Accounting Theory and Analysis 10th Edition
Solutions Manual and Test Bank 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
Table of Contents Page number
Using the Codification to Solve the FASB ASC Cases
3
Solutions Manual Chapter 1
6
Chapter 2
32
Chapter 3
58
Chapter 4
65
Chapter 5
74
Chapter 6
100
Chapter 7
127
Chapter 8
144
Chapter 9
167
Chapter 10
184
Chapter 11
211
Chapter 12
254
Chapter 13
276
Chapter 14
291
Chapter 15
307
Chapter 16
337
Chapter 17
359
2
Test Bank Chapter 1
386
Chapter 2
399
Chapter 3
412
Chapter 4
424
Chapter 5
432
Chapter 6
442
Chapter 7
453
Chapter 8
463
Chapter 9
471
Chapter 10
486
Chapter 11
491
Chapter 12
507
Chapter 13
520
Chapter 14
527
Chapter 15
534
Chapter 16
548
Chapter 17
559
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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 left-hand 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. 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 4
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 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
ƒ Page/Print functions select Printer-friendly with sources 5. Page through the material to find content originally sourced from the EITF
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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. b. 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. c. 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 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. Regulation S-X (SX) 2. Financial Reporting Releases (FRR)/Accounting Series Releases (ASR) 3. Interpretive Releases (IR) 6
4. SEC Staff guidance in: a. Staff Accounting Bulletins (SAB) b. EITF Topic D and SEC Staff Observer comments d. 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: i. Practices that are widely recognized and prevalent either generally or in the industry ii. FASB Concepts Statements iii. American Institute of Certified Public Accountants (AICPA) Issues Papers iv. International Financial Reporting Standards of the International Accounting Standards Board Pronouncements of professional associations or regulatory agencies v. Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids vi. 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.
b.
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.
c.
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.
d.
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 7
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 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 8
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.
c.
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.
2.
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.
3.
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.
4.
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.
2.
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 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.
4.
The use of consensus to develop accounting principles would decrease the professional status of the accountant. 9
5
This approach would lead to "lobbying" by various parties to influence the establishment of accounting principles.
Case 1-4 a.
b.
c.
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 principles 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 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 1-6 Another 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 10
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).
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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 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 1-7 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, timeconsuming 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.
b.
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 12
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 $11 million a year to support the activities of the FASB.
b.
The members of the Financial Accounting Foundation are nominated by electors from nine organizations that support the activities of the FASB. These nine organizations are the AICPA, the Financial Executives Institute, the National Association of Accountants, the Financial Analysts Federation, the American Accounting Association, the Security Industry Association, and three not-for-profit organizations.
c.
A number of key characteristics or qualities that make accounting information desirable are described in the Statement of Financial Accounting Concepts No. 2. The importance of three of these characteristics or qualities are discussed below. 1.
2.
3.
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. Reliability--the reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has representational quality.
(Note to instructor: Other qualities might be discussed by the student, such as secondary qualities. All of these qualities are defined in the textbook.)
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FASB ASC 1-1 Variable Interest Entities 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 810-10-05 Overview and Background Consolidation of VIEs 05-8 The Variable Interest Entities Subsections clarify the application of the General Subsections to certain legal entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the legal entity to finance its activities without additional subordinated financial support. Paragraph 810-10-10-1 states that consolidated financial statements are usually necessary for a fair presentation if one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities. Paragraph 810-10-15-8 states that the usual condition for a controlling financial interest is ownership of a majority voting interest. However, application of the majority voting interest requirement in the General Subsections of this Subtopic to certain types of entities may not identify the party with a controlling financial interest because the controlling financial interest may be achieved through arrangements that do not involve voting interests. 05-9 The Variable Interest Entities Subsections explain how to identify variable interest entities (VIEs) and how to determine when a reporting entity should include the assets, liabilities, noncontrolling interests, and results of activities of a VIE in its consolidated financial statements. Transactions involving VIEs have become increasingly common. Some reporting entities have entered into arrangements using VIEs that appear to be designed to avoid reporting assets and liabilities for which they are responsible, to delay reporting losses that have already been incurred, or to report gains that are illusory. At the same time, many reporting entities have used VIEs for valid business purposes and have properly accounted for those VIEs based on guidance and accepted practice. 05-10 Some relationships between reporting entities and VIEs are similar to relationships established by majority voting interests, but VIEs often are arranged without a governing board or with a governing board that has limited ability to make decisions that affect the VIE's activities. A VIE's activities may be limited or predetermined by the articles of incorporation, bylaws, partnership agreements, trust agreements, other establishing documents, or contractual agreements between the parties involved with the VIE. A reporting entity implicitly chooses at the time of its investment to accept the activities in which the VIE is permitted to engage. That reporting entity may not need the ability to make decisions if the activities are predetermined or limited in ways the reporting entity chooses to accept. Alternatively, the reporting entity may obtain an ability to make decisions that affect a VIE's activities through contracts or the VIE's governing documents. There may be other techniques for protecting a reporting entity's interests. In any case, the reporting entity may receive benefits similar to those received from a controlling financial interest and be exposed to risks similar to those received from a controlling financial interest without holding a majority voting interest (or without holding any voting interest). Risks, benefits, or both are the determinants of consolidation in the Variable Interest Entities Subsections. The ability to make decisions is considered an indication that a reporting entity may have sufficient benefits and risks to require consolidation. However, another key indicator is an ability to benefit from the results of those decisions. Therefore, the Variable Interest Entities Subsections provide guidance on determining whether fees paid to a decision maker should be considered a variable interest in a VIE. That guidance is provided to 14
distinguish between decision making of the kind performed by a hired agent or employee from decision making that is a key indicator of a controlling financial interest. 05-11 VIEs often are created for a single specified purpose, for example, to facilitate securitization, leasing, hedging, research and development, reinsurance, or other transactions or arrangements. The activities may be predetermined by the documents that establish the VIEs or by contracts or other arrangements between the parties involved. However, those characteristics do not define the scope of the Variable Interest Entities Subsections because other entities may have those same characteristics. The distinction between VIEs and other entities is based on the nature and amount of the equity investment and the rights and obligations of the equity investors. 05-12 Because the equity investors in an entity other than a VIE generally absorb losses first, they can be expected to resist arrangements that give other parties the ability to significantly increase their risk or reduce their benefits. Other parties can be expected to align their interests with those of the equity investors, protect their interests contractually, or avoid any involvement with the entity. 05-13 In contrast, either a VIE does not issue voting interests (or other interests with similar rights) or the total equity investment at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support. If a legal entity does not issue voting or similar interests or if the equity investment is insufficient, that legal entity's activities may be predetermined or decision-making ability is determined contractually. If the total equity investment at risk is not sufficient to permit the legal entity to finance its activities, the parties providing the necessary additional subordinated financial support most likely will not permit an equity investor to make decisions that may be counter to their interests. That means that the usual condition for establishing a controlling financial interest as a majority voting interest does not apply to VIEs. Consequently, a standard for consolidation that requires ownership of voting stock or some other form of decisionmaking ability is not appropriate for such entities. 2. The guidance of the consolidation of VIEs is contained in 810-10-15-14 to 17. 15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a variable interest entity [VIE] does not become one because of operating losses. The design of the legal entity is important in the application of these provisions.): a. The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. For this purpose, the total equity investment at risk has all of the following characteristics: 1. Includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights 2. Does not include equity interests that the legal entity issued in exchange for subordinated interests in other VIEs 3. Does not include amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity (for example, by fees, charitable contributions, or other payments), unless the provider is a parent, subsidiary, or 15
affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor 4. Does not include amounts financed for the equity investor (for example, by loans or guarantees of loans) directly by the legal entity or by other parties involved with the legal entity, unless that party is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor. b. As a group the holders of the equity investment at risk lack any one of the following three characteristics of a controlling financial interest: 1. The direct or indirect ability through voting rights or similar rights to make decisions about a legal entity's activities that have a significant effect on the success of the legal entity. The investors do not have that ability through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation or a general partner in a partnership). Legal entities that are not controlled by the holder of a majority voting interest because of minority veto rights as discussed in paragraphs 810-10-25-2 through 25-14 are not VIEs if the shareholders as a group have the power to control the entity and the equity investment meets the other requirements of the Variable Interest Entities Subsections. 2. The obligation to absorb the expected losses of the legal entity. The investor or investors do not have that obligation if they are directly or indirectly protected from the expected losses or are guaranteed a return by the legal entity itself or by other parties involved with the legal entity. See paragraphs 810-10-25-55 through 25-56 and Example 1 (see paragraph 810-10-55-42) for a discussion of expected losses. 3. The right to receive the expected residual returns of the legal entity. The investors do not have that right if their return is capped by the legal entity's governing documents or arrangements with other variable interest holders or the legal entity. For this purpose, the return to equity investors is not considered to be capped by the existence of outstanding stock options, convertible debt, or similar interests because if the options in those instruments are exercised, the holders will become additional equity investors. The objective of this provision is to identify as VIEs those legal entities in which the total equity investment at risk does not provide the holders of that investment with the characteristics of a controlling financial interest. If interests other than the equity investment at risk provide the holders of that investment with the characteristics of a controlling financial interest or if interests other than the equity investment at risk prevent the equity holders from having the necessary characteristics, the entity is a VIE. c.
The equity investors as a group also are considered to lack the characteristic in (b)(1) if both of the following conditions are present: 1. The voting rights of some investors are not proportional to their obligations to absorb the expected losses of the legal entity, their rights to receive the expected residual returns of the legal entity, or both. 2. Substantially all of the legal entity's activities (for example, providing financing or buying assets) either involve or are conducted on behalf of an investor that has disproportionately few voting rights. This provision is necessary to prevent a primary 16
beneficiary from avoiding consolidation of a VIE by organizing the legal entity with nonsubstantive voting interests. Activities that involve or are conducted on behalf of the related parties of an investor with disproportionately few voting rights shall be treated as if they involve or are conducted on behalf of that investor. The term related parties in this paragraph refers to all parties identified in paragraph 810-10-25-43, except for de facto agents under paragraph 810-10-25-43(d)(1). For purposes of applying this requirement, reporting entities shall consider each party’s obligations to absorb expected losses and rights to receive expected residual returns related to all of that party’s interests in the legal entity and not only to its equity investment at risk. 15-15 Portions of legal entities or aggregations of assets within a legal entity shall not be treated as separate entities for purposes of applying the Variable Interest Entities Subsections unless the entire entity is a VIE. Some examples are divisions, departments, branches, and pools of assets subject to liabilities that give the creditor no recourse to other assets of the entity. Majority-owned subsidiaries are legal entities separate from their parents that are subject to the Variable Interest Entities Subsections and may be VIEs. 15-16 Because reconsideration of whether a legal entity is subject to the Variable Interest Entities Subsections is required only in certain circumstances, the initial application to a legal entity that is in the development stage is very important. Guidelines for identifying a development stage entity appear in paragraph 915-10-05-2. A development stage entity is a VIE if it meets any of the conditions in paragraph 810-10-15-14. A development stage entity does not meet the condition in paragraph 810-1015-14(a) if it can be demonstrated that the equity invested in the legal entity is sufficient to permit it to finance the activities it is currently engaged in (for example, if the legal entity has already obtained financing without additional subordinated financial support) and provisions in the legal entity’s governing documents and contractual arrangements allow additional equity investments. However, sufficiency of the equity investment should be reconsidered as required by paragraph 810-10-35-4, for example, if the legal entity undertakes additional activities or acquires additional assets. 15-17 The following exceptions to the Variable Interest Entities Subsections apply to all legal entities in addition to the exceptions listed in paragraph 810-10-15-12: a. Not-for-profit entities (NFPs) are not subject to the Variable Interest Entities Subsections, except that they may be related parties for purposes of applying paragraphs 810-10-25-42 through 25-44. In addition, if an NFP is used by business reporting entities in a manner similar to a VIE in an effort to circumvent the provisions of the Variable Interest Entities Subsections, that NFP shall be subject to the guidance in the Variable Interest Entities Subsections. b. Separate accounts of life insurance entities as described in Topic 944 are not subject to consolidation according to the requirements of the Variable Interest Entities Subsections. c. A reporting entity with an interest in a VIE or potential VIE created before December 31, 2003, is not required to apply the guidance in the Variable Interest Entities Subsections to that entity if the reporting entity, after making an exhaustive effort, is unable to obtain the information necessary to do any one of the following: 1. Determine whether the legal entity is a VIE 2. Determine whether the reporting entity is the VIE's primary beneficiary 17
3. Perform the accounting required to consolidate the VIE for which it is determined to be the primary beneficiary. This inability to obtain the necessary information is expected to be infrequent, especially if the reporting entity participated significantly in the design or redesign of the legal entity. The scope exception in this provision applies only as long as the reporting entity continues to be unable to obtain the necessary information. Paragraph 810-10-50-6 requires certain disclosures to be made about interests in legal entities subject to this provision. Paragraphs 810-10-30-7 through 30-9 provide transition guidance for a reporting entity that subsequently obtains the information necessary to apply the Variable Interest Entities Subsections to a legal entity subject to this exception. d.
A legal entity that is deemed to be a business need not be evaluated by a reporting entity to determine if the legal entity is a VIE under the requirements of the Variable Interest Entities Subsections unless any of the following conditions exist (however, for legal entities that are excluded by this provision, other generally accepted accounting principles [GAAP] should be applied): 1. The reporting entity, its related parties (all parties identified in paragraph 810-10-25-43, except for de facto agents under paragraph 810-10-25-43(d)(1)), or both participated significantly in the design or redesign of the legal entity. However, this condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee. 2. The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties. 3. The reporting entity and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity based on an analysis of the fair values of the interests in the legal entity. 4. The activities d financings or single-lessee leasing arrangements. A legal entity that previously was not evaluated to determine if it was a VIE because of this provision need not be evaluated in future periods as long as the legal entity continues to meet the conditions in (d).
Transition Date: December 15, 2008 Transition Guidance: 860-10-65-2 The following exceptions to the Variable Interest Entities Subsections apply to all legal entities in addition to the exceptions listed in paragraph 810-10-15-12: a. Not-for-profit entities (NFPs) are not subject to the Variable Interest Entities Subsections, except that they may be related parties for purposes of applying paragraphs 810-10-25-42 through 25-44. In addition, if an NFP is used by business reporting entities in a manner similar to a VIE in an effort to circumvent the provisions of the Variable Interest Entities Subsections, that NFP shall be subject to the guidance in the Variable Interest Entities Subsections. b. Separate accounts of life insurance entities as described in Topic 944 are not subject to consolidation according to the requirements of the Variable Interest Entities Subsections. c. A reporting entity with an interest in a VIE or potential VIE created before December 31, 2003, is not required to apply the guidance in the Variable Interest Entities Subsections to that entity if the 18
reporting entity, after making an exhaustive effort, is unable to obtain the information necessary to do any one of the following: 1. Determine whether the legal entity is a VIE 2. Determine whether the reporting entity is the VIE's primary beneficiary 3. Perform the accounting required to consolidate the VIE for which it is determined to be the primary beneficiary. This inability to obtain the necessary information is expected to be infrequent, especially if the reporting entity participated significantly in the design or redesign of the legal entity. The scope exception in this provision applies only as long as the reporting entity continues to be unable to obtain the necessary information. Paragraphs 810-10-50-6 (for a nonpublic entity) and 810-1050-16 (for a public entity) require certain disclosures to be made about interests in legal entities subject to this provision. Paragraphs 810-10-30-7 through 30-9 provide transition guidance for a reporting entity that subsequently obtains the information necessary to apply the Variable Interest Entities Subsections to a legal entity subject to this exception. d.
A legal entity that is deemed to be a business need not be evaluated by a reporting entity to determine if the legal entity is a VIE under the requirements of the Variable Interest Entities Subsections unless any of the following conditions exist (however, for legal entities that are excluded by this provision, other generally accepted accounting principles [GAAP] should be applied): 1. The reporting entity, its related parties (all parties identified in paragraph 810-10-25-43, except for de facto agents under paragraph 810-10-25-43(d)(1)), or both participated significantly in the design or redesign of the legal entity. However, this condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee. 2. The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties. 3. The reporting entity and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity based on an analysis of the fair values of the interests in the legal entity. 4. The activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements. A legal entity that previously was not evaluated to determine if it was a VIE because of this provision need not be evaluated in future periods as long as the legal entity continues to meet the conditions in (d).
