant information about the corporation expressed in quantitative terms. The form and arrangement of the financial statements should be such as to ensure that the most vital information is readily apparent to the financial-statement users. The footnotes should be used to present information that cannot be easily incorporated into the financial statements themselves. However, footnotes should never be used to substitute for the proper valuation of a financial-statement element nor should they be used to contradict information contained in the financial statements. The most common examples of footnotes are: 1. Schedules and exhibits such as long-term debt. 2. Explanations of financial statements such as pensions. 3. General information about the company such as subsequent events or contingencies. Supplementary statements and schedules are intended to improve the understandability of the financial statements. They may be used to highlight trends such as five-year summaries or be required by FASB pronouncements such as information on current costs. The auditor's report is a form of disclosure in that it informs the users of the reliability of the financial statements. That is, an unqualified opinion should indicate more reliable financial statements than would a qualified or adverse opinion. b.

The disclosure issues addressed by the AICPA's Code of Professional Ethics are: adequate auditing procedures, the use of acceptable accounting principles and independence.

ii. The disclosure issue addressed by the Securities Act of 1933 is the protection of the public from fraud when a company is initially issuing securities to the public. iii. The disclosure issues addressed by the Securities Exchange Act of 1934 are the personal duties of corporate officers and owners (insiders) and the corporate reporting requirements. iv. The disclosure issues addressed by the Foreign Corrupt Practices Act of 1977 are the prevention of bribery of foreign officials and the maintenance of adequate financial records. v. One of the more controversial provisions of SOX is Section 404 that contains two subsections sections – 404(a) and 404(b). 404(a) outlines management’s responsibility under the act, and requires that the annual report include an 341

internal control report by management that: (1) Acknowledges its responsibility for establishing and maintaining adequate internal control over financial reporting and (2) Contains an assessment of the effectiveness of internal control over financial reporting as of the end of the most recent fiscal year. It also requires the principal executive and financial officers to make quarterly and annual certifications as to the effectiveness of the company’s internal control over financial reporting. Section 404(b) outlines the independent auditor’s responsibility. It. requires the auditor to report on the internal control assessment made by management and also to make a separate independent assessment of the company’s internal controls over financial reporting. The result of these provisions is to require the auditor to issue two separate opinions. The first opinion states whether management’ assessment is fairly stated, in all material respects. The second opinion indicates whether, in the auditor’s opinion, the company maintained, in all material respects, effective internal control over financial reporting as of the specific date, based on the control criteria used by management. In summary, the auditor reports: (1) on whether management’s assessment of the effectiveness of internal control is appropriate, and (2) whether he or she believes that the company has maintained effective internal control over financial reporting. The cost of compliance with this legislation was seen by some as excessive. According to one study, the net private cost amounted to $1.4 trillion. This amount was obtained by an econometric estimate of the loss in total market value caused by SOX. That is, the costs minus the benefits as perceived by the stock market as the new rules were enacted. Zhang’s study has since been criticized on the grounds that no single factor can be attributed as the cause of stock market behavior. Her critics note that all of the stock market trends around the time SOX was enacted were attributed to the legislation, while the subsequent increase in market value was ignored. Never-the-less, a survey by the Financial Executives Institute in 2005 estimated that companies’ total costs for the first year of compliance with SOX averaged $4.6 million. . The new provisions that emphasize the importance of internal control have obvious benefit; however, a standard rule of thumb for internal control measures is that the benefits should outweigh their costs. Some critics of SOX maintain that its effect has been that the costs of regulation exceed its benefits for many corporations. SOX was effective for companies meeting the definition of accelerated filers (having an equity market capitalization of over $75 million and filing a report with the SEC) for fiscal years ending on or after December 15, 2004; consequently, December 31, 2004 was the effective filing date for most of these companies. Companies that did not meet the definition of accelerated filers 342

were initially required to comply with SOX’s provisions for fiscal periods ending on or after July 15, 2006. Case 17-9 a.

The Securities Act of 1933 regulates the initial public distribution of a corporation's securities. Issuing securities to the public for the first time is termed going public. The Securities Exchange Act of 1934 regulates the trading of securities of publicly held companies. Periodic reporting for publicly held companies is termed being public.