FASB ASC 1-2 Status of ARBs Revenue and Gains 19
Search ARB 43 in cross reference 605 25-1 to 5 25-1 The recognition of revenue and gains of an entity during a period involves consideration of the following two factors, with sometimes one and sometimes the other being the more important consideration: a. Being realized or realizable. Revenue and gains are generally not recognized until realized or realizable. Paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. That paragraph states that revenue and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. b. Being earned. Paragraph 83(b) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue is not recognized until earned. That paragraph states that an entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. That paragraph states that gains commonly result from transactions and other events that involve no earning process, and for recognizing gains, being earned is generally less significant than being realized or realizable. 25-2 See paragraphs 605-10-25-3 through 25-4 for the limited circumstances in which revenue and gains may be recognized using the installment or cost-recovery methods. > Installment and Cost Recovery Methods of Revenue Recognition 25-3 Revenue should ordinarily be accounted for at the time a transaction is completed, with appropriate provision for uncollectible accounts. Paragraph 605-10-25-1(a) states that revenue and gains generally are not recognized until being realized or realizable and until earned. Accordingly, unless the circumstances are such that the collection of the sale price is not reasonably assured, the installment method of recognizing revenue is not acceptable. 25-4 There may be exceptional cases where receivables are collectible over an extended period of time and, because of the terms of the transactions or other conditions, there is no reasonable basis for estimating the degree of collectibility. When such circumstances exist, and as long as they exist, either the installment method or the cost recovery method of accounting may be used. As defined in paragraph 360-20-55-7 through 55-9, the installment method apportions collections received between cost recovered and profit. The apportionment is in the same ratio as total cost and total profit bear to the sales value. Under the cost recovery method, equal amounts of revenue and expense are recognized as collections are made until all costs have been recovered, postponing any recognition of profit until that time.) 25-5 In the absence of the circumstances referred to in this Subtopic or other guidance, such as that in Sections 360-20-40 and 360-20-55, the installment method is not acceptable. Treasury Stock 505-30-25 and 30 use print function printer friendly with sources to find relevant sections 505-30-25-2 [Laws of some states govern the circumstances under which an entity may acquire its own stock and prescribe the accounting treatment therefor. If such requirements are at variance with the requirements of paragraphs 505-30-25-7 and 505-30-30-6 through 30-10, the accounting shall conform to the applicable law. [ARB 43, paragraph Ch. 1B Par. 11A, sequence 128.1] ] 20
Subsequent Resale of Shares Repurchased 505-30-25-7 After an entity's repurchase of its own outstanding common stock, sometimes it may either retire the repurchased shares and issue additional common shares, or, as an alternative, resell the repurchased shares. In either case, the price received may differ from the amount paid to repurchase the shares. [While the net asset value of the shares of common stock outstanding in the hands of the public may be increased or decreased by such repurchase and retirement, such transactions relate to the capital of the corporation and do not give rise to corporate profits or losses. There is no essential difference between the following: [ARB 43, paragraph Ch. 1B Par. 7, sequence 118.2.1] ] a. [The repurchase and retirement of a corporation's own common stock and the subsequent issue of common shares [ARB 43, paragraph Ch. 1B Par. 7, sequence 118.2.2.1] ] b. [The repurchase and resale of its own common stock. [ARB 43, paragraph Ch. 1B Par. 7, sequence 118.2.2.2] ] 505-30-25-8 [Even though there may be cases where the transactions involved are so inconsequential as to be immaterial, as a broad general principle, such transactions shall not be reflected in retained earnings (either directly or through inclusion in the income statement). [ARB 43, paragraph Ch. 1B Par. 10, sequence 126] ][ The qualification shall not be applied to any transaction that, although in itself inconsiderable in amount, is a part of a series of transactions that in the aggregate are of substantial importance. [ARB 43, paragraph Ch. 1B Par. 11, sequence 127] ] 505-30-25-9 [The difference between the repurchase and resale prices of a corporation's own common stock shall be reflected as part of the capital of a corporation and allocated to the different components within stockholder equity as required by paragraphs 505-30-30-5 through 30-10. [ARB 43, paragraph Ch. 1B Par. 5, sequence 116] ] Allocating the Cost of Treasury Shares to Components of Shareholder Equity Upon Formal or Constructive Retirement 505-30-30-6 [Once the cost of the treasury shares is determined under the requirements of this Section, and if a corporation's stock is acquired for purposes other than retirement (formal or constructive), or if ultimate disposition has not yet been decided, paragraph 505-30-45-1 permits the cost of acquired stock to either be shown separately as a deduction from the total of capital stock, additional paid-in capital, and retained earnings, or be accorded the following accounting treatment appropriate for retired stock. [ARB 43, paragraph Ch. 1B Par. 7, sequence 122.1] ] 505-30-30-7 [The difference between the cost of the treasury shares and the stated value of a corporation's common stock repurchased and retired, or repurchased for constructive retirement, shall be reflected in capital. [ARB 43, paragraph Ch. 1B Par. 7, sequence 118.1] ] 505-30-30-8 [When a corporation's stock is retired, or repurchased for constructive retirement (with or without an intention to retire the stock formally in accordance with applicable laws), [ARB 43, paragraph Ch. 1B Par. 7, sequence 119] ][an excess of repurchase price over par or stated value may be allocated between additional paid-in capital and retained earnings. [ARB 43, paragraph Ch. 1B Par. 7, sequence 120.1.1] ][ Alternatively, the excess may be charged entirely to retained earnings in recognition of the fact that a corporation can always capitalize or allocate retained earnings for such purposes. [ARB 43, paragraph Ch. 1B Par. 7, sequence 120.2.2.2.2] ][ If a portion of the excess is allocated to additional 21
paid-in capital, it shall be limited to the sum of both of the following: [ARB 43, paragraph Ch. 1B Par. 7, sequence 120.1.2] ] a. [All additional paid-in capital arising from previous retirements and net gains on sales of treasury stock of the same issue [ARB 43, paragraph Ch. 1B Par. 7, sequence 120.2.1] ] b. [The pro rata portion of additional paid-in capital, voluntary transfers of retained earnings, capitalization of stock dividends, and so forth, on the same issue. [ARB 43, paragraph Ch. 1B Par. 7, sequence 120.2.2.1] ][ For this purpose, any remaining additional paid-in capital applicable to issues fully retired (formal or constructive) is deemed to be applicable pro rata to shares of common stock. [ARB 43, paragraph Ch. 1B Par. 7, sequence 120.2.2.2.1] ] 505-30-30-9 [When a corporation's stock is retired, or repurchased for constructive retirement (with or without an intention to retire the stock formally in accordance with applicable laws), an excess of par or stated value over the cost of treasury shares shall be credited to additional paid-in capital. [ARB 43, paragraph Ch. 1B Par. 7, sequence 121] ] 505-30-30-10 [Gains on sales of treasury stock not previously accounted for as constructively retired shall be credited to additional paid-in capital; losses may be charged to additional paid-in capital to the extent that previous net gains from sales or retirements of the same class of stock are included therein, otherwise to retained earnings. [ARB 43, paragraph Ch. 1B Par. 7, sequence 122.2] ] Comparative Financial Statements 205-10-45 Use print function printer friendly with sources
205-10-45-1 [The presentation of comparative financial statements in annual and other reports enhances the usefulness of such reports and brings out more clearly the nature and trends of current changes affecting the entity. Such presentation emphasizes the fact that statements for a series of periods are far more significant than those for a single period and that the accounts for one period are but an installment of what is essentially a continuous history. [ARB 43, paragraph Ch. 2A Par. 1, sequence 130] ] 205-10-45-2 [In any one year it is ordinarily desirable that the statement of financial position, the income statement, and the statement of changes in equity be presented for one or more preceding years, as well as for the current year. [ARB 43, paragraph Ch. 2A Par. 2, sequence 131.1] ] 205-10-45-3 [Prior-year figures shown for comparative purposes shall in fact be comparable with those shown for the most recent period. Any exceptions to comparability shall be clearly brought out as described in Topic 250. [ARB 43, paragraph Ch. 2A Par. 3, sequence 132] ] 205-10-45-4 [Notes to financial statements, explanations, and accountants' reports containing qualifications that appeared on the statements for the preceding years shall be repeated, or at least referred to, in the comparative statements to the extent that they continue to be of significance. [ARB 43, paragraph Ch. 2A Par. 2, sequence 131.2.1] ] FASB ASC 1-3 Accounting for the Investment Tax Credit 22
Search investment tax credit 740-10-25-46 While it shall be considered preferable for the allowable investment credit to be reflected in net income over the productive life of acquired property (the deferral method), treating the credit as a reduction of federal income taxes of the year in which the credit arises (the flow-through method) is also acceptable. 740-10-47-27 & 28 Statement of Financial Position 45-27 The reflection of the allowable credit as a reduction in the net amount at which the acquired property is stated (either directly or by inclusion in an offsetting account) may be preferable in many cases. However, it is equally appropriate to treat the credit as deferred income, provided it is amortized over the productive life of the acquired property.
> > Income Statement 45-28 It is preferable that the statement of income in the year in which the allowable investment credit arises should be affected only by the results which flow from the accounting for the credit set forth in paragraph 740-10-25-46. Nevertheless, reflection of income tax provisions, in the income statement, in the amount payable (that is, after deduction of the allowable investment credit) is appropriate provided that a corresponding charge is made to an appropriate cost or expense (for example, to the provision for depreciation) and the treatment is adequately disclosed in the financial statements of the first year of its adoption. 740-10-25-45 Anticipated Future Tax Credits In the separate financial statements of an entity that pays dividends subject to the tax credit to its shareholders, a deferred tax asset shall not be recognized for the tax benefits of future tax credits that will be realized when the previously taxed income is distributed; rather, those tax benefits shall be recognized as a reduction of income tax expense in the period that the tax credits are included in the entity's tax return. 740-10-50-20 Investment Tax Credit Recognition Policy 50-20 Paragraph 740-10-25-46 identifies the deferral method and the flow-through method as acceptable methods of accounting for investment tax credits. Whichever method of accounting for the investment credit is adopted, it is essential that full disclosure be made of the method followed and amounts involved, when material. FASB ASC 1-4 SEC Comments a. Search revenue recognition customer payment and incentives 605-50
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Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings > > > SEC Observer Comment: Accounting for Consideration Given by a Vendor to a Customer (Including Reseller of the Vendor's Products) S99-1 The following is the text of SEC Observer Comment: Accounting for Consideration Given by a Vendor to a Customer (Including Reseller of the Vendor's Products). As it relates to consideration given by a vendor to a customer the SEC staff believes that the expense associated with a "free" product or service delivered at the time of sale of another product or service should be classified as cost of sales. b. Search debt with conversions and other options 470-20 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings > > > SEC Observer Comment: Debt Exchangeable for the Stock of Another Entity S99-1 The following is the text of the SEC Observer Comment: Debt Exchangeable for the Stock of Another Entity. An issue has been discussed involving an enterprise that holds investments in common stock of other enterprises and issues debt securities that permit the holder to acquire a fixed number of shares of such common stock. These types of transactions are commonly affected through the sale of either debt with detachable warrants that can be exchanged for the stock investment or debt without detachable warrants (the debt itself must be exchanged for the stock investment - also referred to as "exchangeable" debt). Those debt issues differ from traditional warrants or convertible instruments because the traditional instruments involve exchanges for the equity securities of the issuer. There have been questions as to whether the exchangeable debt should be treated similar to traditional convertibles as specified in Subtopic 470-20 or whether the transaction requires separate accounting for the exchangeability feature. The SEC staff believes that Subtopic 470-20 does not apply to the accounting for debt that is exchangeable for the stock of another entity and therefore separation of the debt element and exchangeability feature is required c. Search software cost of sales and services 985-705 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings > > > SEC Observer Comment: Accounting for the Film and Software Costs Associated with Developing Entertainment and Educational Software Products S99-1 The following is the text of SEC Observer Comment: Accounting for the Film and Software Costs Associated with Developing Entertainment and Educational Software Products. The SEC staff has become aware of diversity in the application of generally accepted accounting principles to exploitation, film, and other software development costs associated with EE products. The SEC staff has learned that certain registrants are recording all costs incurred in the development of EE products pursuant to the provisions of Topics 340, 720, and 985. Other registrants are separating exploitation and film costs from other software development costs and accounting for the other software development costs using Topic 985 and capitalizing film and exploitation costs as film cost inventory as described in Topic 926. Still other registrants, principally film production companies, are capitalizing all costs relating to the development of EE products as film cost inventory.
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The SEC staff views stated here are not intended to apply to costs incurred to produce computergenerated special effects and images used in products that are exhibited in theaters or licensed to television stations because those costs are addressed by Topic 926. Topic 985 establishes standards of financial accounting and reporting for the costs of all computer software to be sold, leased, or otherwise marketed as a separate product or as part of a product or process, whether internally developed and produced or purchased. The SEC staff believes that EE products that are sold, leased, or otherwise marketed are subject to the accounting requirements of Topic 985. The SEC staff does not believe that other standards of financial accounting and reporting or that industry practice are acceptable alternatives to those requirements. The SEC staff also believes that film costs incurred in the development of an EE product should be accounted for under the provisions of Topic 985, not the provisions of Topic 926. In addition, exploitation costs should be expensed as incurred unless those costs include advertising costs that qualify for capitalization in accordance with the provisions of Topics 340 and 720. FASB ASC 1-5 GAAP Guidelines Search “generally accepted accounting principles.” 105 Generally Accepted Accounting Principles 10 Overall 105-10-05 Overview and Background General 05-1 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 This Topic establishes the Financial Accounting Standards Board (FASB) Accounting Standards Codification™ (Codification) as the source of authoritative generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. In addition to the SEC’s rules and interpretive releases, the SEC staff issues Staff Accounting Bulletins that represent practices followed by the staff in administering SEC disclosure requirements, and it utilizes SEC Staff Announcements and Observer comments made at Emerging Issues Task Force meetings to publicly announce its views on certain accounting issues for SEC registrants. 05-2 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 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. An entity shall not follow the accounting treatment specified in accounting guidance for similar transactions or events in cases in which those accounting principles either prohibit the application of the accounting treatment to the particular transaction or event or indicate that the accounting treatment should not be applied by analogy. 05-3 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 25
Accounting and financial reporting practices not included in the Codification are nonauthoritative. Sources of nonauthoritative accounting guidance and literature include, for example, the following: a. Practices that are widely recognized and prevalent either generally or in the industry b. FASB Concepts Statements c. American Institute of Certified Public Accountants (AICPA) Issues Papers d. International Financial Reporting Standards of the International Accounting Standards Board e. Pronouncements of professional associations or regulatory agencies f. Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids g. Accounting textbooks, handbooks, and articles. The appropriateness of other sources of accounting guidance depends on its relevance to particular circumstances, the specificity of the guidance, the general recognition of the issuer or author as an authority, and the extent of its use in practice. 05-4 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 The Codification contains the authoritative standards that are applicable to both public nongovernmental entities and nonpublic nongovernmental entities. Content contained in the SEC Sections (designated by an “S” preceding the Section number) is provided for convenience and relates only to SEC registrants. The SEC Sections do not contain the entire population of SEC rules, regulations, interpretive releases, and staff guidance. Content in the SEC Sections is expected to change over time, and there may be delays between SEC and staff changes to guidance and Accounting Standards Updates. The Codification does not replace or affect guidance issued by the SEC or its staff for public entities in their filings with the SEC. 05-5 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 As of the effective date in paragraph 105-10-65-1(a), the FASB will not consider Accounting Standards Updates as authoritative in their own right. Instead, new Accounting Standards Updates will serve only to update the Codification, provide background information about the guidance, and provide the bases for conclusions on the change(s) in the Codification. Other than the standards listed in paragraph 105-1065-1(d), all nongrandfathered non-SEC accounting guidance not included in the Codification is superseded and deemed nonauthoritative. 05-6 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 The provisions of the Codification need not be applied to immaterial items. 105-10-10 Objectives General 10-1 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 The objective of this Topic is to establish the Financial Accounting Standards Board (FASB) Accounting Standards Codification™ as the source of authoritative principles and standards recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles (GAAP). Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. 10-2 26
Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 This Topic also identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP in the United States (the GAAP hierarchy). 105-10-15 Scope and Scope Exceptions General > Entities 15-1 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 The Financial Accounting Standards Board (FASB) Accounting Standards Codification™ applies to financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP). 15-2 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 Content in the Securities and Exchange Commission (SEC) Sections of the Codification is provided for convenience and relates only to financial statements of SEC registrants that are presented in conformity with GAAP. 105-10-20 Glossary Nongovernmental Entity Note: The following definition is Pending Content; see Transition Guidance in 105-10-65-1. An entity that is not required to issue financial reports in accordance with guidance promulgated by the Governmental Accounting Standards Board or the Federal Accounting Standards Advisory Board. Nonpublic Entity Note: The following definition is Pending Content; see Transition Guidance in 105-10-65-1. Any entity that does not meet any of the following conditions: a. Its debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally. b. It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets). c. It files with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market. d. It is required to file or furnish financial statements with the Securities and Exchange Commission. e. It is controlled by an entity covered by criteria (a) through (d).
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105-10-65 Transition and Open Effective Date Information General > Transition Related to FASB Statement No. 168, The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles 65-1 The following represents the transition and effective date information related to FASB Statement No. 168, The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles: a. The pending content that links to this paragraph shall be effective for financial statements issued for interim and annual periods ending after September 15, 2009. b. The Financial Accounting Standards Board (FASB) Accounting Standards Codification™ shall become the source of authoritative generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. c. As of the effective date stated in paragraph 105-10-65-1(a), all then-existing non-SEC accounting and reporting standards that had been included in levels (a) through (d) GAAP are superseded, except as noted in paragraph 105-10-65-1(d) and as described in Section 105-10-70. Concurrently, all nongrandfathered, non-SEC accounting literature not included in the Codification is deemed nonauthoritative. d. The following standards shall remain authoritative until such time that each is integrated into the Codification: 1. FASB Statement No. 164, Not-for-Profit Entities: Mergers and Acquisitions 2. FASB Statement No. 166, Accounting for Transfers of Financial Assets 3. FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R) 4. FASB Statement No. 168, The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles. e. Nonpublic nongovernmental entities that previously have not applied the guidance in the paragraphs listed below shall account for the adoption of that guidance as a change in accounting principle on a prospective basis for revenue arrangements entered into or materially modified in those fiscal years beginning on or after December 15, 2009, and interim periods within those years: 1. Paragraph 855-10-60-4 2. Paragraphs 985-605-15-3 through 15-4 3. Paragraphs 985-605-55-4 through 55-118 4. Paragraphs 985-605-55-186 through 55-203 28
5. Paragraphs 985-845-25-1 through 25-7 6. Paragraphs 985-845-55-1 through 55-8. f. The appropriate disclosures related to that adoption shall be made in accordance with Section 250-10-50. 105-10-70 Grandfathered Guidance General 70-1 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 Financial Accounting Standards Board (FASB) Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles, contained a description of the categories of the generally accepted accounting principles (GAAP) hierarchy that existed before the Codification. An entity that has followed, and continues to follow, an accounting treatment that was previously in category (c) or category (d) of that GAAP hierarchy as of March 15, 1992, need not change to an accounting treatment in a higher category ((b) or (c)) of that hierarchy if its effective date was before March 15, 1992. For example, a nongovernmental entity that followed a prevalent industry practice (category (d)) as of March 15, 1992, does not have to change to an accounting treatment included in a standard in category (b) or category (c) (such as an accounting principle in a cleared American Institute of Certified Public Accountants [AICPA] Statement of Position or Accounting Standards Executive Committee Practice Bulletin) whose effective date is before March 15, 1992. For standards whose effective date is after March 15, 1992, and for entities initially applying an accounting principle after March 15, 1992 (except for Emerging Issues Task Force consensus positions issued before March 16, 1992, which become effective in the hierarchy for initial application of an accounting principle after March 15, 1993), an entity shall follow guidance in the Codification. 70-2 Pending Content: Transition Date: September 15, 2009 Transition Guidance: 105-10-65-1 Certain accounting standards have allowed for the continued application of superseded accounting standards for transactions that have an ongoing effect in an entity’s financial statements. That superseded guidance has not been included in the Codification, shall be considered grandfathered, and shall continue to remain authoritative for those transactions after the effective date of FASB Statement No. 168, The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles. While not comprehensive, the following are examples of such grandfathered items: a. Pooling of interests in a business combination (originally addressed by APB Opinion No. 16, Business Combinations) described in paragraph B217 of FASB Statement No. 141, Business Combinations b. Pension transition assets or obligations described in paragraph 77 of FASB Statement No. 87, Employers’ Accounting for Pensions c. Employee stock ownership plan shares (originally addressed by AICPA Statement of Position 763, Accounting Practices for Certain Employee Stock Ownership Plans) purchased by, and held as of, December 31, 1992, as described in paragraphs 97 and 102 of AICPA Statement of Position 93-6, Employers’ Accounting for Employee Stock Ownership Plans
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d. Loans restructured in a troubled debt restructuring before the effective date of FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan, described in paragraph 24 of FASB Statement No. 118, Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures e. Stock compensation for nonpublic and other entities (originally addressed by FASB Statement No. 123, Accounting for Stock-Based Compensation, or APB Opinion No. 25, Accounting for Stock Issued to Employees) described in paragraph 83 of FASB Statement No. 123 (revised 2004), Share-Based Payment f. For nonpublic entities electing the deferral of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, FASB Statement No. 109, Accounting for Income Taxes, and related standards g. For business combinations with an acquisition date before the first annual reporting period beginning on or after December 15, 2008, Statement 141 and any other relevant standards h. For not-for-profit entities, pooling of interests as allowed for under Opinion 16, even though it has been superseded by Statement 141 until FASB Statement No. 164, Not-for-Profit Entities: Mergers and Acquisitions, is effective i. For goodwill and intangible assets arising from a combination between two or more not-for-profit entities or acquired in the acquisition of a for-profit business entity by a not-for-profit entity until Statement 164 is effective, Opinion 16 and APB Opinion No. 17, Intangible Assets. Room for Debate Debate 1-1 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 resultsofoperations. 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 that accountants, not government officials, best understand their role and how best to measure and report financial information. 30
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 inclinedto 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, eg., 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. 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 31
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. Case 1-8 The answer to this case requires an analysis of the financial statements of the three companies at the time it is assigned. Case 1-9 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 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. 2. 3.
b.
guiding the FASB in establishing accounting standards on a consistent basis. determining bounds for judgment in preparing financial statements by prescribing the nature, functions, and limits of financial accounting and reporting. increasing users understanding of and confidence in financial reporting.
Statement of Financial Accounting Concepts No. 2 identifies the most important quality for accounting information as usefulness for decision-making. Relevance and reliability 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.
Case 2-2. a. i.
The Conceptual Framework Project was 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 to be viewed not as a package of solutions to problems but rather as a common basis for 32
identifying and discussing issues, for asking relevant questions, and for suggesting avenues for research. The Conceptual Framework Project has resulted in the issuance of five statements of Financial Accounting Concepts that impact upon financial accounting: No.1-Objectives of Financial Reporting by Business Enterprises; No.2-Qualitative Characteristics of Accounting Information; No.3-Elements of Financial Statements of Business Enterprises; No.5-Recognition and Measurement in Financial Statements of Business Enterprises; No.6-Elements of Financial Statements and No. 7-“Using Cash Flow Information and Present Value in Accounting Measurements.” 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.
In recent years 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. 1.
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 (discussed later in the chapter).
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. 33
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.
b.
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 toconsequences 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’. ii. Similarly, SFAC No. 1 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. b. 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. c. 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, 34
to make more automobiles. The prior transaction that caused the asset to exist is the acquisition of the building. b. 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. c. 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 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. b. 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 2-7 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. Relevant information has predictive value, feedback value, and timeliness. The reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user that it has that representational quality. $42,000 represents the historical cost of the machine. It is reliable because it can be verified, because the value of the stock used to acquire it is readily determinable. However, the $50,000 appraisal value is more relevant because it measures what the asset is worth to the company, and thus to the investor. It measures what it would cost to replace the machine or to sell it. Case 2-8 35
a. 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 is 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. b. 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 820-10-55. It can be accessed through the glossary. 55-4 FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, provides guidance for using present value techniques to measure fair value. That guidance focuses on a traditional or discount rate adjustment technique and an expected cash flow (expected present value) technique. This Section clarifies that guidance. (That guidance is included or otherwise referred to principally in paragraphs 39–46, 51, 62–71, 114, and 115 of Concepts Statement 7.) This Section neither prescribes the use of one specific present value technique nor limits the use of present value techniques to measure fair value to the techniques discussed herein. The present value technique used to measure fair value will depend on facts and circumstances specific to the asset or liability being measured (for example, whether comparable assets or liabilities can be observed in the market) and the availability of sufficient data. > > > > The Components of a Present Value Measurement 55-5 A fair value measurement of an asset or liability, using present value should capture all of the following elements from the perspective of market participants as of the measurement date: a. An estimate of future cash flows for the asset or liability being measured. b.
Expectations about possible variations in the amount and/or timing of the cash flows representing the uncertainty inherent in the cash flows.
c. The time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows (risk-free interest rate). For present value computations denominated in nominal U.S. dollars, the yield curve for U.S. Treasury securities determines the appropriate risk-free interest rate. U.S. Treasury securities are deemed (default) risk free because they pose neither uncertainty in timing nor risk of default to the holder. d. The price for bearing the uncertainty inherent in the cash flows (risk premium). e. Other case-specific factors that would be considered by market participants.
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f.
In the case of a liability, the nonperformance risk relating to that liability, including the reporting entity’s (obligor’s) own credit risk. >>>>
a. b. c.
General Principles
55-6 Present value techniques differ in how they capture those elements. However, all of the following general principles govern the application of any present value technique: Cash flows and discount rates should reflect assumptions that market participants would use in pricing the asset or liability. Cash flows and discount rates should consider only factors attributed to the asset (or liability) being measured. To avoid double counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects expectations about future defaults is appropriate if using contractual cash flows of a loan (discount rate adjustment technique). That same rate would not be used if using expected (probability-weighted) cash flows (expected present value technique) because the expected cash flows already reflect assumptions about future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used. d. Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows (that include the effect of inflation) should be discounted at a rate that includes the effect of inflation. The nominal risk-free interest rate includes the effect of inflation. Real cash flows (that exclude the effect of inflation) should be discounted at a rate that excludes the effect of inflation. Similarly, after-tax cash flows should be discounted using an after-tax discount rate. Pretax cash flows should be discounted at a rate consistent with those cash flows (for example, a U.S. Treasury rate is quoted on a pretax basis, as is a London Interbank Offered Rate [LIBOR] or a prevailing term loan rate). e. Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.
> > > > Risk and Uncertainty 55-7 A fair value measurement, using present value, is made under conditions of uncertainty because the cash flows used are estimates rather than known amounts. In many cases, both the amount and timing of the cash flows will be uncertain. Even contractually fixed amounts, like the payments on a loan, will be uncertain if there is risk of default. 55-8 A fair value measurement should include a risk premium reflecting the amount market participants would demand because of the risk (uncertainty) in the cash flows. Otherwise, the measurement would not faithfully represent fair value. In some cases, determining the appropriate risk premium might be difficult. However, the degree of difficulty alone is not a sufficient basis on which to exclude a risk adjustment. 55-9 Present value techniques differ in how they adjust for risk and in the type of cash flows they use. For example: a. The discount rate adjustment technique uses a risk-adjusted discount rate and contractual, promised, or most likely cash flows. b. Method 1 of the expected present value technique uses a risk-free rate and risk-adjusted expected cash flows. c. Method 2 of the expected present value technique uses a risk-adjusted discount rate (which is different from the rate used in the discount rate adjustment technique) and expected cash flows. 37
FASB ASC 2-2 Search conceptual framework 605 Revenue Recognition 10 Overall S99 SEC Materials SEC Staff Guidance >>
Staff Accounting Bulletins
>>> S99-1
SAB Topic 13, Revenue Recognition The following is the text of SAB Topic 13, Revenue Recognition.
SAB Topic 13.A, Selected Revenue Issues SAB Topic 13.A.1, Revenue Recognition—General The accounting literature on revenue recognition includes both broad conceptual discussions as well as certain industry-specific guidance. FN1 If a transaction is within the scope of specific authoritative literature that provides revenue recognition guidance, that literature should be applied. However, in the absence of authoritative literature addressing a specific arrangement or a specific industry, the staff will consider the existing authoritative accounting standards as well as the broad revenue recognition criteria specified in the FASB's conceptual framework that contain basic guidelines for revenue recognition. FN1 The February 1999 AICPA publication "Audit Issues in Revenue Recognition" provides an overview of the authoritative accounting literature and auditing procedures for revenue recognition and identifies indicators of improper revenue recognition. Based on these guidelines, revenue should not be recognized until it is realized or realizable and earned. FN2 Concepts Statement 5, paragraph 83(b) states that "an entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues" [footnote reference omitted]. Paragraph 84(a) continues "the two conditions (being realized or realizable and being earned) are usually met by the time product or merchandise is delivered or services are rendered to customers, and revenues from manufacturing and selling activities and gains and losses from sales of other assets are commonly recognized at time of sale (usually meaning delivery)" [footnote reference omitted]. In addition, paragraph 84(d) states that "If services are rendered or rights to use assets extend continuously over time (for example, interest or rent), reliable measures based on contractual prices established in advance are commonly available, and revenues may be recognized as earned as time passes." FN2 Concepts Statement 5, paragraphs 83-84; ARB 43, Chapter 1A, paragraph 1 [paragraph 605-10-25-1]; and Opinion 10, paragraph 12 [paragraph 605-10-25-3]. The citations provided herein are not intended to present the complete population of citations where a particular criterion is relevant. Rather, the citations are intended to provide the reader with additional reference material.
38
The staff believes that revenue generally is realized or realizable and earned when all of the following criteria are met: Persuasive evidence of an arrangement exists, FN3 FN3 Concepts Statement 2, paragraph 63 states "Representational faithfulness is correspondence or agreement between a measure or description and the phenomenon it purports to represent." The staff believes that evidence of an exchange arrangement must exist to determine if the accounting treatment represents faithfully the transaction. See also SOP 97-2, paragraph 8 [paragraph 985-605-25-3]. The use of the term "arrangement" in this SAB Topic is meant to identify the final understanding between the parties as to the specific nature and terms of the agreed-upon transaction. Delivery has occurred or services have been rendered, FN4. FN4 Concepts Statement 5, paragraph 84(a), (b), and (d). Revenue should not be recognized until the seller has substantially accomplished what it must do pursuant to the terms of the arrangement, which usually occurs upon delivery or performance of the services. The seller's price to the buyer is fixed or determinable, FN5 and FN5 Concepts Statement 5, paragraph 83(a); Statement 48, paragraph 6(a) [paragraph 60515-25-1(a)]; SOP 97-2, paragraph 8 [paragraph 985-605-25-3]. SOP 97-2 [Subtopic 985605] defines a "fixed fee" as a "fee required to be paid at a set amount that is not subject to refund or adjustment. A fixed fee includes amounts designated as minimum royalties." Paragraphs 26-33 of SOP 97-2 [paragraphs 985-605-25-30 through 25-40] discuss how to apply the fixed or determinable fee criterion in software transactions. The staff believes that the guidance in paragraphs 26 and 30-33 [paragraphs 985-605-25-30 through 25-31 and 985605-25-36 through 25-40] is appropriate for other sales transactions where authoritative guidance does not otherwise exist. The staff notes that paragraphs 27 through 29 [paragraphs 985-605-25-33 through 25-35] specifically consider software transactions, however, the staff believes that guidance should be considered in other sales transactions in which the risk of technological obsolescence is high. Collectibility is reasonably assured. FN6 FN6 ARB 43, Chapter 1A, paragraph 1 [paragraph 605-10-25-3] and Opinion 10, paragraph 12. See also Concepts Statement 5, paragraph 84(g) and SOP 97-2, paragraph 8 [paragraph 985-605-25-3]. Some revenue arrangements contain multiple revenue-generating activities. The staff believes that the determination of the units of accounting within an arrangement should be made prior to the application of the guidance in this SAB Topic by reference to the applicable accounting literature. FASB ASC 2-3 Search decision maker 280 Segment Reporting > 10 Overall > 05 Overview and Background 05-1
The Segment Reporting Topic contains only the Overall Subtopic. 39
05-2 This Subtopic provides guidance to public business entities (referred to as public entities throughout this Subtopic) on how to report certain information about operating segments in complete sets of financial statements of the public entity and in condensed financial statements of interim periods issued to shareholders. It also requires that public entities report certain information about their products and services, the geographic areas in which they operate, and their major customers. 05-3 A public entity could provide complete sets of financial statements that are disaggregated in several different ways, for example, by products and services, by geography, by legal entity, or by type of customer. However, it is not feasible to provide all of that information in every set of financial statements. The guidance in this Subtopic requires that general-purpose financial statements include selected information reported on a single basis of segmentation. The method for determining what information to report is referred to as the management approach. The management approach is based on the way that management organizes the segments within the public entity for making operating decisions and assessing performance. Consequently, the segments are evident from the structure of the public entity's internal organization, and financial statement preparers should be able to provide the required information in a cost-effective and timely manner. 05-4 The management approach facilitates consistent descriptions of a public entity in its annual report and various other published information. It focuses on financial information that a public entity's decision makers use to make decisions about the public entity's operating matters. The components that management establishes for that purpose are called operating segments. 05-5 To provide some comparability between public entities, this Subtopic requires that an entity report certain information about the revenues that it derives from each of its products and services (or groups of similar products and services) and about the countries in which it earns revenues and holds assets, regardless of how the entity is organized. As a consequence, some entities are likely to be required to provide limited information that may not be used for making operating decisions and assessing performance. 350 Intangibles—Goodwill and Other > 20 Goodwill > 55 Implementation Guidance and Illustrations General Implementation Guidance 55-1 Determining whether a component of an operating segment is a reporting unit is a matter of judgment based on an entity's individual facts and circumstances. Although paragraphs 350-20-35-33 through 35-35 includes a number of characteristics that must be present for a component of an operating segment to be a reporting unit, no single factor or characteristic is determinative. How an entity manages its operations and how an acquired entity is integrated with the acquiring entity are key to determining the reporting units of the entity. 55-2 The characteristics identified in paragraphs 350-20-35-33 through 35-35 that must be present for a component to be a reporting unit are discussed in the following implementation guidance. > > The Component Constitutes a Business 55-3 The determination of whether a component constitutes a business requires judgment based on specific facts and circumstances. The guidance in Section 805-10-55 should be considered in determining whether a group of assets constitutes a business. The business must contain all of the inputs and processes necessary for it to continue to conduct normal operations after the transferred set is separated from the transferor. The fact that operating information (revenues and expenses) exists for a component of an operating segment does not mean that the component constitutes a business. For example, a component for which operating information is prepared might be a product line or a brand that is part of a business rather than a business itself. 40
Transition Date: December 15, 2008 Transition Guidance: 805-10-65-1 The determination of whether a component constitutes a business requires judgment based on specific facts and circumstances. The guidance in Section 805-10-55 should be considered in determining whether a group of assets constitutes a business. Transition Date: December 15, 2009 Transition Guidance: 350-10-65-1 The determination of whether a component constitutes a business or a nonprofit activity requires judgment based on specific facts and circumstances. The guidance in Section 805-10-55 should be considered in determining whether a group of assets constitutes a business or a nonprofit activity. > > Discrete Financial Information 55-4 The term discrete financial information should be applied in the same manner that it is applied in determining operating segments in accordance with paragraph 280-10-50-1. That guidance indicates that it is not necessary that assets be allocated for a component to be considered an operating segment (that is, no balance sheet is required). Thus, discrete financial information can constitute as little as operating information. Therefore, in order to test goodwill for impairment in accordance with this Subtopic, an entity may be required to assign assets and liabilities to reporting units (consistent with the guidance in paragraphs 350-20-35-39 through 35-40). > > Reviewed by Segment Management 55-5 Segment management, as defined in paragraphs 280-10-50-7 through 50-8, is either a level below or the same level as the chief operating decision maker. According to Topic 280, a segment manager is directly accountable to and maintains regular contact with the chief operating decision maker to discuss operating activities, financial results, forecasts, or plans for the segment. The approach used in this Subtopic to determine reporting units is similar to the one used to determine operating segments ; however, this Subtopic focuses on how operating segments are managed rather than how the entity as a whole is managed; that is, reporting units should reflect the way an entity manages its operations. > > Similar Economic Characteristics 55-6 Evaluating whether two components have similar economic characteristics is a matter of judgment that depends on specific facts and circumstances. That assessment should be more qualitative than quantitative. 55-7 In determining whether the components of an operating segment have similar economic characteristics, all of the factors in paragraph 280-10-50-11 should be considered. However, every factor need not be met in order for two components to be considered economically similar. In addition, the determination of whether two components are economically similar need not be limited to consideration of the factors described in that paragraph. In determining whether components should be combined into one reporting unit based on their economic similarities, factors that should be considered in addition to those in that paragraph include but are not limited to, the following: a. The manner in which an entity operates its business and the nature of those operations b. Whether goodwill is recoverable from the separate operations of each component business or from two or more component businesses working in concert (which might be the case if the components are economically interdependent) c. The extent to which the component businesses share assets and other resources, as might be evidenced by extensive transfer pricing mechanisms 41
d. Whether the components support and benefit from common research and development projects. The fact that a component extensively shares assets and other resources with other components of the operating segment may be an indication that the component either is not a business or may be economically similar to those other components. Transition Date: December 15, 2009 Transition Guidance: 350-10-65-1 In determining whether the components of an operating segment have similar economic characteristics, all of the factors in paragraph 280-10-50-11 should be considered. However, every factor need not be met in order for two components to be considered economically similar. In addition, the determination of whether two components are economically similar need not be limited to consideration of the factors described in that paragraph. In determining whether components should be combined into one reporting unit based on their economic similarities, factors that should be considered in addition to those in that paragraph include but are not limited to, the following: a. The manner in which an entity operates its business or nonprofit activity and the nature of those operations b. Whether goodwill is recoverable from the separate operations of each component business (or nonprofit activity) or from two or more component businesses (or nonprofit activities) working in concert (which might be the case if the components are economically interdependent) c. The extent to which the component businesses (or nonprofit activities) share assets and other resources, as might be evidenced by extensive transfer pricing mechanisms d. Whether the components support and benefit from common research and development projects. The fact that a component extensively shares assets and other resources with other components of the operating segment may be an indication that the component either is not a business or nonprofit activity or it may be economically similar to those other components. 55-8 Components that share similar economic characteristics but relate to different operating segments may not be combined into a single reporting unit. For example, an entity might have organized its operating segments on a geographic basis. If its three operating segments (Americas, Europe, and Asia) each have two components (A and B) that are dissimilar to each other but similar to the corresponding components in the other operating segments, the entity would not be permitted to combine component A from each of the operating segments to make reporting unit A. > > Operating Segments that May Be Economically Dissimilar that Are Aggregated Into a Reportable Segment 55-9 If two operating segments have been aggregated into a reportable segment by applying the aggregation criteria in paragraph 280-10-50-11, it would be possible for one or more of those components to be economically dissimilar from the other components and thus be a reporting unit for purposes of testing goodwill for impairment. That situation might occur if an entity's operating segments are based on geographic areas. The following points need to be considered in addressing this circumstance: a. The determination of reporting units under this Subtopic begins with the definition of an operating segment in paragraph 280-10-50-1 and considers disaggregating that operating segment into economically dissimilar components for the purpose of testing goodwill for impairment. The determination of reportable segments under Topic 280 also begins with an operating segment, but considers whether certain economically similar operating segments should be aggregated into a single operating segment or into a reportable segment. 42
b. The level at which operating performance is reviewed differs between this Subtopic and Topic 280 . It is the chief operating decision maker who reviews operating segments and the segment manager who reviews reporting units (components of operating segments). Therefore, a component of an operating segment would not be considered an operating segment for purposes of that Topic unless the chief operating decision maker regularly reviews its operating performance; however, that same component might be a reporting unit under this Subtopic if a segment manager regularly reviews its operating performance (and if other reporting unit criteria are met). FASB ASC 2-4 Search understandability 715 compensation—Retirement Benefits > 10 Overall > 10 Objectives The objectives of this Topic are as follows: a. To enhance the relevance and representational faithfulness of the employer's reported results of operations by recognizing net periodic pension cost and net periodic other postretirement benefit cost as employees render the services necessary to earn their pension and other postretirement benefits b. To enhance the relevance and representational faithfulness of the employer's statement of financial position by including a measure of the obligation to provide pension and other postretirement benefits based on a mutual understanding between the employer and its employees of the terms of the underlying plan c. To enhance the ability of users of the employer's financial statements to understand the extent and effects of the employer's undertaking to provide pension and other postretirement benefits to its employees by disclosing relevant information about the obligation and cost of the pension and other postretirement benefit plans and how those amounts are measured d. To improve the understandability and comparability of amounts reported by requiring employers with similar plans to use the same method to measure their pension and other postretirement benefit obligations and the related costs of the postretirement benefits. FASB ASC 2-5 805 Business Combinations > 10 Overall > 10 Objectives 10-1 Transition Date: December 15, 2008 Transition Guidance: 805-10-65-1 The objective of the Subtopics in this Topic that address business combinations is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. 715 compensation—Retirement Benefits > 10 Overall > 10 Objectives The objectives of this Topic are as follows: a. To enhance the relevance and representational faithfulness of the employer's reported results of operations by recognizing net periodic pension cost and net periodic other postretirement benefit 43
cost as employees render the services necessary to earn their pension and other postretirement benefits b. To enhance the relevance and representational faithfulness of the employer's statement of financial position by including a measure of the obligation to provide pension and other postretirement benefits based on a mutual understanding between the employer and its employees of the terms of the underlying plan FASB ASC 2-6 Search recognition and measurement-over 70 hits FASB ASC 2-7 Reporting Comprehensive Income is contained in sections FASB ASC 220-10-45. It is found by searching comprehensive income. 45-1 This Subtopic requires that all items that meet the definition of components of comprehensive income be reported in a financial statement for the period in which they are recognized. 45-2 This Subtopic requires that changes in the balances of items that are reported directly in a separate component of equity in a statement of financial position shall be reported in a financial statement that is displayed as prominently as other financial statements. 45-3 A full set of financial statements for a period should show: financial position at the end of the period, earnings (net income) for the period, comprehensive income (total nonowner changes in equity) for the period, cash flows during the period, and investments by and distributions to owners during the period. 45-4 This Subtopic does not require that an entity use the terms comprehensive income or other comprehensive income in its financial statements, even though those terms are used throughout this Subtopic. 45-5 All components of comprehensive income shall be reported in the financial statements in the period in which they are recognized. A total amount for comprehensive income shall be displayed in the financial statement where the components of other comprehensive income are reported. Transition Date: December 15, 2008 Transition Guidance: 810-10-65-1 All components of comprehensive income shall be reported in the financial statements in the period in which they are recognized. A total amount for comprehensive income shall be displayed in the financial statement where the components of other comprehensive income are reported. Paragraph 810-10-501A(a) states that, if an entity has an outstanding noncontrolling interest (minority interest), amounts for both comprehensive income attributable to the parent and comprehensive income attributable to the noncontrolling interest in a less-than-wholly-owned subsidiary are reported on the face of the financial statement in which comprehensive income is presented in addition to presenting consolidated comprehensive income. FASB ASC 2-8 Search present value-over 100 hits Room for Debate Debate 2-1 44
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.