The main items now required to be analyzed and discussed by management are: 1. Unusual or infrequent events that materially affect the reported amount of income. 2. Trends or uncertainties having or expected to have a significant impact on reported income. 3. Changes in volume or price and the introduction of new products that materially affect income. 4. Factors that might have an impact on the company's liquidity or ability to generate enough cash to maintain operations. 5. Commitments for capital projects and anticipated sources of funds to finance these projects. 6. Companies are encouraged but not required to provide financial forecasts.

Case 17-10 a.

The accounting profession, similar to all professions, has a responsibility to provide quality service to the public. Because the body of knowledge in any profession is complex, the public often cannot evaluate the quality of a professional person's service. By establishing rules of conduct, a profession assumes self-discipline beyond the requirements of law. In auditing, users of financial statements cannot be expected to always understand generally accepted accounting and auditing standards, and other complex areas of accounting and auditing knowledge. Through a code of professional ethics, CPAs provide assurances that quality services have been provided.

Public accounting firms are generally required to be organized as sole proprietorships or partnerships. Corporate organizational forms do not protect the public interest (That is, they shield the firm's personnel from liability). Although the legal liability question is now receiving a great deal of attention in the press through public statements by officials in large public accounting firms, attempts to limit legal liability through the 343

formation of corporations have not yet been successful. The legal liability issue will continue to be an important topic in the near future. Case 17-11 a.

From Mason Enterprises’ perspective, the lease is in substance a purchase of an asset, financed by debt. Capital leases embody the acquisition of future benefits similar to those acquired by purchases of long-term fixed assets. The fair value of the leased asset should be recorded because the benefits acquired meet the definition of an asset. The asset is controlled by the entity and results from a transaction, the initiation of the lease agreement. The obligation to make lease payments constitutes probably future sacrifices, a present obligation to pay cash in the future, resulting from a prior transaction, the initiation of the lease agreement. The asset and liability should be reported as such so that the financial statements will be represenationally faithful and will display amounts with predictive value are evaluating the future cash flows.

b. & c. are part of the same question. According to the efficient market hypothesis investors would not be fooled by the Mason strategy if they are aware of the net assets of the financing subsidiary. If not, the published financial statement of Mason would contain no details of the lease either in the balance sheet or in the notes. If so, the existence of the asset and associated liability, or knowledge that these are Mason’s asset and liability may not be publicly available. In this case the market may be fooled. d.

Mason’s management is clearly attempting to make the financial statements appear as though there is less debt than there really is. The leasing subsidiary arrangement is a sham perpetrated to bias the accounting information. Agency theory predicts that management may be motivated to choose accounting strategies which are aimed at reducing the debt-to-equity ratio. This is particularly true for Mason’s management because of the existence of debt covenants. In my opinion it is unethical for Mason to bias their financial statement to present a more favorable picture, one that does not represent what it purports to represent. It is unethical to try to fool investors or creditors and to make what are in effect false representations of the economic facts

No, the financing strategy does not provide financial statements that are representationally faithful and unbiased. The strategy is designed to “get around’ debt covenants and bonus agreements. The strategy being employed is similar to what Enron used when it created special purpose entities. The resulting financial statements are not transparent in that they fail to disclose the company’s true financial picture.

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Case 17-12 a.

It is unethical for Fillups to select an accounting approach because it produces a positive effect on the firm’s financial statements. Financial statements should be reliable. They should be neutral and free from bias. Clearly the Fillups financial statements are not neutral. Neutrality means that in either formulating or implementing accounting standards, the primary concern should be the relevance and reliability of the information being provided, not the effect that the accounting standards will have on a particular interested party. That is, accounting information should be free from bias toward a predetermined result. Neutrality implies that accounting information reports economic activity and financial position as faithfully as possible without attempting to influence behavior in some particular direction. Accounting information that is not neutral loses credibility.

No. Again, to do so would not be neutral. The financial statements would not be free from bias and could be misleading to investors, creditors, and other users. See a. above for a discussion of neutrality

FASB ASC 17-1 Disclosure of Loss Contingency and Subsequent Event The topic of loss contingencies is addressed in FASB ASC 450-20 and. It is accessed by searching ‘contingencies.” Part a. The discussion indicates that the potential loss should be disclosed; however, since no amount is given, the amount of the loss cannot be accrued. Part b Given the FASB ASC 450-20 criteria, the accident generally would not be accrued and reported in the financial statements because it did not occur until after December 31 (post balance sheet). FASB ASC 17-2 Accounting Policies The issue of accounting policy disclosure is contained in section 235-10. It is accessed through the cross reference function and APB Opinion No 22. The EITF information can be found by using the Printer Friendly with sources link after accessing the topic. FASB ASC 17-3 Accounting for Changing Prices 345

Search Changing Prices Topic 255-10

FASB ASC 17-4 Interim Financial Reports in the Oil and Gas Industry Search oil and gas and interim reporting Or access through the industry link-extractive industries-oil and gas-interim reporting. 932-270 FASB ASC 17-5 Interim Financial Reports in the Construction Industry Search contractors and accounting policies Or access through the industry link-Construction-Contractors-Disclosure 910-235-50

FASB ASC 17-6 Disclosure of Foreign Activities Access through industry link financial services depository and lending companiesdisclosure 942-235-S99 FASB ASC 17-7 Common Interest Realty Associations Search common interest realty association 972-235 Room for Debate Debate 17-1 Ethical Consideration of Off–Balance Sheet Financing Team 1 Argue for recording the lease as a capital lease This is an ethics case. It is unethical to structure the lease so that the company will be able to keep the debt off balance sheet. This is masking the economic facts and results in biased reporting. By paying a third party to guarantee the lease, Snappy is able to circumvent the 346

requirement that the lease be capitalized. In my opinion, self-guarantee is in substance the sale as taking out insurance, i.e., paying a third party to guarantee the lease. In either case, the lessee has taken care of the guarantee of the residual value. In any event the conditions of the lease satisfy the definition of assets and liabilities found in the conceptual framework. SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. An asset embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net assets. A lease embodies the transfer of rights to the lessee to use the leased asset. The use of the asset singly, or in combination with other assets contributes directly or indirectly to generate future cash flows. A particular entity can obtain the benefit derived from an asset or control other’s access to it. The lease transfers rights to use the asset to the lessee who then obtains benefits derived from its use. The transaction or event giving rise to the entity’s right to or control of the asset has already occurred. That transaction is the initiation of the lease agreement. It is clear that a lease agreement has all three characteristics of an asset even when it does not meet the SFAS No. 13 criteria for capitalization as an asset. Similarly, the lease obligates the entity to make future cash payments and meets the definition of a liability. Liabilities are defined by SFAC No. 6 as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. They embody a present duty or responsibility to one or more other entities (in this case to the lessor) that entails settlement by probable future transfer or use of assets at a specified determinable date. The lease payments are set and will entail the payment of assets (cash) to the lessor at specified amounts and dates according to the lease contract. Finally, the transaction or event (the initiation of the lease contract) obligating the entity to make the lease payments has already happened. Since the lease meets the definitions of assets and liabilities, it should be reported as a capital lease. If not, the financial statements will not be reliable. They will not report what they purport to represent. That is they will not be representationally faithful, nor will they be neutral. They will omit information which is have predictive value and is relevant to user decision-making. Finally, it is not reasonable to assume that no one owns the asset. If it is a sale to the lessor, the lessor does not report the asset. If the asset does not belong to the lessor, then it must be the lessee’s asset. Team 2 Argue for treating the lease as an operating lease If the lessee does not guarantee the salvage value, then the lessee is not acting as an owner. The lessee is only using the asset temporarily. Rather, the payments to the lessor only 347