2.
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.
3.
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 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. Reliability 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 is 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/benefit 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 45
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. 1.
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.
2.
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. 46
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: 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 Nos. 1 and 2 can be described as the goals 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. 47
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 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-10 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-11 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-12 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 48
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: 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 2-13 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 two Boards pledged to use their best efforts to (a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) to coordinate their future work programs to ensure that once achieved, compatibility is maintained. To achieve compatibility, the Boards agreed to: a) undertake a short-term project aimed at removing a variety of individual differences between U.S. GAAP and International Financial Reporting Standards (IFRSs, discussed in Chapter 3), b) remove other differences between IFRSs and U.S. GAAP that remain at January 1, 2005, through coordination of their future work programs; that is, through the mutual undertaking of discrete, substantial projects which both Boards would address concurrently; c) continue progress on the joint projects that they are currently undertaking; and, d) encourage their respective interpretative bodies to coordinate their activities. In a Memorandum of Understanding the Boards agreed: 1. To commit the necessary resources to complete such a major undertaking. 2. To quickly commence deliberating differences identified for resolution in the short-term project with the objective of achieving compatibility by identifying common, high-quality solutions. 3. To use their best efforts to issue an exposure draft of proposed changes to U.S. GAAP or IFRSs that reflect common solutions to some, and perhaps all, of the differences identified for inclusion in the short term project during 2003. Later, at another joint meeting in October 2004, the boards decided to add to their agendas a joint project to develop an improved and common conceptual framework that is based on and builds on their existing frameworks; that is, the IASB’s framework For The Preparation And Presentation of Financial Statements (discussed in chapter 3 and the FASB’s conceptual framework :project The project will: 1. Focus 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. Give priority to addressing and deliberating those issues within each phase that are 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. Thus, work on several phases of the project will be conducted simultaneously and the Boards expect to benefit from work being conducted on other projects 49
3. Initially consider concepts applicable to private sector business entities. Later, the Boards will jointly consider the applicability of those concepts to private sector not-for-profit organizations. Representatives of public sector (governmental) standard-setting Boards are monitoring the project and, in some cases, are considering what the consequences of private sector deliberations might be for public sector entities. The Boards plan to conduct the joint project in eight phases. Each of the first seven phases (A through G) are expected to involve planning, research, and initial Board deliberations on major aspects of the Boards’ frameworks and to result in an initial document that will seek comments on the Boards’ tentative decisions for that phase. This will be followed by a period of redeliberations—the Boards’ consideration of constituents’ comments and redeliberations of the tentative decisions. While the Boards may seek comments on each phase separately they have not precluded seeking comments on several phases concurrently. An eighth phase will be used to address any remaining issues. The Boards are conducting the project in eight phases as follows: A. Objectives and qualitative characteristics B. Elements and recognition C. Measurement D. Reporting entity E. Presentation and disclosure F. Framework purpose G. Applicability to the not-for-profit sector H. Remaining In February, 2006, the two Boards reaffirmed their commitment to this process in a Memorandum of Understanding (MOU) and voiced the shared objective of developing high quality, common accounting standards for use in the world’s capital markets. The MOU outlines a “roadmap” for the elimination of the reconciliation requirement for non-US companies that use IFRSs and are registered in the United States (discussed in Chapter 3). The MOU maintaines that trying to eliminate differences between standards is not the best use of resources; rather new common standards should be developed. Convergence will proceed as follows: First, the Boards will reach a conclusion about whether major differences in focused areas should be eliminated through one or more short-term standard-setting projects, and, if so, the goal is to complete or substantially complete work in those areas by 2008. Second, the FASB and the IASB will seek to make continued progress in other areas identified by both Boards where accounting practices under U. S. GAAP and IFRSs are regarded as candidates for improvement. In July, 2006, the first publication from the joint conceptual project was released. This document titled “Preliminary Views Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information,” is quite similar to SFAC No’s 1 and 2. The introduction to Preliminary Views notes that the Boards’ existing frameworks differ in their authoritative status. For companies preparing financial statements under IFRSs, management is expressly required to consider the IASB’s Framework for the Preparation and Presentation of Financial Statements if no standard or interpretation specifically applies or deals with a similar and related issue. In contrast, the FASB’s SFACs have a lower standing in the hierarchy of GAAP in the United States, and entities are not required to consider those concepts when preparing financial statements. However, the GAAP hierarchy in the United States is under reconsideration. The Boards have deferred consideration 50
of how to accommodate any differences in the authoritative standing of the conceptual framework in their jurisdictions until that reconsideration is complete. In Chapter 1 of Preliminary Views, the basic objective of external financial is defined as providing information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions. To help achieve its objective, financial reporting should provide information to help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity’s future cash inflows and outflows (the entity’s future cash flows). That information is essential in assessing an entity’s ability to generate net cash inflows and thus to provide returns to investors and creditors. Additionally, to help present and potential investors and creditors and others in assessing an entity’s ability to generate net cash inflows, financial reporting should provide information about the economic resources of the entity (its assets) and the claims to those resources (its liabilities and equity). Information about the effects of transactions and other events and circumstances that change resources and claims to them is also essential. Chapter 2 defines the qualities of decision-useful financial reporting information as relevance, faithful representation, comparability, and understandability. These qualities are subject to the two pervasive constraints of materiality and benefits that justify costs. The comment period for this document ended November 6, 2006 and the two Boards hope to have a final document published in 2007. Case 2-14 The purpose of the financial statement presentation project is to establish a standard that will guide the organization
and presentation of information in the financial statements. The boards’ goal is to improve the usefulness of the information provided in an entity’s financial statements to help users make decisions in their capacity as capital providers Accordingly, as a part of the Norwalk Agreement, the FASB and IASB committed to (1) undertake a short-term project aimed at removing a variety of individual differences between U.S. GAAP and International Financial Reporting Standards (IFRSs, discussed in Chapter 3); (2) remove other differences between IFRSs and U.S. GAAP that remained at January 1, 2005, through coordination of their future work programs; that is, through the mutual undertaking of discrete, substantial projects that both Boards would address concurrently; (3) continue progress on the joint projects that they are currently undertaking; and (4) encourage their respective interpretative bodies to coordinate their activities. The goal is to present information in individual financial statements (and among financial statements) in ways that improve the ability of investors, creditors, and other financial statement users to: 1. Understand an entity’s present and past financial position. 2. Understand the past operating, financing, and other activities that caused an entity’s financial position to change and the components of those changes. 3. Use that financial statement information, along with information from other sources, to assess the amounts, timing, and uncertainty of an entity’s future cash flows. The project is being conducted in three phases Phase A addresses what constitutes a complete set of financial statements and requirements to present comparative information. Phase B addresses the more fundamental issues for presentation of information on the face of the financial statements, including: 51
1. Developing principles for aggregating and disaggregating information in each financial statement. 2. Defining the totals and subtotals to be reported in each financial statement (which might include categories such as business and financing). 3. Deciding whether components of other comprehensive income/other recognized income and expense should be recycled to profit or loss and, if so, the characteristics of the transactions and events that should be recycled and when recycling should occur. 4. Reconsidering SFAS No. 95, “Statement of Cash Flows,” and IAS 7, Cash Flow Statements, including whether to require the use of the direct or indirect method. Some preliminary decisions regarding the presentation of the financial statements have been published by the FASB. These decisions are discussed and illustrated in Chapter 6 and 7. Phase C addresses the presentation and display of interim financial information in U.S. GAAP, including: 1. Which financial statements, if any, should be required to be presented in an interim financial report. 2. Whether financial statements required in an interim financial report should be allowed to be presented in a condensed format, and if so, whether guidance should be provided related on how the information may be condensed. 3. What comparative periods, if any, should be required to be allowed in interim financial reports and when, if ever, should 12 month-to-date financial statements be required or allowed to be presented in interim financial reports. 4. Whether guidance for nonpublic companies should differ from guidance for public companies. The boards completed their deliberations on Phase A in December 2005. On March 16, 2006, the IASB published its Phase A exposure draft, “Proposed Amendments to IAS 1 Presentation of Financial Statements: A Revised Presentation.” The FASB decided to consider phases A and B issues together and, therefore, did not publish an exposure draft on phase A. After considering the responses to its exposure draft, the IASB issued a revised version of IAS No. 1 in September 2007 (See Chapter 3 for a discussion of IAS No. 1). The revisions to IAS No. 1 affected the presentation of changes in equity and the presentation of comprehensive income, bringing IAS No. 1 largely into line with FASB Statement No. 130, Reporting Comprehensive Income (FASB ASC 220). Previously, in February 2006, the two Boards reaffirmed their commitment to the process of convergence in a Memorandum of Understanding (MOU) and voiced the shared objective of developing high-quality, common accounting standards for use in the world’s capital markets. The MOU outlines a “roadmap” for the elimination of the reconciliation requirement for non-U.S. companies that use IFRSs and are registered in the United States (discussed in Chapter 3). The MOU maintains that trying to eliminate differences between standards is not the best use of resources; rather, new common standards should be developed. Convergence will proceed as follows: First, the Boards will reach a conclusion about whether major differences in focused areas should be eliminated through one or more short-term standard-setting projects, and, if so, the goal was to complete or substantially complete work in those areas by 2008. Second, the FASB and the IASB will seek to make continued progress in other areas identified by both Boards where accounting practices under U.S. GAAP and IFRSs are regarded as candidates for improvement. In an effort to comply with the goals of the Norwalk Agreement the FASB issued four new statements to bring U. S. GAAP into consistency with IFRSs (SFAS No.151(Superseded), SFAS No. 153 (Superseded), SFAS No. 154 (FASB ASC 250-10) and SFAS No. 163 (FASB ASC 944). Additionally, it issued a revised SFAS No. 141(FASB ASC 805). The IASB published new standards 52
on borrowing costs (IAS No. 23 revised) and segment reporting (IFRS No. 8). Each of these new or revised statements are discussed under the relevant topics later in the text. Phase B is being conducted with the following principles in mind: Financial statements should present information in a manner that: 1. 2. 3. 4.
Portrays a cohesive financial picture of an entity. Separates an entity’s financing activities from its business and other activities. Helps a user access the liquidity of an entity’s assets and liabilities. Disaggregates line items if that disaggregation enhances the usefulness of that information in predicting future cash flows. 5. Helps a user understand: • how assets and liabilities are measured • the uncertainty and subjectivity in measurements of individual assets and liabilities • what causes a change in reported amounts of individual assets and liabilities The project has adopted cohesiveness as a standard for assessing its ability to attain these principles. That is, each financial statement should contain the same sections and categories, and the classification of assets and liabilities will drive the classification of the related changes in the statement of cash flows and comprehensive income statements. This is expected to obtain more clarity in the relationships between statements and to facilitate financial analysis. The Statements of Comprehensive Income, Financial Position, and Cash Flows will each contain a Business Section, which will report operating activities and investing activities of the specific statement. For example, the Statement of Comprehensive Income’s Business Section will contain operating income and expenses as well as investing income and expenses; the Statement of Financial Position’s Business Section will report operating assets and liabilities and investing assets and liabilities. In addition to the Business Section, in three of the four statements (excluding the Changes in Equity Statement), a Financing Section is provided as well as a section on taxes and discontinued operations (net of taxes).Each financial statement will contain the following two primary sections: (1) business, and (2) financing. The following guidelines were adopted for displaying the items in each section: 1. The business section should have two defined categories: operating and investing. These categories require an entity to make a distinction between business activities that are part of an entity’s day-to-day business activities (and the business activity generates revenue through a process that requires the interrelated use of the net resources of the entity) [operating category] and business activities that generate non-revenue income (and no significant synergies are created from combining assets) [investing category]. 2. The financing section will include items that are part of an entity’s activities to obtain (or repay) capital and consist of two categories: debt and equity (a change from their decisions in September). a. The debt category will include liabilities where the nature of those liabilities is a borrowing arrangement entered into for the purpose of raising (or repaying) capital. b. The equity category will include equity as defined in either IFRS or U.S. GAAP Case 2-15 53
a. The goal of the CFP is to create a sound foundation for future accounting standards that are principles-based, internally consistent and internationally converged. 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 H. Remaining issues, if any. The objectives and summary of the decisions reached for each phase of the project at the time this text was published are outlined in the following paragraphs. Objectives and Qualitative Characteristics Phase The aim of the Objectives and Qualitative Characteristics phase of Financial Reporting is to consider: • The objective of financial reporting • The qualitative characteristics of financial reporting information • The trade-offs among qualitative characteristics and how they relate to the concepts of materiality and cost-benefit relationships. In July 2006, the first publication from the CFP was released. This document, that addressed Phase A of the CFP was titled “Preliminary Views Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information,” (PV) and is quite similar to SFAC No. 1 and 2. Finally, in May 2008, the FASB and IASB jointly published an exposure draft (ED) of Chapters I and 2 of the CFP. This document updated PV to reflect the comments received on the initial document and stated: The Conceptual Framework for Financial Reporting establishes the concepts that underlie financial reporting. The framework is a coherent system of concepts that flow from an objective. The objective of financial reporting is the foundation of the framework. The other concepts provide guidance on identifying the boundaries of financial reporting; selecting the transactions, other events, and circumstances to be represented; how they should be recognized, measured, and disclosed; and how they should be summarized and communicated in financial reports. The ED indicated that he objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. Capital providers were defined the primary users of financial reporting. The ED also indicated that in order to accomplish the defined objective, financial reports should communicate information about an entity’s economic resources, claims to those resources, and the transactions and other events and circumstances that change them. The ED noted that the degree to which that financial information is useful will depend on its qualitative characteristics. Qualitative characteristics were defined as the attributes that make 54
financial reporting information useful. Additionally, the qualitative characteristics were defined as complementary concepts that each contribute to the usefulness of financial reporting information. The exposure draft maintains that two fundamental qualitative characteristics relevance and faithful representation distinguish useful financial reporting information from information that is not useful or is misleading. Relevant information was seen as capable of making a difference in decision making by virtue of its predictive or confirmatory value. Financial reporting information is viewed as faithfully representative if it depicts the substance of an economic phenomenon completely, neutrally, and without material error. The ED suggests that financial reporting information may have varying degrees of usefulness to different capital providers and that certain enhancing qualitative characteristics (EQCs) distinguish more useful information from less useful information. These EQCs augment the decision usefulness of financial reporting information that is relevant and faithfully represented. The EQCs were defined as comparability, verifiability, timeliness, and understandability. The ED maintains that these enhancing qualitative characteristics should be maximized to the extent possible. Nevertheless, the Boards maintained that the EQCs, either individually or in concert with each other, cannot make information useful for decisions if that information is irrelevant or not faithfully represented. The enhancing qualitative characteristics were defined as follows: 1. Comparable information enables users to identify similarities in and differences between two sets of economic phenomena. 2. Verifiable information lends credibility to the assertion that financial reporting information represents the economic phenomena that it purports to represent. 3. Timeliness provides information to decision makers when it has the capacity to influence decisions. 4. Understandability is the quality of information that enables users to comprehend its meaning. Finally, the ED maintains that providing useful financial reporting information is limited by two pervasive constraints, materiality and cost. Information was defined as material if its omission or misstatement could influence the decisions that users make on the basis of an entity’s financial information. With respect to cost, the ED indicates that he benefits of providing financial reporting information should justify the costs of providing that information. Definitions of Elements, Recognition and Derecognition Phase The objectives of the Elements and Recognition phase are to refine and converge the Boards’ frameworks in the following manner: 1. Revise and clarify the definitions of asset and liability. – The Boards have agreed that the FASB and IASB definitions of these elements have several shortcomings and have tentatively agreed on the following working definitions: a. An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have. b. A liability of an entity is a present economic obligation for which the entity is the obligor. 2. Resolve differences regarding other elements and their definitions. - The FASB Concepts Statements presently identify more elements than does the IASB Framework, and the two frameworks define differently those elements that are common. The Boards’ approach will focus initially on converging and defining only those key elements that are defined today in the FASB and IASB Frameworks. As well, the Boards will need to consider the extent to which, and if so how, to define elements that are not currently defined, such as comprehensive income. 55
3. Revise the recognition criteria concepts to eliminate differences and provide a basis for resolving issues such as derecognition and unit of account. - Each Board’s current framework describes specific recognition criteria, some of which are similar and some of which are different. Neither Board's frameworks contain criteria to determine when an item should be derecognized. The Boards plan to revise their recognition criteria concepts to eliminate those differences and provide a framework for resolving derecognition issues. The Boards' current frameworks provide little or no guidance on how the unit of account should be determined. A Discussion Paper is expected to be issued late in 2010. Measurement Phase The objective of the Measurement phase is to provide guidance for selecting measurement bases that satisfy the objectives and qualitative characteristics of financial reporting. It consists of the following three “milestones:” • • •
Milestone I will inventory and defines a list of measurement basis candidates that might be used as a basis for measurement on financial statements; Milestone II will evaluate the basis candidates identified in Milestone I; and Milestone III will draw conceptual conclusions from Milestones I and II while addressing practical issues.