represent rent. When the lessee calculates the present value of the minimum lease payments, the third party guarantees of salvage are not included, and the present value thus calculated is not virtually all of the value of the asset. The lessee then treats the lease as an operating lease. The lessee will be following generally accepted accounting principles. The lease criteria found in SFAS No. 13 are intended to be used to determine whether a lease should be capitalized or not. If they do not meet at least one of the four lease criteria, the transaction does not indicate that a purchase of an asset has occurred or that a liability has been incurred. Instead the lease payments are considered a period expense. If none of the lease criteria are met, then the leased asset will revert to the lessor at the end of the lease term. Title to the asset will never have belonged to the lessee. Hence, the lessee has only temporary use or control of the asset and does not meet the definition of an asset. Moreover, the lessee will not have acquired substantially all of the economic benefits to be derived from the leased asset because it is apparent from the facts in the case that the lessee will not derive benefit for virtually all of its useful life (at least 75% thereof). Nor do the amount and timing of the lease payments imply that the lessee is essentially paying for the asset (present value of minimum lease payments at least 90%). The implication of the agreement is that the lessor owns and controls the asset, but is allowing the lessee to use the asset temporarily for a fee, or rent. If the leased asset does not belong to the lessee then payments for its use are merely periodic rent and as such should be treated as rent expense. As such they do not represent payments on a liability. Thus, it would be inappropriate to record a liability for a lease that is not in essence a purchase of an asset. Debate 17-2 Booking the Budget Team 1 In general, APB Opinion No. 28 (FASB ASC 270) supports the integral view of interim reporting. According to the integral view, interim periods are an integral part of the annual period, thus revenues and expenses might be allocated to various interim periods even though they occurred only in one period. The APB noted that interim financial information is essential to provide timely data on the progress of the enterprise and that the usefulness of the data rests on its relationship to annual reports. Accordingly, the Board determined that interim periods should be viewed as integral parts of the annual period and that the principles and practices followed in the annual period should be followed in the interim period. However, certain modifications were deemed necessary in order to provide a better relationship to the annual period. Under APB Opinion No. 28 (FASB ASC 270), costs that are related to revenues should be allocated and matched with revenue in the same manner as the annual report. We argue that Microsoft’s marketing expenditures are related to sales and can be allocated across 348

interim periods so that the results of interim periods better relate to the results of operations reported in the annual report. For example, Microsoft may make marketing expenditures in one accounting period that result in sales of another period. Since no causal relationship can be adequately determined, allocation across accounting periods of the total expected cost (such as those in the budget) would provide a reasonable approximation of the annual results. The above is consistent with cost estimates and allocations that are allowed under APB Opinion No. 28 (FASB ASC 270) . The Opinion APB allows companies to use estimated gross profit rates to estimate and report interim cost of goods sold. It also allows companies to estimate accruals to be made at a later date in an effort to achieve a fair measure of results of operations for the annual period and to present fairly the financial position at the end of the annual period. Allocation of cost that will benefit more than one accounting period is allowed. According to APB Opinion No. 28 (FASB ASC 270) , the amounts of certain costs are frequently subjected to year-end adjustments even though they can be reasonably approximated at interim dates. To the extent possible such adjustments should be estimated and the estimated costs assigned to interim periods so that the interim periods bear a reasonable portion of the anticipated annual amount. Use of budgeted amounts is normally related to sales projections. Hence, we argue that they provide a reasonable estimate of the relationship to annual sales and thus result in the assignment of costs to interim periods that allow the interim reports to bear a reasonable portion of the anticipated annual results. Team 2 We disagree with the interim accounting approach used by Microsoft. We base our arguments on the discrete view of interim reporting. Proponents of the discrete view believe that each interim period should be treated as a separate accounting period in the same manner as the annual period. Thus, the same principles used to report deferrals, accruals, and estimated items in the annual report would also be employed in preparing interim reports. In accordance with the discrete approach, there generally should be no allocation to other interim periods of expenses incurred in one interim period. Instead, Microsoft should have reported all expenses incurred during the accounting period, rather than reporting budgeted expenses. According to APB Opinion 28 (FASB ASC 270), interim information is essential to provide investors and others with timely information as to the progress of the company. The company should apply the same accounting principles and approaches to an interim report that they do for the annual report. Since companies must report cost incurred during the period in their annual report, it follows that the companies should report cost incurred during the interim period in the interim report. Thus use of the discrete approach wherein the actual expenses incurred during the interim period are reported for that period would 349

allow the investor to see what actually occurred during the interim period and thus the real progress toward year end. Costs incurred during an accounting period that cannot be identified with the activities or benefits of other interim periods should be charged to the interim period in which they were incurred. Advertising costs are incurred in hopes of generating company sales. However, no causal relationship between advertising costs and sales can be established. Since the relationship at best can only be assumed, companies should not arbitrarily assign these costs to interim periods. Debate 17-3 Full Disclosure Investors, creditors and other users of financial statements often argue that there should be more transparency in published financial statements. This argument is based, at least to some extent on concerns that management has too much leeway in the selection of accounting alternatives. Team 1:

Argue that management should continue to be allowed to choose among different accounting alternatives because full disclosure in the notes to financial statements provides sufficient transparency.