During its deliberations of Milestone I, the Boards addressed the following five issues: 1. What are the measurement basis candidates? The Boards agreed to a list of nine candidates: past entry price, past exit price, modified past amount, current entry price, current exit price, current equilibrium price, value in use, future entry price, and future exit price. 2. How are the measurement bases defined? The Boards agreed to provide two definitions for each candidate—one from the perspective of an asset and one from the perspective of a liability. They further decided to focus on the concepts behind entry and exit prices, without respect to the way they are measured. 3. What are the basic properties of the measurement bases? The Boards concluded that most candidates are either prices or values, and that each candidate provides information primarily about a specific time frame. 4. Are the measurement issues appropriate for both assets and liabilities? The Boards concluded that all the candidates were appropriate for use with assets and liabilities 5. Should any measurement basis candidates be eliminated from consideration for evaluation in Milestone II? The Boards agreed not to eliminate any of the nine candidates identified at the end of Milestone I. However, they did eliminate some other candidates in the earlier stages of Milestone I deliberations. A discussion paper is expected to be released in 2010. Reporting Entity Concept Phase The objective of the Reporting Entity phase is to determine what constitutes a reporting entity for the purposes of financial reporting. The FASB has authorized its staff to prepare an exposure draft. The IASB had not formally addressed this issue at the time this text was published but a final draft is expected by the end of 2010. Boundaries of Financial Reporting, and Presentation and Disclosure Phase 56
An objective of the Presentation and Disclosure, including Financial Reporting Boundaries phase is to determine the concepts underlying the display and disclosure of financial information, including the boundaries of such information that will achieve the objective of general purpose financial reporting. This phase is currently inactive. The Boards have not yet deliberated or made decisions regarding concepts for financial presentation and disclosure of financial information. Purpose and Status of the Framework Phase The objective of the Purpose and Status of the Framework phase, is to consider the framework’s authoritative status in GAAP Hierarchy. The goal is to develop a framework that is of comparable authority for the use of both Boards in the standard-setting process. At present, there are differences in the status of the Boards’ existing frameworks. For an entity preparing financial statements under International Financial Reporting Standards, the IASB’s Framework provides guidance when there is no standard or interpretation that specifically applies to a transaction or other event or condition, or that deals with a similar and related issue. In those situations, the entity’s management is required to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. Under US GAAP, the FASB’s Concepts Statements have a much lower status— they are ranked no higher than accounting textbooks, handbooks, and articles, and below widely recognized and prevalent general or industry practices. The FASB has decided that the authoritative status of the framework within the US GAAP hierarchy should be considered once the framework is more substantially complete. However, for the purposes of providing comments on documents issued by the Boards, respondents will be asked to assume that the framework’s authoritative status will be elevated in the US GAAP hierarchy to have a status comparable to the IASB’s current Framework. The FASB and the IASB agreed that each Board, within the context of its current GAAP hierarchy, will finalize the common framework as parts are completed and that later parts may include consequential amendments to earlier parts. The Boards noted that the decision of how to finalize the joint framework may need to be readdressed when the Boards discuss the placement of the framework within the IASB and FASB hierarchies. This phase of the Conceptual Framework Project is currently inactive. Application of the Framework to Not-For-Profit Entities Phase The objective of this phase of the Conceptual Framework Project is to consider the applicability of the concepts developed in earlier phases to not-for-profit entities in the private sector. This phase is currently inactive. The Boards have not yet deliberated or made decisions regarding the applicability of particular concepts to not-for-profit entities. Remaining Issues, If Any Phase The objective of the Remaining Issues phase is to consider remaining issues that have not been addressed by the previous seven phases. This phase is currently inactive. The Boards will not deliberate or make decisions regarding final issues until the first seven phases are complete. Financial Analysis Case The solutions to the financial analysis depend upon the company and year selected.
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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 or 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. 2. 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. 3. 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. 58
4. 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 countries 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. 5. 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. 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 t \o develop worldwide accounting standards.
b.
The IASC standards are currently used by over 12,000 companies from approximately 113 countries. 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.
Case 3-4 a.
The IASC’s 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. Understandability - Information should be provided so that individuals with a reasonable knowledge of business and economic activities and accounting and an willingness to study the information are capable of using it. Never-the-less, complex information should not be withheld because it is too difficult for some users to understand. Relevance - Information is relevant when it influences the economic decisions of users by helping them evaluate past present or future events or by confirming or correcting their past evaluations. Relevance is also affected by materiality. Reliability - Information is reliable when it is free from material error and bias and can be depended upon by users to represent faithfully that which it purports to represent. As a consequence, events should be accounted for and presented in accordance with their substance and economic reality not merely their legal form. Comparability - Users must be able to compare an enterprise's performance over time, and to make comparisons with the performance of other enterprises. 59
The framework also recognized that timeliness and the balance between benefits and costs were constraints on providing both relevant and reliable information. b.
The qualitative characteristics identified by the FASB Conceptual Framework in SFAC No. 2 were described as a hierarchy of accounting qualities. As such they were more specific than those identified by the IASC.
Case 3-5 a.
SFAC 2 defines comparability as the quality or state of having certain characteristics in common. It is the quality of the relationship between two or more pieces of information. 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. 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. 2, representational faithfulness 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 60
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. 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 3-6 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.
b.
According to SFAC No. 2, 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, resulting in lower reported profits and lower asset values that Honda and Daimler-Benz. 61
FASB ASC 3-1 Search “International accounting standards” 105-10-05 The following guidance eis provided and since IASB standards are not included they are not presently considered GAAP This Topic establishes the Financial Accounting Standards Board (FASB) Accounting Standards Codification™ (Codification) as the source of authoritative generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. In addition to the SEC’s rules and interpretive releases, the SEC staff issues Staff Accounting Bulletins that represent practices followed by the staff in administering SEC disclosure requirements, and it utilizes SEC Staff Announcements and Observer comments made at Emerging Issues Task Force meetings to publicly announce its views on certain accounting issues for SEC registrants.
FASB ASC 3-2 Information on stock compensation is contained in FASB ASC 718-10. It is accessed through the expense topic field. 10-1 The objective of accounting for transactions under share-based payment arrangements with employees is to recognize in the financial statements the employee services received in exchange for equity instruments issued or liabilities incurred and the related cost to the entity as those services are consumed. This Topic uses the terms compensation and payment in their broadest senses to refer to the consideration paid for employee services. 10-2 This Topic requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Topic establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee stock ownership plans. Room for Debate Debate 3-1 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 62
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 statue 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 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 3-7 a. The roadmap attempts to address the issue of comparability. b. The following seven milestones are contained in the roadmap: 1. Improvements to accounting standards - whether the standards are high in quality and sufficiently comprehensive, whether the standard-setting process is robust and independent with input and consideration of views from investors and other affected parties, and whether the standards, when implemented, are capable of improving the effectiveness of financial reporting and providing financial information useful to investors 2. Funding of the International Accounting Standards Committee Foundation - the SEC will consider the degree to which the Foundation has a secure, stable, and equitable funding mechanism that allows the IASB to function independently of any specific constituent group 3. The SEC would also consider how effectively regulators oversee the Foundation. 4. Improved ability to use interactive data for IFRS reporting - the SEC has proposed rules that would require public companies to provide financial information formatted in the XBRL 63
computer language. The level of detail in the existing IFRS XBRL taxonomy would have to be improved, according to the proposal, in order to realize the benefits of IFRS reporting in XBRL. 5. Improved education and training in the US - a significant investment in preparing investors, management and financial-statement preparers, auditors, audit committees, specialists (such as actuaries and valuation professionals), and regulators would be needed before IFRS is widely understood in the U.S. College and university curricula would need to incorporate IFRS, and the CPA and other relevant professional exams would need to cover IFRS. 1. Limited use in a narrow group of companies (i.e. December 31, 2009) 2. SEC to determine in 2011 whether mandatory adoption of IFRS is feasible based on the
progress in the first five milestones 3. Mandatory use – If decided to go full steam ahead (as discussed in milestone 6) then large
accelerated, accelerated and non-accelerated filers would be required to adopt IFRS beginning with their years ending on or after December 15, 2014, 2015 and 2016, respectively. Case 3-8 a.
The SEC’s rationale for this decision was to foster the adoption of a set of globally accepted accounting standards.
b.
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. The committee noted the following points in support of its conclusion: 1.
2.
3.
4.
5.
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. 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. 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 cross-border implementation practices. 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. Differential implementation of standards across countries and differential enforcement efforts directed toward domestic and cross-listed firms creates differences in financial 64
6.
7.
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. 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. 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 3-9 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, 65
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: 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.
b.
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.
c.
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. According to this 66
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 Semi-strong form Strong form -
Available information consists of past price history of the security. Available information includes past price history and all other publicly available information. Past price history, all publicly available information and insider information.
Case 4-3 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 4-4 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 4-5 67
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. 2. 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. 3. 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 4-6 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 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.
c.
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: 68
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 4-7 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. 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 pay-as-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.
c.
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.
d.
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 4-8 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 69
represent claims to resources. According to SFAC No. 1 claims to resources are relevant for user decision making. 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 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.
c.
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.
FASB ASC 4-1 Employee Stock Options Information on stock compensation is contained in FASB ASC 718-10. It is accessed through the expense topic field. 10-1 The objective of accounting for transactions under share-based payment arrangements with employees is to recognize in the financial statements the employee services received in exchange for equity instruments issued or liabilities incurred and the related cost to the entity as those services are consumed. This Topic uses the terms compensation and payment in their broadest senses to refer to the consideration paid for employee services. 10-2 This Topic requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Topic establishes fair value as the measurement objective in 70
accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee stock ownership plans. Room for Debate Debate 4-1 The efficient market hypothesis and accounting information Team 1 Given the EMH, argue that accounting is relevant The three forms of the efficient market hypothesis (EMH) are the weak form, the semi-strong 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 semi-strong 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 that is not publicly available and accounting information would be irrelevant. They could do just as well picking stock randomly.
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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 cooccurrences. 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 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 1Support reliance on positive theory to develop a general theory of accounting
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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 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 1Support 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 73
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 4-9 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 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-to-equity ratio and thus would be perceived as increasing risk. Increase in risk may increase the cost of debt via increased interest rate.
c.
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 4-10 The students will have different answers to this case depending on the companies selected and the time period chosen. 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 74
(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. Note to instructors: Although not specifically addressed in the case, it might be noted that efforts to manage earnings may be irrelevant in light of efficient market research. The general findings of this research indicate that the market is not deceived by the manipulation of accounting numbers. Alternately, if compensation is tied to earnings, there may be utility maximization reasons why managers attempt to manage earnings. Such explanations are tied to agency theory. b.
Some methods that may be used by management to smooth earnings are: postponing end-of-theyear 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 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
•
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 75
a.
b.
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?
2.
Review recent changes in accounting principles and changes in estimates to determine if they inflate earnings.
3.
Determine if discretionary expenditures, such as advertising, have been postponed by comparing them to previous periods.
4.
Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income statement.
5.
Determine the replacement cost of inventories and other assets. generating sufficient cash flow to replace their assets?
6.
Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings and cash flows.
7.
Review the relationship between sales and receivables to determine if receivables are increasing more rapidly than sales.
8.
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.
Is the company
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 a.
Income results from economic activity in which one entity furnishes goods or services to another. To warrant revenue recognition, the earning process must be substantially complete and there must be realization--a change in assets that is capable of being objectively measured. Normally this involves an arm's length exchange transaction with a party external to the entity. The existence and terms of the transaction may be defined by operation of law, by established trade practice or may be stipulated in a contract. 76
Events that give rise to revenue recognition are: the completion of a sale; the performance of a service; the progress of a long-term construction project, as in shipbuilding; and the production of a standard interchangeable good (such as a precious metal or an agricultural product) which has an immediate market, a determinable market value, and only minor costs of marketing. The passing of time may also be the event that establishes the recognition of revenues, as in the case of interest or rental revenue As a practical consideration, there must be a reasonable degree of certainty in measuring the amount of revenue. Problems of measurement may arise in estimating the degree of completion of a contract, the net realizable value of a receivable, or the value of a nonmonetary asset received in an exchange transaction. In some cases, while the revenue may be readily measured, it may be impossible to reasonably estimate the related expenses. In such instances revenue recognition must be deferred until the matching process can be completed. b.
Bonanza, in effect, is a merchandising firm which collects cash (for stamps) far in advance of furnishing the goods. In addition, since the data indicates that about five percent of the stamps sold will never be redeemed, it also has revenue from this source unless the stamps escheat. Bonanza's revenues from these two sources could be recognized on one of three major bases. First, all revenue could be recognized when the stamps are sold--the sales basis or cashcollection basis if all sales are for cash. Secondly, amounts collected at the time stamps are sold could be treated as an advance (sometimes referred to as deferred or unearned revenue) until stamps are exchanged for the merchandise premiums at which time all of the revenue including that relating to the never-to-redeemed stamps could be recognized. Thirdly, some revenue could be recognized at the time of redemption--this treatment would be especially appropriate for approximately five percent of the total, the stamps that will never be redeemed. A modification of this basis would be to recognize the revenue from the never-to-be-redeemed stamps on a passage-of-time basis. The principal expense, merchandise premium costs, should be matched with the revenue. If all revenue is recognized when stamps are sold, and accrual of the cost of future premium redemptions would be necessary. In such a case, when stamp redemptions and related premium issuances occurred, the costs of the premiums would be charged to the accrued liability account. On the other hand, if stamp sales were treated as an advance, the deferred revenue would be recognized and the matching cost of the premiums issued would be recognized with the revenue at the time of redemption. Under the third alternative, some predetermined portion, at least, of the revenue from the never-to-be-redeemed stamps would be recognized when the stamps are sold, but the recognition of the merchandise premium expense would be deferred until time of redemption. Reasonable estimation is crucial to income determination. Under the first alternative it is necessary to estimate future costs of premium issuances well in advance of the actual occurrence. In the second case it is necessary to estimate the proportion of revenue which has already been earned on the basis of premium costs already incurred. It is a vital certainty that not all stamps sold will ultimately be presented for redemption. Such factors as the number of stamps required to fill a book, the types of customers who receive stamps, and the ease of exchanging stamp books for premiums will all affect the proportion of stamps actually redeemed in relation to the potential redemptions. The difference between the five percent initial estimate and the actual proportion of unredeemed stamps affects the accrual of a liability for redemption 77
of stamps issued under the first method and the rate of transfer of revenue from the advances account under the second and third methods. There will be other expenses aside from the costs of premiums issued but they should be relatively small after the initial promotion period and they should be accounted for under the usual principles which apply to accrual-basis accounting. Thus, premium catalogs printed but undistributed would ordinarily be treated as prepaid expenses; wages and salaries would be treated as expenses when incurred; depreciation, taxes, and similar expenses would be recognized in the usual manner. c.
Under all of the alternatives Bonanza's major asset (in terms of data given in the question) would be its inventory of premiums. Another inventory item, perhaps minor in amount, would be the cost of printing the stamps that were on hand awaiting sale to dealers. The major account with a credit balance would be either an estimated liability for cost of redeeming the outstanding stamps under the first alternative or an advance (deferred revenue) account under the second and third alternatives. In view of the nature of the operation, the inventory account(s) would be included in the current asset classification and the liability would be classified as current. The advances could be reported preferably as a current liability or possibly as deferred credit.
Case 5-4 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 extraordinary items exceed revenues during an accounting period. 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. 78
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. c.
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 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 5-5 a.
The point of sale is the most widely used basis for the timing of revenue recognition because in most cases it provides the degree of objective evidence accountants consider necessary to reliably measure periodic business income. In other words, sales transactions with outsiders represent the point in the revenue generating process when most of the uncertainty about the final outcome of business activity has been alleviated. 79
It is also at the point of sale in most cases that substantially all of the costs of generating revenues are known, and they can at this point be matched with the revenues generated to produce a reliable statement of a firm's effort and accomplishment for the period. Any attempt to measure business income prior to the point of sale would, in the vast majority of cases, introduce considerably more subjectivity in financial reporting than most accountants are willing to accept. b.i.
Though it is recognized that revenue is earned throughout the entire production process, generally it is not feasible to measure revenue on the basis of operating activity. It is not feasible because of the absence of suitable criteria for consistently and objectively arriving at a periodic determination of the amount of revenue to take up. Also, in most situations the sale represents the most important single step in the earnings process. Prior to the sale the amount of revenue anticipated from the processes of production is merely prospective revenue; its realization remains to be validated by actual sales. The accumulation of costs during production does not alone generate revenue; rather, revenues are earned by the entire process, including making sales. Thus, as a general rule the sale cannot be regarded as being an unduly conservative basis for the timing of revenue recognition. Except in unusual circumstances, revenue recognition prior to sale would be anticipatory in nature and unverifiable in amount.
ii.
To criticize the sales basis as not being sufficiently conservative because accounts receivable do not represent disposable funds, it is necessary to assume that the collection of receivables is the decisive step in the earning process and that periodic review measurement, and therefore net income, should depend on the amount of cash generated during the period. This assumption disregards the fact that the sale usually represents the decisive factor in the earning process and substitutes for it the administrative function of managing and collecting receivables. In other words, the investment of funds in receivables should be regarded as a policy designed to increase total revenues, properly recognized at the point of sale; and the cost of managing receivables (e.g., bad debts and collection costs) should be matched with the sales in the proper period. The fact that some revenue adjustments (e.g., sales returns) and some expenses (e.g., bad debts and collection costs) may occur in a period subsequent to the sale does not detract from the overall usefulness of the sales basis for the timing of revenue recognition. Both can be estimated with sufficient accuracy so as not to detract from the reliability of reported net income. Thus, in the vast majority of cases for which the sale basis is used, estimating errors, though unavoidable, will be too immaterial in amount to warrant deferring revenue recognition to a later point in time.
c.i.
During production. This basis of recognizing revenue is frequently used by firms whose major source of revenue is long-term construction projects. For these firms the point of sale is far less significant to the earning process than is production activity because the sale is assured under the contract, except of course where performance is not substantially in accordance with the contract terms. To defer revenue recognition until the completion of long-term construction projects could significantly impair the usefulness of the intervening annual financial statements because the 80
volume of completed contracts during a period is likely to bear no relationship to production volume. During each year that a project is in process a portion of the contract price is therefore appropriately recognized as that year's revenue. The amount of the contract price to be recognized should be proportionate to the year's production progress on the project. It should be noted that the use of the production basis in lieu of the sales basis for the timing of revenue recognition is justifiable only when total profit or loss on the contracts can be estimated with reasonable accuracy and its ultimate realization is reasonably assured. ii.
When cash is received. The most common application of this basis for the timing of revenue recognition is in connection with installment sales contracts. Its use is justified on the grounds that, due to the length of the collection period, increased warrant revenue recognition until cash is received. The mere fact that sales are made on an installment contract basis does not justify using the cash receipts basis of revenue recognition. The justification for this departure from the sales depends essentially upon an absence of a reasonably objective basis for estimation the amount of collection costs and bad debts that will be incurred in late periods. If these expenses can be estimated with reasonable accuracy, the sales basis should be used.
Case 5-6 Statement of Financial Accounting Concepts No.5, "Recognition and Measurement in Financial Statements of Business Enterprises." does not suggest major changes in the current structure and context of financial statements. However, it did suggest that a statement of cash flows should replace the then required statement of changes in financial position (this change was subsequently adopted). 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: 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. Earnings is 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 current practice. However, it excludes certain adjustments from earlier periods now recognized in the current period. It is expected that the concept of earnings will continue to be subject to the process of gradual change that has characterized its development. 81
Comprehensive income is defined as a broad measure of the effects of transactions and other events on an entity. It comprises all recognized changes in equity of the entity during a period from transactions except those resulting from investments by owners and distributions to owners. The relationship between earnings and comprehensive income is illustrated as follows. 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
The statement of cash flows should directly or indirectly reflect an entity's cash receipts classified by major source and its cash payments classified by major uses during a period. The statement should include cash flow information about its operating, investing and financing activities. A statement of investments by and distributions to owners reflects an entity's capital transactions during a period, that is, the extent to which and in what ways the equity of the entity increased or decreased from transactions with owners. Case 5-7 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.
b.
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.
c.
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. 82
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 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 5-8 a.
According to SFAC No. 2, 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.
b.
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 sale-leasebacks where more than a minor portion is leased back, losses on sales are recognized; whereas, gains are deferred. Lower-ofcost-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.
c.
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.
d.
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.
e.
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 83
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.
FASB ASC 5-1 Revenue Recognition A search for revenue recognition resulted in 96 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. The students’ answers should incorporate the following: >
Initial Franchise Fees
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Individual Franchise Sales
952-605-25-1 Franchise fee revenue from an individual franchise sale shall be recognized, with an appropriate provision for estimated uncollectible amounts, when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor. 952-605-25-2 Substantial performance for the franchisor means that all of the following conditions have been met: •
a. The franchisor has no remaining obligation or intent—by agreement, trade practice, or law— to refund any cash received or forgive any unpaid notes or receivables.
•
b. Substantially all of the initial services of the franchisor required by the franchise agreement have been performed.
•
c. No other material conditions or obligations related to the determination of substantial performance exist.
952-605-25-3 If the franchise agreement does not require the franchisor to perform initial services but a practice of voluntarily rendering initial services exists or is likely to exist because of business or regulatory circumstances, substantial performance shall not be assumed until either the initial services have been substantially performed or reasonable assurance exists that the services will not be performed. The commencement of operations by the franchisee shall be presumed to be the earliest point at which substantial performance has occurred, unless it can be demonstrated that substantial performance of all obligations, including services rendered voluntarily, has occurred before that time. 952-605-25-4 Sometimes, large initial franchise fees are required but continuing franchise fees are small in relation to future services. If it is probable that the continuing fee will not cover the cost of the continuing services to be provided by the franchisor and a reasonable profit on those continuing services, then a portion of the initial franchise fee shall be deferred and amortized over the life of the franchise. The portion deferred shall be an amount sufficient to cover the estimated cost in excess of continuing franchise fees and provide a reasonable profit on the continuing services. 84
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Area Franchise Sales
952-605-25-5 Initial franchise fees relating to area franchise sales shall be accounted for following the same principles described in paragraphs 952-605-25-1 through 25-4 for individual franchise sales, that is, revenue ordinarily shall be recognized when all material services or conditions relating to the sale(s) have been substantially performed or satisfied by the franchisor. If the franchisor's substantial obligations under the franchise agreement relate to the area franchise and do not depend significantly on the number of individual franchises to be established, substantial performance shall be determined using the same criteria applicable to individual franchises (see paragraph 952-605-25-1). However, if the franchisor's substantial obligations depend on the number of individual franchises established within the area, area franchise fees shall be recognized in proportion to the initial mandatory services provided. Revenue that may have to be refunded because future services are not performed shall not be recognized by the franchisor until the franchisee has no right to receive a refund. 952-605-25-6 The substance of an area franchise agreement shall determine when material services or conditions relating to a sale have been substantially performed or satisfied. Sometimes, the efforts and total cost relating to initial services are not affected significantly by the number of outlets opened in an area and, therefore, the area franchise sale is similar to an individual franchise sale. Conversely, when the efforts and total cost relating to initial services are affected significantly by the number of outlets opened in an area, it may be necessary to regard the franchise agreement as a divisible contract and to estimate the number of outlets involved so that revenue may be recognized in proportion to the outlets for which the required services have been substantially performed. Estimates shall consider the anticipated number of outlets based on the terms of the franchise agreement (for example, time limitations and any specified minimum or maximum number of outlets). Any change in estimate resulting from a change in circumstance shall result in recognizing remaining fees as revenue in proportion to remaining services to be performed. >>
Collectibility of Franchise Fees
952-605-25-7 Installment or cost recovery accounting methods (see paragraphs 605-10-25-3 through 25-5) shall be used to account for franchise fee revenue only in those exceptional cases when revenue is collectible over an extended period and no reasonable basis exists for estimating collectibility. > >>
Relationship Between Franchisor and Franchisee Franchisor Guarantees Borrowing of a Franchisee
952-605-25-8 A franchisor may guarantee borrowings of a franchisee, have a creditor interest in the franchisee, or control a franchisee's operations by sales or other agreements to such an extent that the franchisee is, for all practical purposes, an affiliate of the franchisor. Sometimes, two franchisors may agree to pool their risks by selling their respective franchises to each other. In all those circumstances, revenue shall not be recognized if all material services, conditions, or obligations relating to the sale have not been substantially performed or satisfied (see paragraph 952-605-25-1). >>
Franchisor Option to Purchase Franchisee's Business
952-605-25-9 A franchise agreement may give the franchisor an option to purchase the franchisee's business. For example, a franchisor may purchase a profitable franchised outlet as a matter of management policy, or purchase a franchised outlet that is in financial difficulty or unable to continue in business to preserve the reputation and goodwill of the franchise system. If such an option exists, the 85
likelihood of the franchisor's acquiring the franchised outlet shall be considered in accounting for the initial franchise fee. If at the time the option is given, an understanding exists that the option will be exercised or it is probable that the franchisor ultimately will acquire the franchised outlet, the initial franchise fee shall not be recognized as revenue but shall be deferred. When the option is exercised, the deferred amount shall reduce the franchisor's investment in the outlet. > >>
Commingled Revenue Tangible Property Provided to the Franchisee
952-605-25-10 The franchise agreement ordinarily establishes a single initial franchise fee as consideration for the franchise rights and the initial services to be performed by the franchisor. Sometimes, however, the fee also may cover tangible property, such as signs, equipment, inventory, and land and building. In those circumstances, the portion of the fee applicable to the tangible assets shall be based on the fair value of the assets and may be recognized before or after recognizing the portion applicable to the initial services. For example, when the portion of the fee relating to the sale of specific tangible assets is objectively determinable, it would be appropriate to recognize that portion when their titles pass, even though the balance of the fee relating to services is recognized when the remaining services or conditions in the franchise agreement have been substantially performed or satisfied. >>
Services Provided to the Franchisee
952-605-25-11 Although a franchise agreement may specify portions of the total fee that relate to specific services to be provided by the franchisor, the services usually are interrelated to such an extent that the amount applicable to each service cannot be segregated objectively. The fee shall not be allocated among the different services as a means of recognizing any part of the fee for services as revenue before all the services have been substantially performed unless actual transaction prices are available for individual services; for example, through recent sales of the separate specific services. >
Continuing Franchise Fees
952-605-25-12 Continuing franchise fees shall be reported as revenue as the fees are earned and become receivable from the franchisee. For guidance on related franchise costs, see Subtopic 952-720. 952-605-25-13 Although a portion of the continuing fee may be designated for a particular purpose, such as an advertising program, it shall not be recognized as revenue until the fee is earned and becomes receivable from the franchisee. An exception to the foregoing exists if the franchise constitutes an agency relationship under which a designated portion of the continuing fee is required to be segregated and used for a specified purpose. In that case, the designated amount shall be recorded as a liability against which the specified costs would be charged. >
Continuing Product Sales
952-605-25-14 The franchisee may purchase some or all of the equipment or supplies necessary for its operations from the franchisor. Sometimes, the franchisee is given the right to make bargain purchases of equipment or supplies for a specified period or up to a specified amount, when the initial franchise fee is paid. If the bargain price is lower than the selling price of the same product to other customers or if the price does not provide the franchisor a reasonable profit on the equipment or supply sales, then a portion 86
of the initial franchise fee shall be deferred and accounted for as an adjustment of the selling price when the franchisee purchases the equipment or supplies. 952-605-25-15 The portion deferred shall be either of the following: a. The difference between the selling price to other customers and the bargain purchase price b. An amount sufficient to cover any cost in excess of the bargain purchase price and provide a reasonable profit on the sale, as appropriate. >
Agency Sales
952-605-25-16 Some franchisors engage in transactions in which they are, in substance, an agent for franchisees by placing orders for inventory and equipment and selling to franchisees at no profit. The franchisor shall account for such transactions as receivables and payables in its balance sheet and not as revenue and costs or expenses. See Section 605-45-55 for a discussion relating to reporting revenue gross as a principal versus net as an agent. >
Repossession of Franchise Rights
952-605-25-17 If franchise rights are repossessed but no refund is made, any consideration retained for which revenue was not previously recognized shall be reported as revenue. 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. The students’ answers should incorporate the following: > Criteria for Recognizing Profit on Sales of Real Estate Under Full Accrual Method 40-3 Profit shall be recognized in full when real estate is sold, provided that both of the following conditions are met: a. The profit is determinable, that is, the collectibility of the sales price is reasonably assured or the amount that will not be collectible can be estimated. b. The earnings process is virtually complete, that is, the seller is not obliged to perform significant activities after the sale to earn the profit. Unless both conditions exist, recognition of all or part of the profit shall be postponed. Recognition of all of the profit at the time of sale or at some later date when both conditions exist is referred to as the full accrual method in this Subtopic. 40-4 In accounting for sales of real estate, collectibility of the sales price is demonstrated by the buyer's commitment to pay, which in turn is supported by substantial initial and continuing investments that give the buyer a stake in the property sufficient that the risk of loss through default motivates the buyer to honor its obligation to the seller. Collectibility shall also be assessed by considering factors such as the credit standing of the buyer, age and location of the property, and adequacy of cash flow from the property. 40-5Profit on real estate sales transactions shall not be recognized by the full accrual method until all of the following criteria are met: a. A sale is consummated (see the following paragraph). 87
b. The buyer's initial and continuing investments are adequate to demonstrate a commitment to pay for the property (see paragraphs 360-20-40-9 through 40-24). c. The seller's receivable is not subject to future subordination (see paragraph 360-20-40-25). d. The seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is in substance a sale and does not have a substantial continuing involvement with the property (see paragraph 360-20-40-26). Profit on a sale of a partial interest in real estate shall be subject to the same criteria for profit recognition as a sale of a whole interest. Recognition of Profit when the Full Accrual Method Is Not Appropriate 40-27 If a real estate sales transaction does not satisfy the criteria in paragraphs 360-20-40-3 through 4026 for recognition of profit by the full accrual method, the transaction shall be accounted for as specified in paragraphs 360-20-40-28 through 40-64. >>
Sale Not Consummated
40-28 The deposit method of accounting described in paragraphs 360-20-55-17 through 55-20 shall be used until a sale has been consummated (see paragraph 360-20-40-7). Consummation usually requires that all conditions precedent to closing have been performed, including that the building be certified for occupancy. However, because of the length of the construction period of office buildings, apartments, condominiums, shopping centers, and similar structures, such sales and the related income may be recognized during the process of construction, subject to the criteria in paragraphs 360-20-40-61 through 40-63, even though a certificate of occupancy, which is a condition precedent to closing, has not been obtained. 40-29If the net carrying amount of the property exceeds the sum of the deposit received, the fair value of the unrecorded note receivable, and the debt assumed by the buyer, the seller shall recognize the loss at the date the agreement to sell is signed. If a buyer defaults, or if circumstances after the transaction indicate that it is probable the buyer will default and the property will revert to the seller, the seller shall evaluate whether the circumstances indicate a decline in the value of the property for which an allowance for loss should be provided. 40-30Paragraph 970-360-35-3 specifies the accounting for property that is substantially completed and that is to be sold. > > Buyer's Initial or Continuing Investments Do Not Qualify 40-31 If the buyer's initial investment does not meet the criteria specified in paragraphs 360-20-40-9 through 40-18 for recognition of profit by the full accrual method and if recovery of the cost of the property is reasonably assured if the buyer defaults, the installment method described in paragraphs 36020-55-7 through 55-12 shall be used. If recovery of the cost of the property is not reasonably assured if the buyer defaults or if cost has already been recovered and collection of additional amounts is uncertain, the cost recovery method (described in paragraphs 360-20-55-13 through 55-15) or the deposit method (described in paragraphs 360-20-55-17 through 55-20) shall be used. The cost recovery method may be used to account for sales of real estate for which the installment method would be appropriate. 40-32 Under the installment, cost recovery, and reduced-profit recognition methods, debt incurred by the buyer that is secured by the property, whether incurred directly from the seller or other parties or indirectly through assumption, and payments to the seller from the proceeds of such indebtedness shall not be considered buyer's cash payments. However, if the profit deferred under the applicable method 88
exceeds the outstanding amount of seller financing and the outstanding amount of buyer's debt secured by the property for which the seller is contingently liable, the seller shall recognize the excess in income.
FASB ASC 5-4 Current Value Search current value 274 Personal Financial Statements 10 Overall 05 Background 05-1 This Subtopic addresses personal financial statements. Personal financial statements are prepared for individuals either to formally organize and plan their financial affairs in general or for specific purposes, such as obtaining of credit, income tax planning, retirement planning, gift and estate planning, or public disclosure of their financial affairs. Users of personal financial statements rely on them in determining whether to grant credit, in assessing the financial activities of individuals, in assessing the financial affairs of public officials and candidates for public office, and for similar purposes. > Basis of Presentation of Personal Financial Statements 05-2 The primary focus of personal financial statements is a person's assets and liabilities, and the primary users of personal financial statements normally consider estimated current value information to be more relevant for their decisions than historical cost information. Lenders require estimated current value information to assess collateral, and most personal loan applications require estimated current value information. Estimated current values are required for estate, gift, and income tax planning, and estimated current value information about assets is often required in federal and state filings of candidates for public office. FASB ASC 5-5 Accounting for Inflation Search inflation 255 Changing Prices10 Overall 255-10-05 Overview and Background General 05-1 The Changing Prices Topic provides guidance on reporting the effects of changing prices, or inflation, on financial statements of business entities. The reporting addresses both general inflation and price changes of certain assets. 255-10-15 Scope and Scope Exceptions General > Overall Guidance 15-1 The Scope Section of the Overall Subtopic establishes the pervasive scope for the Changing Prices Topic. > Entities 15-2 The guidance in the Changing Prices Topic applies to the following entities: 89
a. Business entities that prepare their financial statements in U.S. dollars and in accordance with U.S. generally accepted accounting principles (GAAP) b. Foreign entities that prepare financial statements in the currency of the country in which the operations reported on are conducted and that operate in countries with hyperinflationary economies. 255-10-30 Initial Measurement General 30-1 This Subtopic provides guidance on encouraged disclosures on the effects of changing prices. For that reason, the guidance that describes how to measure items provided in the disclosures is included in paragraphs 255-10-50-19 through 50-55 rather than this Section. 255-10-35 Subsequent Measurement General 35-1 This Subtopic provides guidance on encouraged disclosures on the effects of changing prices. For that reason, the guidance that describes how to measure items provided in the disclosures is included in paragraphs 255-10-50-19 through 50-55 rather than this Section. 255-10-45 Other Presentation Matters General 45-1 This Subtopic provides guidance on encouraged disclosures on the effects of changing prices. For that reason, the guidance that describes how to present the disclosures is included in Section 255-1050 rather than this Section. > Price-Level Adjusted Financial Statements for Certain Entities in Highly Inflationary Economies 45-2 The degree of inflation or deflation in an economy may become so great that conventional statements lose much of their significance and general price-level statements clearly become more meaningful. Although this is obvious with respect to some countries, the degree of inflation or deflation at which general price level statements clearly become more meaningful depends on the circumstances. 45-3 This Subtopic permits a comprehensive application of price-level adjusted financial statements (to the extent such presentation is not inconsistent with guidance in this Subtopic regarding historical cost-constant purchasing power accounting, such as the classification of assets and liabilities as monetary or nonmonetary) in presenting the basic foreign currency financial statements of entities operating in countries with highly inflationary economies if the statements are intended for readers in the United States. 45-4 This guidance applies only to statements prepared in the currency of the country in which the operations reported on are conducted. Only conventional statements of foreign subsidiaries should be used to prepare historical-dollar consolidated statements. 255-10-50 Disclosure General > Introduction 90
50-1 A business entity that prepares its financial statements in U.S. dollars and in accordance with U.S. generally accepted accounting principles (GAAP) is encouraged, but not required, to disclose supplementary information on the effects of changing prices. Entities are not discouraged from experimenting with other forms of disclosure. > Presentation 50-2 This Subtopic provides guidance on those encouraged disclosures. For that reason, the guidance that describes how to present the disclosures is included in this Section rather than Section 250–10–45. > > Five-Year Summary of Selected Financial Data 50-3 An entity shall disclose all of the following information for each of the five most recent years: a. Net sales and other operating revenues b. Income from continuing operations on a current cost basis c. Purchasing power gain or loss on net monetary items d. Increase or decrease in the current cost or lower recoverable amount of inventory and property, plant, and equipment, net of inflation e. The aggregate foreign currency translation adjustment on a current cost basis, if applicable f. Net assets at year-end on a current cost basis g. Income per common share from continuing operations on a current cost basis h. Cash dividends declared per common share i. Market price per common share at year-end. 50-4 For the purposes of this Subtopic, except where otherwise provided, inventory and property, plant, and equipment shall include land and other natural resources and capitalized leasehold interests but not goodwill or other intangible assets. 50-5 An entity that presents consolidated financial statements shall present the information required by this Subtopic on the same consolidated basis. The information required by this Subtopic need not be presented for a parent company, an investee company, or other entity in a financial report that includes the results for that entity in consolidated financial statements. 50-6 The information required by this Subtopic shall be presented as supplementary information in any published annual report that contains the primary financial statements of the entity except that the information need not be presented in an interim financial report. The information required by this Subtopic need not be presented for segments of a business entity although such presentations are encouraged. 50-7 The information presented in the five-year summary shall be stated as either of the following: a. In average-for-the-year or end-of-year units of constant purchasing power b. In dollars having a purchasing power equal to that of dollars of the base period used by the Bureau of Labor Statistics in calculating the Consumer Price Index for All Urban Consumers. As a practical matter, this option is not available to entities that measure a significant part of their operations in one or more functional currencies other than the U.S. dollar and that elect to use the restate-translate method for measuring inflation-adjusted current cost information. 50-8 An entity shall disclose the level of the Consumer Price Index for All Urban Consumers used for each of the five most recent years. If the level of the Consumer Price Index at the end of the year and the data required to compute the average level of the index over the year have not been published in time for preparation of the annual report, they may be estimated by referring to published forecasts based on economic statistics or by extrapolation based on recently reported changes in the index. 50-9 If the entity has a significant foreign operation measured in a functional currency other than the U.S. dollar, it shall disclose whether adjustments to the current cost information to reflect the effects of 91