We argue that management should be allowed to choose among different accounting alternatives. We also believe that full disclosure in the notes combined with the alternatives chosen provide sufficient transparency to allow investors, creditors, and other users to evaluate the company’s financial position as well as its financial performance. The financial statements, footnotes, and supplementary schedules constitute the company’s financial report. And all significant information should be included in the financial report. Additionally, other relevant information, which can assist in understanding the financial report, is presented in narrative form. Examples of these types of items are management’s discussion and analysis and the letter to stockholders. The footnotes to a company’s financial statements provide a significant amount of additional information about the items on the company’s financial statements. In general, the footnotes disclose information that explains, clarifies, or develops items appearing on the financial statements, which cannot easily be incorporated into the financial statements themselves. The most common examples of footnotes are: 1. Accounting policies 2. Schedules and exhibits—Firms typically report schedules or exhibits concerning longterm debt and income tax, for example. 3. Explanations of financial statement items—Some items require additional explanation so that users can make sense of the reported information. Pensions and postretirement 350

benefits are two examples. 4. General information about the company—Occasionally, firms face events that may impact their financial performance or position but cannot yet be recognized on the financial statements. In that case, investors have an interest in learning this information as soon as possible. Information concerning subsequent events and contingencies are two examples. The purpose of supplementary schedules is to improve the understandability of the financial statements. They may be used to highlight trends, such as five-year summaries; or they may be required by FASB pronouncements, such as information on current costs. The SEC recently announced a proposed rule requiring additional disclosures that are designed to improve the transparency of companies’ financial disclosure. These new disclosures would enhance investors’ understanding of the application of companies’ critical accounting policies. The proposals encompass disclosure in two areas: accounting estimates a company makes in applying its accounting policies and the initial adoption by a company of an accounting policy that has a material impact on its financial presentation. Under the first part of the proposal, a company would identify the accounting estimates reflected in its financial statements that required it to make assumptions about matters that were highly uncertain at the time of estimation. Disclosure about those estimates would then be required if different estimates that the company reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the presentation of the company’s financial condition, changes in financial condition or results of operations. A company’s disclosure about these critical accounting estimates would include a discussion of the methodology and assumptions underlying them; the effect the accounting estimates have on the company’s financial presentation; and the effect of changes in the estimates. Under the second part of the proposal, a company that has initially adopted an accounting policy with a material impact would be required to disclose information that indicates what gave rise to the initial adoption; the impact of the adoption; the accounting principle adopted and method of applying it; and the choices it had among accounting principles. Companies would place all of the new disclosure in the MD&A section of their annual reports, registration statements, and proxy and information statements. In addition, companies would be required to update the information regarding their critical accounting estimates to disclose material changes. Current accounting practice requires full disclosure of accounting changes and their impact on the company’s financial statements. If the accounting procedures and policies are clearly disclosed in the notes, management should continue to be able to choose that method that is most appropriate for the company. Also, disclosure of the accounting procedures and policies should enable financial analysts to make adjustments that allow him/her to compare a company over time and to compare one company with another. 351