general inflation are based on the Consumer Price Index for All Urban Consumers (the translate-restate method) or on a functional currency general price level index (the restate-translate method). 50-10 The entity shall provide an explanation of the disclosures required by this Subtopic and a discussion of their significance in the circumstances of the entity. Disclosure and discussion of additional information to help users of the financial report understand the effects of changing prices on the activities of the entity are encouraged. > > Additional Disclosures for the Current Year 50-11 In addition to the information required by paragraphs 255-10-50-3 through 50-10, an entity shall provide the information specified in paragraphs 255-10-50-12 through 50-16 if income from continuing operations on a current cost-constant purchasing power basis would differ significantly from income from continuing operations in the primary financial statements. 50-12 An entity shall disclose certain components of income from continuing operations for the current year on a current cost basis (see paragraphs 255-10-50-39 through 50-41), applying the same constant purchasing power option used for presentation of the five-year summary. The information may be presented in any of the following formats: a. In a statement format (disclosing revenues, expenses, gains, and losses) b. In a reconciliation format (disclosing adjustments to the income from continuing operations that is shown in the primary income statement) c. In notes to the five-year summary required by paragraph 255-10-50-3. 50-13 Formats for presenting the supplementary information are illustrated in Example 1 (see paragraphs 255-10-55-14 through 55-21). Whichever format is used, the presentation shall disclose (for example, in a reconciliation format) or allow the reader to determine (for example, in a statement format) the difference between the amount in the primary statements and the current cost amount of all of the following items: a. Cost of goods sold and depreciation b. Depletion c. Amortization expense. 50-14 If depreciation has been allocated among various expense categories in the supplementary computations of income from continuing operations (for example, among cost of goods sold and other functional expenses), the aggregate amount of depreciation on a current cost basis shall be included in the notes to the supplementary information. In addition to information about income from continuing operations, the entity may include the following items in a schedule of current year information: a. The purchasing power gain or loss on net monetary items b. The increase or decrease in the current cost or lower recoverable amount of inventory and property, plant, and equipment, net of inflation c. The translation adjustment. 50-15 As illustrated in Example 1 (see paragraphs 255-10-55-14 through 55-21, income from continuing operations does not include the information that is described in paragraph 255-10-50-14(a) through 50-14(c). 50-16 An entity shall also disclose all of the following: 92
a. Separate amounts for the current cost or lower recoverable amount at the end of the current year of inventory and property, plant, and equipment (see paragraphs 255-10-50-20 through 50-33 and 255-10-50-36 through 50-38) b. The increase or decrease in current cost or lower recoverable amount before and after adjusting for the effects of inflation of inventory and property, plant, and equipment for the current year (see paragraphs 255-10-50-42 through 50-43}) c. The principal types of information used to calculate the current cost of inventory; property, plant, and equipment; cost of goods sold; and depreciation, depletion, and amortization expense (see paragraphs 255-10-50-24 through 50-33) d. Any differences between: 1. The depreciation methods, estimates of useful lives, and salvage values of assets used for calculations of current cost-constant purchasing power depreciation 2. The methods and estimates used for calculations of depreciation in the primary financial statements (see paragraph 255-10-50-29 ). FASB ASC 5-6 Revenue and Gains Use revenue link 605-10-25 Recognition Revenue and Gains 25-1 The recognition of revenue and gains of an entity during a period involves consideration of the following two factors, with sometimes one and sometimes the other being the more important consideration: a. Being realized or realizable. Revenue and gains generally are not recognized until realized or realizable. Paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. That paragraph states that revenue and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. b. Being earned. Paragraph 83(b) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue is not recognized until earned. That paragraph states that an entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. That paragraph states that gains commonly result from transactions and other events that involve no earning process, and for recognizing gains, being earned is generally less significant than being realized or realizable. 25-2 See paragraphs 605-10-25-3 through 25-4 for the limited circumstances in which revenue and gains may be recognized using the installment or cost-recovery methods. FASB ASC 5-7 Accounting for Long-term Construction Contracts 93
Search percentage of completion 605 Revenue Recognition 35 Construction-Type and Production-Type Contracts\ 605-35-05 Overview and Background General 05-1 This Subtopic provides guidance on the accounting for the performance of contracts for which specifications are provided by the customer for the construction of facilities or the production of goods or for the provision of related services. 05-2 Contracts consist of legally enforceable agreements in any form and include amendments, revisions, and extensions of such agreements. Performance will often extend over long periods, and the seller's right to receive payment depends on the seller's performance in accordance with the agreement. The service may consist of designing, engineering, fabricating, constructing, or manufacturing related to the construction or the production of tangible assets. 05-3 The problems in accounting for construction-type contracts arise particularly in connection with long-term contracts as compared with those requiring relatively short periods for completion. 05-4 The determination of the point or points at which revenue shall be recognized as earned and costs shall be recognized as expenses is a major accounting issue common to all business entities engaged in the performance of contracts of the types covered by this Subtopic. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods. This involves considerable use of estimates in determining revenues, costs, and profits and in assigning the amounts to accounting periods. The process is complicated by the need to evaluate continually the uncertainties inherent in the performance of contracts and by the need to rely on estimates of revenues, costs, and the extent of progress toward completion. 05-5 Two accounting methods commonly followed by contractors are the percentage-of-completion method and the completed-contract method. The two methods should be used in specified circumstances and should not be used as acceptable alternatives for the same circumstances. Accordingly, identifying the circumstances in which either of the methods is preferable and the accounting that should be followed in the application of those methods are among the primary objectives of this Subtopic. 05-6 The use of either of the two generally accepted methods involves, to a greater or lesser extent, the following three key areas of estimates and uncertainties: a. The extent of progress toward completion b. Contract revenues c. Contract costs. > Percentage-of-Completion Method 05-7 The principal advantages of the percentage-of-completion method are periodic recognition of income currently rather than irregularly as contracts are completed, and the reflection of the status of the uncompleted contracts provided through the current estimates of costs to complete or of progress toward completion. The principal disadvantage of the percentage-of-completion method is that it is necessarily dependent on estimates of ultimate costs and consequently of currently accruing income, which are subject to the uncertainties frequently inherent in long-term contracts. 05-8 Under most contracts for construction of facilities, production of goods, or provision of related services to a buyer's specifications, both the buyer and the seller (contractor) obtain enforceable rights. The legal right of the buyer to require specific performance of the contract means that the contractor has, in effect, agreed to sell his rights to work-in-progress as the work progresses. Furthermore, the contractor 94
has the right to require the buyer, under most financing arrangements, to make progress payments to support the buyer's ownership investment and to approve the facilities constructed (or goods produced or services performed) to date if they meet the contract requirements. 05-9 Also, under most contracts for the production of goods and the provision of related services that are accounted for on the basis of units delivered, both the contractor and the customer obtain enforceable rights as the goods are produced or the services are performed. As units are delivered, title to and the risk of loss on those units normally transfer to the customer, whose acceptance of the items indicates that they meet the contractual specifications. For such contracts, delivery and acceptance are objective measurements of the extent to which the contracts have been performed. The percentage-of-completion method recognizes the legal and economic results of contract performance on a timely basis. 05-10 Financial statements based on the percentage-of-completion method present the economic substance of an entity's transactions and events more clearly and more timely than financial statements based on the completed-contract method, and they present more accurately the relationships between gross profit from contracts and related period costs. The percentage-of-completion method informs the users of the general purpose financial statements of the volume of economic activity of an entity. 05-11 Paragraph 605-35-25-56 explains that the use of the percentage-of-completion method depends on the ability to make reasonably dependable estimates, which, for purposes of this Subtopic, relates to estimates of the extent of progress toward completion, contract revenues, and contract costs. > Completed-Contract Method 05-12 The principal advantage of the completed-contract method is that it is based on results as finally determined, rather than on estimates for unperformed work that may involve unforeseen costs and possible losses. The principal disadvantage of the completed-contract method is that it does not reflect current performance when the period of any contract extends into more than one accounting period and under such circumstances it may result in irregular recognition of income. FASB ASC 5-8 Use of the Installment and Cost Recovery Methods Search installment method. 605-10-25-3 >
Installment and Cost Recovery Methods of Revenue Recognition
25-3 Revenue should ordinarily be accounted for at the time a transaction is completed, with appropriate provision for uncollectible accounts. Paragraph 605-10-25-1(a) states that revenue and gains generally are not recognized until being realized or realizable and until earned. Accordingly, unless the circumstances are such that the collection of the sale price is not reasonably assured, the installment method of recognizing revenue is not acceptable. 25-4 There may be exceptional cases where receivables are collectible over an extended period of time and, because of the terms of the transactions or other conditions, there is no reasonable basis for estimating the degree of collectibility. When such circumstances exist, and as long as they exist, either the installment method or the cost recovery method of accounting may be used. As defined in paragraph 360-20-55-7 through 55-9, the installment method apportions collections received between cost recovered and profit. The apportionment is in the same ratio as total cost and total profit bear to the sales value. Under the cost recovery method, equal amounts of revenue and expense are recognized as collections are made until all costs have been recovered, postponing any recognition of profit until that time.) 25-5 In the absence of the circumstances referred to in this Subtopic or other guidance, such as that in Sections 360-20-40 and 360-20-55, the installment method is not acceptable. 95
FASB ASC 5-9 Matching
Search matching - 31 hits FASB ASC 5-10 Conservatism
Search conservatism 852 Reorganizations > 20 Quasi-Reorganizations > 30 Initial Measurement 30-1 This Section provides guidance on the adjustment of accounts required by paragraph 852-20-253 as of the readjustment date in connection with the readjustments addressed by this Subtopic. 30-2 A write-down of assets below amounts that are likely to be subsequently realized, though it may result in conservatism in the balance sheet at the readjustment date, may also result in overstatement of earnings or of retained earnings when the assets are subsequently realized. Therefore, in general, assets shall be carried forward as of the date of readjustment at fair and not unduly conservative amounts, determined with due regard for the accounting to be subsequently employed by the entity. 30-3 If the fair value of any asset is not readily determinable a conservative estimate may be made, but in that case the amount shall be described as an estimate. Paragraph 852-20-35-2 describes the subsequent accounting for any material difference arising through realization or otherwise and not attributable to events occurring or circumstances arising after that date. 30-4 Similarly, if potential losses or charges are known to have arisen before the date of readjustment but such amounts are then indeterminate, provision may properly be made to cover the maximum probable losses or charges. FASB ASC 5-11 Materiality
Search materiality - 19 hits Room for Debate Debate 5-1 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.
2.
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. 96
3.
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.
4.
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.
5.
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.
2.
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).
3.
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. 2, understandability is a desirable of useful accounting information.
4.
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.
5.
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 Team 1 Argue in favor of the economist’s view of income
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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. 1, 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. 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.
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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. 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 5-9 a.
Companies typically recognize revenue at the point of sale. At the point of sale, the merchandise sold is typically delivered and title passes to the buyer. Hence, the earnings process is complete, or virtually complete and is evidenced by an arm’s length exchange transaction. 99
Also, there is relative certainty about the realization of the revenue in terms of cash inflow. Either the cash has been received or a measurable amount is receivable. b.
In this industry, the selling price is assured by the market, hence, the critical event is getting the metal out of the ground, rather than a sale transaction.
c.
The reasoning for the typical practice is that until the sale’s transaction takes place, the earnings process is not virtually complete, and there is uncertainty about the realizability of any expected future cash flows.
Case 5-10 The answer to this case requires the student to visit the WWW to answer the questions about a company’s current financial statements. Financial Analysis Case a.
The students answers will vary depending on the company selected. They should use the following eight techniques outlined in the text. To assess their company’s quality of earnings. 1.
2. 3. 4. 5. 6. 7. 8.
b.
Compare the accounting principles employed by the company with those generally used in the industry and by competitors. 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 reflected on the income statement. Determine the replacement cost of inventories and other assets. Assess whether the company is generating sufficient cash flow to replace its 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 MD&A 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.
Answers will vary
CHAPTER 6
Case 6-1
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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.
b.
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.
c.
Revenues should be recognized from each market as they are earned under the realization principle. Under this concept, revenue from each of the markets should be recognized as contracts are signed or film rights are sold to each of the various markets.
d.
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
e.
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 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 a..
i.
Extraordinary items are material items of a character significantly different from the typical or customary business activities of the entity. Extraordinary items are events and transactions that are distinguished by their unusual nature and infrequent occurrence. The product tampering and recall is material because the credits and refunds alone are ten percent of earnings before income taxes, is unusual because of its catastrophic nature, and is infrequent because it is the first occurrence in the more than fifty year history of Goods Company with no indication that the event will recur. 101
b.
ii.
The extraordinary charge should be properly described as "Loss from product tampering and recall" and placed in a separate section in the 2010 income statement after discontinued operations. The charge must be presented net of its applicable income taxes and the taxes may be shown parenthetically of in columnar form. Reporting per share amounts on extraordinary items is optional. Details of the extraordinary charge should be disclosed in the notes to 2010 financial statements.
i.
Items 1,3,5,6,7,8,10 and 13 should be included in the extraordinary charge for 2010.
ii.
Items not included in the extraordinary charge and the reason for each is as follows.
Item Number
Reason Not Included
2
Insurance to cover possible future events is not directly related to the 2010 event. Should be capitalized and expensed over future periods.
4
Future security measures are future costs and not directly related to the 2010 event. Should be expensed over future periods.
9
These packaging costs are not directly related to the 2010 event and should be matched against revenues from the sale of the packaged products.
11
These costs resulted from a decision of the company in its reaction to the 2010 event. The costs are related to future operations and should be charged to operating expense or spread over the estimated period that the redesigned package will be in use.
12
The cost of the packaging equipment should be charged to an asset account and expensed over its estimated useful life.
14
Lost sales revenue is an opportunity cost and is not recorded or disclosed anywhere on the financial statements.
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 all-inclusive 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, profit-directed 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 individuals believe that the total net 102
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 view points agree on the information to be presented but disagree on where to disclose different types of revenues, expenses, gains, and losses. b.i.
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 allinclusive concepts.
iii. Extraordinary items are considered gains and losses under the current operating performance concept and revenues and expenses under the all-inclusive concept. iv.
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.
b.
c.
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 income before extraordinary items, 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 (a special type of change in accounting principle). Such a change requires that the consolidated income statements be restated to reflect the different reporting entity.
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, 103
except relatively small nonrecurring stock dividends may be ignored. The computation should be made for income before extraordinary items, extraordinary items net of income tax, and net income. The earnings per share from each of the foregoing should be presented in the income statement and it is desirable that the method of computation be disclosed. b.
c.
Meanings of terms often used in discussing earnings per share and the types of items to which they apply follow: 1.
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 which enter into the determination of net income.
2.
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 and also net income before extraordinary items 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.
v.
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 104
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.i.
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)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 firstin, first-out (FIFO) method; a change in depreciation method for previously recorded assets, such as from the double-declining 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 constructiontype 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 judgement. 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 105
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 included in combined financial statements. A different group of companies comprises the reporting entity after each change. A business combination accounted for by the pooling-of-interests method also results in a different reporting entity. 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 Opinion of the Accounting Principles Board 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 income before extraordinary items, 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. 106
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. 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 107
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 income before extraordinary items, 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 Accounting Principles Board 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 earnings 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 a =n 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 earnings before extraordinary items, net earnings, and related per-share amounts should be disclosed for all periods presented. Financial statements of subsequent periods need not repeat the disclosures.
Situation 3 a. b. c.
d.
The change in the method of computing depreciation for all fixed assets (previously recorded and future acquisitions) represents a change in an accounting estimate. Accordingly, the effect of the change should be reflected in the current-year future financial statements. 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. 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
b.
The effects of the hailstorm should be reported as an extraordinary item in the income statement because it meets both of the criteria for classification as an extraordinary item. It is unusual in 108
nature and infrequent in occurrence, taking into account the environment in which the entity operates. c.
The classification in the income statement of an extraordinary item differs from that of an operating item in the following ways. First, an extraordinary item should be shown as a separate item in the income statement below the continuing operations section of the income statement. Second, an extraordinary item should be shown net of applicable income taxes. An extraordinary item is unrelated to Morgan's normal and ongoing operations.
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.
b.
Earnings as defined under SFAC No. 5 reflects 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.
c.
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, 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.
e.
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.
f.
For financial reporting practices to be consistent with the concept of physical capital maintenance, assets would need to 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. 109
FASB ASC 6-1 Extraordinary Items Extraordinary items are contained at FASB ASC 225-20. FASB ASC 225-20-55-3&4 give examples of items that satisfy and fail to satisfy the infrequent and unusual criteria. The students’ summaries should incorporate the following: Events or Transactions Meeting Extraordinary Item Criteria 55-3 The following are illustrative of events or transactions which would meet both criteria in the circumstances described and should be reported as extraordinary items: a. A large portion of a tobacco manufacturer's crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare. b. A steel fabricating entity sells the only land it owns. The land was acquired 10 years ago for future expansion, but shortly thereafter the entity abandoned all plans for expansion and held the land for appreciation. c. An earthquake destroys one of the oil refineries owned by a large multinational oil entity. > > Events or Transactions That Do Not Meet Extraordinary Item Criteria 55-4 The following are illustrative of events or transactions which do not meet both criteria in the circumstances described and thus should not be reported as extraordinary items: a. A citrus grower's Florida crop is damaged by frost. Frost damage is normally experienced every three or four years. The criterion of infrequency of occurrence taking into account the environment in which the entity operates would not be met since the history of losses caused by frost damage provides evidence that such damage may reasonably be expected to recur in the foreseeable future. b. An entity that operates a chain of warehouses sells the excess land surrounding one of its warehouses. When the entity buys property to establish a new warehouse, it usually buys more land than it expects to use for the warehouse with the expectation that the land will appreciate in value. In the past five years, there have been two instances in which the entity sold such excess land. The criterion of infrequency of occurrence has not been met since past experience indicates that such sales may reasonably be expected to recur in the foreseeable future. c. A large diversified entity sells a block of shares from its portfolio of securities which it has acquired for investment purposes. This is the first sale from its portfolio of securities. Since the entity owns several securities for investment purposes, it should be concluded that sales of such securities are related to its ordinary and typical activities in the environment in which it operates and thus the criterion of unusual nature would not be met. d. A textile manufacturer with only one plant moves to another location. It has not relocated a plant in 20 years and has no plans to do so in the foreseeable future. Notwithstanding the infrequency of occurrence of the event as it relates to this particular entity, moving from one location to another is an occurrence which is a consequence of customary and continuing business activities, some of which are finding more favorable labor markets, more modern facilities, and proximity to customers or suppliers. Therefore, the criterion of unusual nature has not been met and the moving expenses (and related gains and losses) should not be reported as an extraordinary item.