Some have argued that full disclosure of risk, various debt instruments, and lease obligations provides more meaningful information than does the way these items are accounted for on the balance sheet. Finally, one shoe does not fit all. Straight-line depreciation may provide a better way to allocate cost for some companies while an accelerated method may be appropriate for another. Doing away with management’s ability to pick and choose among the various accounting alternatives that are currently available to choose from it likely to narrow the scope for individual thought and judgment. It is wrong to assume that all accounting choices are made to manage earnings or to manipulate what is reported in financial statements. Team 2: Argue that there should be a narrowing of accounting alternatives because full disclosure in the notes is not sufficient to curb potential management abuses. We disagree that companies should be allowed to arbitrarily pick and choose which accounting approaches they wand and we do not believe that full disclosure in the notes is sufficient to allow for transparency of what is reported and thereby reduce the need to narrow the number of accounting alternatives. Under the Conceptual Framework, the most relevant information should always appear in one of the financial statements, provided that it meets the SFAC No. 5 criteria for measurement and recognition. Conversely, we believe that there should be a narrowing of accounting alternatives because full disclosure in the notes is not sufficient to curb potential management abuses. We believe that management should not be allowed to select an accounting alternative solely on the basis of its financial statement effect. The myriad requirements for full disclosure did not stop companies have not stopped management from managing earnings and even committing fraud – note the behavior of WorldCom and Enron. The Conceptual Framework states that reliable financial information is free from bias. Clearly the more accounting alternatives that management has to choose from, the greater the temptation and occurrence of earnings management and other forms of financial statement manipulations. Not only is greater standardization more consistent with freedom from bias, it also results in another desirable characteristic, comparability. According to the Conceptual Framework, useful information should not only be relevant and reliable, it should also provide comparability for one company over time and among companies. The selection of one accounting approach over another can have a material impact on the measurement of amounts reported in financial statements. For example, LIFO and FIFO can result in significantly different values reported in the balance sheet and income statement. LIFO inventory values can severely understate a company’s current assets while producing a significantly lower net income than FIFO or even weighted-average inventory values. 352

Therefore the use of different methods causes confusion among the readers of financial statements and prevents meaningful comparison of statements of different companies. There is strong support in the profession for narrowing the areas of differences in accounting. Reduction in the number of alternatives may narrow the differences and thus lead to more comparability. We argue, the very purpose of GAAP is to narrow the range of acceptable accounting alternatives. Conceptual framework is intended to provide guidance to help the FASB select appropriate principles and rules of measurement and recognition. Furthermore, SFAC No. states that the Conceptual Framework should also provide a frame of reference for resolving accounting questions in the absence of a specific promulgated standard. Determine bounds for judgment in preparing financial statements. The result should be enhanced comparability WWW Case 17-13 a.

The company should report its quarterly results as if each interim period is an integral part of the annual period.

The company’s revenue and expenses would be reported as follows on its quarterly report prepared for the first quarter of the 2017 fiscal year: Sales revenue Cost of goods sold Variable selling expenses Fixed selling expenses Advertising ($2,000,000 ÷ 4) Other ($3,000,000 – $2,000,000)

60,000 36,000 1,000,000 500,000 1,000,000

Sales revenue and cost of goods sold receive the same treatment as if this were an annual report. Costs and expenses other than product costs should be charged to expense in interim periods as incurred or allocated among interim periods. Consequently, the variable selling expense and the portion of fixed selling expenses not related to the television advertising should be reported in full. One-fourth of the television advertising is reported as an expense in the first quarter, assuming TV advertising is constant throughout the year. These costs can be deferred within the fiscal period if the benefits of the expenditure clearly extend beyond the interim period in which the expenditure is made. c.

The financial information to be disclosed to its stockholders in its quarterly reports as a minimum includes: 353

1. 2. 3. 4. 5. 6. 7. 8.

Sales revenue or gross revenues, provision for income taxes and net income. Basic and diluted earnings per share. Seasonal revenue, costs or expenses. Significant changes in estimates or provisions for income taxes. Disposal of a component of a business Contingent items. Changes in accounting principles or estimates. Significant changes in financial position.

Case 17-14 a.

Substantial doubt means that it is probable that a company will be unable to meet its obligations as they become due within one year after the financial statement issuance date. The likelihood threshold of probable is defined as “the future event or events are likely to occur,” which is consistent with its current use in U.S. GAAP applicable to loss contingencies.

Management’s assessment should be based on the relevant conditions that are “known and reasonably knowable” at the date the financial statements are issued, rather than at the balance sheet date. This means that the assessment should consider the most current information available before the financial statements are issued, requiring companies to consider all relevant subsequent events after the balance sheet date Examples of events that suggest that a company may be unable to meet its obligations, include: 1. Negative financial trends, such as, recurring operating losses, working capital deficiencies, negative cash flows from operating activities, and other adverse key financial ratios. 2. Other indications of possible financial difficulties, such as, default on loans or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, a need to restructure debt to avoid default, noncompliance with statutory capital requirements, and a need to seek new sources or methods of financing or to dispose of substantial assets. 3. Internal matters, such as, work stoppages or other labor difficulties, substantial dependence on the success of a particular project, uneconomic long-term commitments, and a need to significantly revise operations. 4. External matters, such as, legal proceedings, legislation, or similar matters that might jeopardize the entity’s ability to operate; loss of a key franchise, license, or patent; loss of a principal customer or supplier; and an uninsured or underinsured catastrophe such as a hurricane, tornado, earthquake, or flood.

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If management identifies events or conditions that indicate that it is probable that the company will be unable to meet its obligations as they become due, ASU 2014-15 indicates that management’s plans to mitigate its inability to meet its obligations can be considered only if both of the following conditions are met: 1. It is probable that the plans will be effectively implemented within one year after the date that the financial statements are issued. 2. It is probable that management’s plans, when implemented, will mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.

Case 17-15 a.

Liquidation is defined as “the process by which an entity converts its assets to cash or other assets and partially or fully settles its obligations with creditors in anticipation of the entity ceasing its operations. Liquidation is considered imminent when there is only a remote likelihood that the organization will return from liquidation, and either of the following situations occurs: 1. A plan for liquidation has been approved by the person or persons with the authority to make such a plan effective and the likelihood is remote that the execution of the plan will be blocked by other parties. 2. A plan for liquidation is being imposed by other forces (for example, involuntary bankruptcy) and the likelihood is remote that the entity will subsequently return from liquidation.

Financial statements prepared using the liquidation basis will be required to include: The organization’s assets, described in terms of the amount of expected cash proceeds from liquidation. This would include assets that had not previously been recognized but that the organization expects to sell in liquidation or use in settling liabilities. Trademarks would be an example of such assets. The organization’s liabilities. The standard does not allow organizations to anticipate that they will be released from payment of those liabilities. Accrual of the costs the organization expects to incur and the income it expects to earn during liquidation, including disposal costs that may be anticipated.

Case 17-16 a.

The Securities and Exchange Commission (SEC) is an independent federal agency that receives its authority from federal legislation enacted by Congress. The Securities and Exchange Act of 1934 created the SEC.

As a result of the Securities and Exchange Act of 1934, the SEC has legal authority relative to accounting practices. The U.S. Congress has given the SEC broad regulatory power to 355

control accounting principles and procedures in order to fulfill its goal of full and fair disclosure. c.

There is no direct relationship as the SEC was created by Congress and the Financial Accounting Standards Board (FASB) was created by the private sector. However, the SEC historically has followed a policy of relying on the private sector to establish financial accounting and reporting standards known as generally accepted accounting principles (GAAP). The SEC does not necessarily agree with all of the pronouncements of the FASB. In cases of unresolved differences, the SEC rules take precedence over FASB rules for companies within SEC jurisdiction

Case 17-17 a.

In its December 31, 2020 financial statements, Lansing Company should apply the goingconcern basis of accounting as liquidation is not considered “imminent” at that date. Under FASB ASC 205 liquidation is considered “imminent” when: 1. A plan for liquidation has been approved by the person or persons with the authority to make such a plan effective, and the likelihood is remote that the execution of the plan will be blocked by other parties. 2. A plan for liquidation is being imposed by other forces (for example, involuntary bankruptcy), and the likelihood is remote that the entity will subsequently return from liquidation Furthermore, the liquidation basis is applied prospectively only from the day that liquidation becomes imminent, and so a reporting entity adopting the liquidation basis for the first time would not retrospectively adjust its historical financial statements. In this situation, Lansing Company’s liquidation does not meet the imminent threshold until the required shareholder approval is obtained. Although going-concern accounting is utilized as of December 31, 2020, given the significance of the subsequent event and the pending change in the basis of accounting, it may be necessary to provide a pro forma statement of net assets in liquidation giving effect to the change to liquidation basis of accounting as if it had occurred on the date of the balance sheet.

Case 17-18 The solution to this case requires a visit to the SEC’s home page at the time the case is assigned. 356

Case 17-19 The answer depends on the companies selected. Case 17-2The answer depends on the companies selected. Financial Analysis Case The answer depends on the companies selected.

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