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e. A consequence of customary and typical business activities (namely financing) is an unsuccessful public registration, the cost of which should not be reported as an extraordinary item. (For additional examples, see paragraph 225-20-45-4 f. An impairment loss does not have characteristics that warrant special treatment, for instance, as an extraordinary item. g. Entities holding receivables from bankrupt railroads shall not account for losses arising from charging off such assets as extraordinary losses in determining net income. Paragraph 225-2025-4 specifies that losses from receivables shall not constitute extraordinary losses. The fact that the loss arises from a receivable from an entity in bankruptcy proceedings does not alter this. h. The costs incurred by an entity to defend itself from a takeover attempt or the cost attributed to a standstill agreement do not meet the criteria for extraordinary classification as discussed in paragraph 225-20-45-2 The event that gave rise to those costs—a takeover attempt—cannot be considered to be both unusual and infrequent as those terms are used in this Subtopic. The only EITF pronouncement dealing with extraordinary items identified in the FASB ASC is: 225-20-20 Glossary Business Interruption Insurance [Insurance that provides coverage if business operations are suspended due to the loss of use of property and equipment resulting from a covered cause of loss. Business interruption insurance coverage generally provides for reimbursement of certain costs and losses incurred during the reasonable period required to rebuild, repair, or replace the damaged property. [EITF 01-13, paragraph ISSUE, sequence 14.2.1] ] FASB ASC 6-2 Comprehensive Income Reporting Comprehensive Income is contained in sections FASB ASC 220-10-45. It is found by searching comprehensive income or by crossreferencing SFAS No. 130. 45-1 This Subtopic requires that all items that meet the definition of components of comprehensive income be reported in a financial statement for the period in which they are recognized. 45-2 This Subtopic requires that changes in the balances of items that are reported directly in a separate component of equity in a statement of financial position shall be reported in a financial statement that is displayed as prominently as other financial statements. 45-3 A full set of financial statements for a period should show: financial position at the end of the period, earnings (net income) for the period, comprehensive income (total nonowner changes in equity) for the period, cash flows during the period, and investments by and distributions to owners during the period. 45-4 This Subtopic does not require that an entity use the terms comprehensive income or other comprehensive income in its financial statements, even though those terms are used throughout this Subtopic. 45-5 All components of comprehensive income shall be reported in the financial statements in the period in which they are recognized. A total amount for comprehensive income shall be displayed in the financial statement where the components of other comprehensive income are reported. Transition Date: December 15, 2008 Transition Guidance: 810-10-65-1 111
All components of comprehensive income shall be reported in the financial statements in the period in which they are recognized. A total amount for comprehensive income shall be displayed in the financial statement where the components of other comprehensive income are reported. Paragraph 810-10-501A(a) states that, if an entity has an outstanding noncontrolling interest (minority interest), amounts for both comprehensive income attributable to the parent and comprehensive income attributable to the noncontrolling interest in a less-than-wholly-owned subsidiary are reported on the face of the financial statement in which comprehensive income is presented in addition to presenting consolidated comprehensive income. FASB ASC 6-3 Net Income Found by searching net income 220-20 Net Income A measure of financial performance resulting from the aggregation of revenues, expenses, gains, and losses that are not items of other comprehensive income. A variety of other terms such as net earnings or earnings may be used to describe net income. FASB ASC 6-4 APB Opinion No. 9 Found by cross reference to APB No. 9. 225-10-05-05 This Subtopic also: a. Specifies the method of treating error corrections in comparative statements for two or more periods b. Specifies the disclosures required when previously issued statements of income are restated c. Recommended methods of presentation of historical, statistical-type financial summaries that are affected by error corrections 250-10-45 15-3The guidance in the Income Statement Topic applies to general-purpose statements that purport to present results of operations in conformity with generally accepted accounting principles (GAAP). 225-10-45 Other Presentation Matters 45-1Net income shall reflect all items of profit and loss recognized during the period with the sole exception of error corrections as addressed in Topic 250. However, the requirement that net income be presented as one amount does not apply to the following entities that have developed income statements with formats different from those of the typical commercial entity: a. Investment companies b. Insurance entities c. Certain not-for-profit entities (NFPs 112
505-10-25 25-1 Additional paid-in capital, however created, shall not be used to relieve income of the current or future years of charges that would otherwise be made to the income statement. See paragraph 852-20-252 for an exception to this guidance related to reorganizations. 25-2 All of the following shall be excluded from the determination of net income or the results of operations under all circumstances a. Adjustments or charges or credits resulting from transactions in the entity's own capital stock b.
Transfers to and from accounts properly designated as appropriated retained earnings (see paragraph 505-10-45-3 for what is meant by properly designated as appropriated retained earnings)
c.
Adjustments made pursuant to a quasi-reorganization (see Subtopic 852-20 for information concerning quasi-reorganizations).
FASB ASC 6-5 Extraordinary Items Link to income statement 225-20-20 Extraordinary Items Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Thus, both of the following criteria should be met to classify an event or transaction as an extraordinary item: a. Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates (see paragraph 225-20-60-3). b. Infrequency of occurrence. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates FASB ASC 6-6 Discontinued Operations Search discontinued operations. 205-20-45 The results of operations of a component of an entity that either has been disposed of or is classified as held for sale under the requirements of paragraph 360-10-45-9, shall be reported in discontinued operations in accordance with paragraph 205-20-45-3 if both of the following conditions are met: a. The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction.
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b. The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. XBRL Elements 45-2 Examples 1 through 9 (see paragraph 205-20-55-28 through 55-79 ) illustrate disposal activities that do or do not qualify for reporting as discontinued operations. 45-3 In a period in which a component of an entity either has been disposed of or is classified as held for sale, the income statement of a business entity or statement of activities of a not-for-profit entity (NFP) for current and prior periods shall report the results of operations of the component, including any gain or loss recognized in accordance with paragraphs 360-10-35-40 and 360-10-40-5, in discontinued operations. The results of operations of a component classified as held for sale shall be reported in discontinued operations in the period(s) in which they occur. The results of discontinued operations, less applicable income taxes (benefit), shall be reported as a separate component of income before extraordinary items (if applicable). For example, the results of discontinued operations may be reported in the income statement of a business entity as follows.
A gain or loss recognized on the disposal shall be disclosed either on the face of the income statement or in the notes to financial statements (see paragraph 205-20-50-1(b)). XBRL Elements 45-4 Adjustments to amounts previously reported in discontinued operations that are directly related to the disposal of a component of an entity in a prior period shall be classified separately in the current period in discontinued operations. XBRL Elements 45-5 Examples of circumstances in which those types of adjustments may arise include the following: a. The resolution of contingencies that arise pursuant to the terms of the disposal transaction, such as the resolution of purchase price adjustments and indemnification issues with the purchaser b. The resolution of contingencies that arise from and that are directly related to the operations of the component prior to its disposal, such as environmental and product warranty obligations retained by the seller c. The settlement of employee benefit plan obligations (pension, postemployment benefits other than pensions, and other postemployment benefits), provided that the settlement is directly related to the disposal transaction. A settlement is directly related to the disposal transaction if there is a demonstrated direct cause-and-effect relationship and the settlement occurs no later 114
than one year following the disposal transaction, unless it is delayed by events or circumstances beyond an entity’s control (see paragraph 360-10-45-11). FASB ASC 6-7 Accounting Changes Search accounting changes 250-10-05 05-1 This Subtopic provides guidance on the accounting for and reporting of accounting changes and error corrections. An accounting change can be a change in an accounting principle, an accounting estimate, or the reporting entity. Guidance for each of these types of changes is presented in separate headings within each Section. Guidance for error corrections is also presented under a separate heading within each Section. > Accounting Changes 05-2 This Subtopic establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to a newly adopted accounting principle. 05-3 This Subtopic provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. > Error Corrections 05-4 The correction of an error in previously issued financial statements is not an accounting change. However, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. Therefore, the reporting of a correction of an error by restating previously issued financial statements is also addressed by this Subtopic. 05-5 This Subtopic also: a. Specifies the method of treating error corrections in comparative statements for two or more periods b. Specifies the disclosures required when previously issued statements of income are restated c. Recommends methods of presentation of historical, statistical-type financial summaries that are affected by error corrections. 250-10-20 Glossary Click on a glossary term to view locations that include links to the term. Accounting Change A change in an accounting principle, an accounting estimate, or the reporting entity. The correction of an error in previously issued financial statements is not an accounting change. Change in Accounting Estimate 115
A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. A change in accounting estimate is a necessary consequence of the assessment, in conjunction with the periodic presentation of financial statements, of the present status and expected future benefits and obligations associated with assets and liabilities. Changes in accounting estimates result from new information. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, and warranty obligations. Change in Accounting Estimate Effected by a Change in Accounting Principle A change in accounting estimate that is inseparable from the effect of a related change in accounting principle. An example of a change in estimate effected by a change in principle is a change in the method of depreciation, amortization, or depletion for long-lived, nonfinancial assets. Change in Accounting Principle A change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle. Change in the Reporting Entity A change that results in financial statements that, in effect, are those of a different reporting entity. A change in the reporting entity is limited mainly to the following: a. Presenting consolidated or combined financial statements in place of financial statements of individual entities b. Changing specific subsidiaries that make up the group of entities for which consolidated financial statements are presented c. Changing the entities included in combined financial statements. Neither a business combination accounted for by the purchase method nor the consolidation of a variable interest entity (VIE) pursuant to Topic 810 is a change in reporting entity. Note: The following definition is pending content; see Transition Guidance in 805-10-65-1. A change that results in financial statements that, in effect, are those of a different reporting entity. A change in the reporting entity is limited mainly to the following: a. Presenting consolidated or combined financial statements in place of financial statements of individual entities b. Changing specific subsidiaries that make up the group of entities for which consolidated financial statements are presented c. Changing the entities included in combined financial statements. 116
Neither a business combination accounted for by the acquisition method nor the consolidation of a variable interest entity (VIE) pursuant to Topic 810 is a change in reporting entity. Direct Effects of a Change in Accounting Principle Those recognized changes in assets or liabilities necessary to effect a change in accounting principle. An example of a direct effect is an adjustment to an inventory balance to effect a change in inventory valuation method. Related changes, such as an effect on deferred income tax assets or liabilities or an impairment adjustment resulting from applying the lower-of-cost-or-market test to the adjusted inventory balance, also are examples of direct effects of a change in accounting principle. Error in Previously Issued Financial Statements An error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of generally accepted accounting principles (GAAP), or oversight or misuse of facts that existed at the time the financial statements were prepared. A change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error. Indirect Effects of a Change in Accounting Principle Any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively. An example of an indirect effect is a change in a nondiscretionary profit sharing or royalty payment that is based on a reported amount such as revenue or net income. Restatement The process of revising previously issued financial statements to reflect the correction of an error in those financial statements. Retrospective Application 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. 250-10-45 >
Accounting Changes
> > Change in Accounting Principle 45-1 A presumption exists that an accounting principle once adopted shall not be changed in accounting for events and transactions of a similar type. Consistent use of the same accounting principle from one accounting period to another enhances the utility of financial statements for users by facilitating analysis and understanding of comparative accounting data. Neither of the following is considered to be a change in accounting principle: a. 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 117
b. Adoption or modification of an accounting principle necessitated by transactions or events that are clearly different in substance from those previously occurring. 45-2 A reporting entity shall change an accounting principle only if either of the following apply: a. The change is required by a newly issued Codification update. b. The entity can justify the use of an allowable alternative accounting principle on the basis that it is preferable. 45-3 It is expected that Codification updates normally will provide specific transition requirements. However, in the unusual instance that there are no transition requirements specific to a particular Codification update, a change in accounting principle effected to adopt the requirements of that Codification update shall be reported in accordance with paragraphs 250-10-45-5 through 45-8. Early adoption of a Codification update, when permitted, shall be effected in a manner consistent with the transition requirements of that update. 45-4 This requirement is not limited to newly issued Codification updates. For example, if existing Codification guidance permits a choice between two or more alternative accounting principles, and provides requirements for changing from one to another, those requirements shall be followed. 45-5 An entity shall report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application requires all of the following: a. The cumulative effect of the change to the new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented. b. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period. c. Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle. 45-6 If the cumulative effect of applying a change in accounting principle to all prior periods can be determined, but it is impracticable to determine the period-specific effects of that change on all prior periods presented, the cumulative effect of the change to the new accounting principle shall be applied to the carrying amounts of assets and liabilities as of the beginning of the earliest period to which the new accounting principle can be applied. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period. 45-7 If it is impracticable to determine the cumulative effect of applying a change in accounting principle to any prior period, the new accounting principle shall be applied as if the change was made prospectively as of the earliest date practicable. See Example 1 (paragraphs 250-10-55-3 through 55-11) for an illustration of a change from the first-in, first-out (FIFO) method of inventory valuation to the lastin, first-out (LIFO) method. That Example does not imply that such a change would be considered preferable as required by paragraph 250-10-45-12. 45-8 Retrospective application shall include only the direct effects of a change in accounting principle, including any related income tax effects. Indirect effects that would have been recognized if the newly adopted accounting principle had been followed in prior periods shall not be included in the retrospective application. If indirect effects are actually incurred and recognized, they shall be reported in the period in which the accounting change is made. 118
> > > Impracticability 45-9 It shall be deemed impracticable to apply the effects of a change in accounting principle retrospectively only if any of the following conditions exist: a. After making every reasonable effort to do so, the entity is unable to apply the requirement. b. Retrospective application requires assumptions about management's intent in a prior period that cannot be independently substantiated. c. Retrospective application requires significant estimates of amounts, and it is impossible to distinguish objectively information about those estimates that both: 1. Provides evidence of circumstances that existed on the date(s) at which those amounts would be recognized, measured, or disclosed under retrospective application 2. Would have been available when the financial statements for that prior period were issued. 45-10 This Subtopic requires a determination of whether information currently available to develop significant estimates would have been available when the affected transactions or events would have been recognized in the financial statements. However, it is not necessary to maintain documentation from the time that an affected transaction or event would have been recognized to determine whether information to develop the estimates would have been available at that time. > > > Justification for a Change in Accounting Principle 45-11 In the preparation of financial statements, once an accounting principle is adopted, it shall be used consistently in accounting for similar events and transactions. 45-12 An entity may change an accounting principle only if it justifies the use of an allowable alternative accounting principle on the basis that it is preferable. However, 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 shall not be changed. For example, the method of accounting shall not be changed for a tax or tax credit that is being discontinued. Additionally, the method of transition elected at the time of adoption of a Codification update shall not be subsequently changed. However, a change in the estimated period to be benefited by an asset, if justified by the facts, shall be recognized as a change in accounting estimate. 45-13 The issuance of a Codification update that requires use of a new accounting principle, interprets an existing principle, expresses a preference for an accounting principle, or rejects a specific principle may require an entity to change an accounting principle. The issuance of such an update constitutes sufficient support for making such a change. FASB ASC 6-8 Earnings Per Share Link presentation-earnings per share 260-10 Basic EPS 10-1 The objective of basic earnings per share (EPS) is to measure the performance of an entity over the reporting period. 119
> Diluted EPS 10-2 The objective of diluted EPS is consistent with that of basic EPS—to measure the performance of an entity over the reporting period—while giving effect to all dilutive potential common shares that were outstanding during the period. 260-10-20 Glossary Antidilution An increase in earnings per share amounts or a decrease in loss per share amounts. Basic Earnings Per Share The amount of earnings for the period available to each share of common stock outstanding during the reporting period. Call Option A contract that allows the holder to buy a specified quantity of stock from the writer of the contract at a fixed price for a given period. See Option and Purchased Call Option. Common Stock A stock that is subordinate to all other stock of the issuer. Also called common shares. Consolidated Financial Statements Note: The following definition is Pending Content; see Transition Guidance in 810-10-65-1. The financial statements of a consolidated group of entities that include a parent and all its subsidiaries presented as those of a single economic entity. Consolidated Group Note: The following definition is Pending Content; see Transition Guidance in 810-10-65-1. A parent and all its subsidiaries. Contingent Issuance A possible issuance of shares of common stock that is dependent on the satisfaction of certain conditions. Contingent Stock Agreement An agreement to issue common stock (usually in connection with a business combination) that is dependent on the satisfaction of certain conditions. See Contingently Issuable Shares. Contingently Convertible Instruments Contingently convertible instruments are instruments that have embedded conversion features that are contingently convertible or exercisable based on either of the following: a. A market price trigger b. Multiple contingencies if one of the contingencies is a market price trigger and the instrument can be converted or share settled based on meeting the specified market condition.
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A market price trigger is a market condition that is based at least in part on the issuer's own share price. Examples of contingently convertible instruments include contingently convertible debt, contingently convertible preferred stock, and the instrument described by paragraph 260-10-45-43, all with embedded market price triggers. Contingently Issuable Shares Shares issuable for little or no cash consideration upon the satisfaction of certain conditions pursuant to a contingent stock agreement. Also called contingently issuable stock. See Contingent Stock Agreement. Conversion Rate The ratio of the number of common shares issuable upon conversion to a unit of a convertible security. For example, $100 face value of debt convertible into 5 shares of common stock would have a conversion ratio of 5:1. Also called conversion ratio. Convertible Security A security that is convertible into another security based on a conversion rate. For example, convertible preferred stock that is convertible into common stock on a two-for-one basis (two shares of common for each share of preferred). Diluted Earnings Per Share The amount of earnings for the period available to each share of common stock outstanding during the reporting period and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during the reporting period. Dilution A reduction in EPS resulting from the assumption that convertible securities were converted, that options or warrants were exercised, or that other shares were issued upon the satisfaction of certain conditions. Earnings Per Share The amount of earnings attributable to each share of common stock. For convenience, the term is used to refer to either earnings or loss per share. Employee Stock Ownership Plan An employee stock ownership plan is an employee benefit plan that is described by the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code of 1986 as a stock bonus plan, or combination stock bonus and money purchase pension plan, designed to invest primarily in employer stock. Also called an employee share ownership plan. Exercise Price The amount that must be paid for a share of common stock upon exercise of an option or warrant. If-Converted Method A method of computing EPS data that assumes conversion of convertible securities at the beginning of the reporting period (or at time of issuance, if later). Income Available to Common Stockholders Income (or loss) from continuing operations or net income (or net loss) adjusted for preferred stock dividends. Noncontrolling Interest Note: The following definition is Pending Content; see Transition Guidance in 805-10-65-1 and 810-1065-1. 121
The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest. Option Unless otherwise stated, a call option that gives the holder the right to purchase shares of common stock from the reporting entity in accordance with an agreement upon payment of a specified amount. Options include, but are not limited to, options granted to employees and stock purchase agreements entered into with employees. Options are considered securities. See Call Option. Participating Security A security that may participate in undistributed earnings with common stock, whether that participation is conditioned upon the occurrence of a specified event or not. The form of such participation does not have to be a dividend—that is, any form of participation in undistributed earnings would constitute participation by that security, regardless of whether the payment to the security holder was referred to as a dividend. Potential Common Stock A security or other contract that may entitle its holder to obtain common stock during the reporting period or after the end of the reporting period. Preferred Stock A security that has preferential rights compared to common stock. Purchased Call Option A contract that allows the reporting entity to buy a specified quantity of its own stock from the writer of the contract at a fixed price for a given period. See Call Option. Put Option A contract that allows the holder to sell a specified quantity of stock to the writer of the contract at a fixed price during a given period. Reverse Treasury Stock Method A method of recognizing the dilutive effect on EPS of satisfying a put obligation. It assumes that the proceeds used to buy back common stock (pursuant to the terms of a put option) will be raised from issuing shares at the average market price during the period. See Put Option. Rights Issue An offer to existing shareholders to purchase additional shares of common stock in accordance with an agreement for a specified amount (which is generally substantially less than the fair value of the shares) for a given period. Security The evidence of debt or ownership or a related right. It includes options and warrants as well as debt and stock. Subsidiary An entity that is controlled, directly or indirectly, by another entity. Note: The following definition is Pending Content; see Transition Guidance in 810-10-65-1. An entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary beneficiary.) 122
Treasury Stock Method A method of recognizing the use of proceeds that could be obtained upon exercise of options and warrants in computing diluted EPS. It assumes that any proceeds would be used to purchase common stock at the average market price during the period. Warrant A security that gives the holder the right to purchase shares of common stock in accordance with the terms of the instrument, usually upon payment of a specified amount. Weighted-Average Number of Common Shares Outstanding The number of shares determined by relating the portion of time within a reporting period that common shares have been outstanding to the total time in that period. In computing diluted EPS, equivalent common shares are considered for all dilutive potential common shares. b. 260-10-45 Room for Debate Debate 6-1 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.
2.
Comprehensive income would include changes due to price level, holding gains, which under GAAP are excluded from net income. These changes provide information on 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.
4.
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
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1.
Comprehensive income should not be reported because it is not consistent with the currentoperating performance concept of income and it represents a departure from the realization principle
2.
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.
3.
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.
1. 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 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 the 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 1 124
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 chose 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 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 125
objectives of financial reporting found in SFAS No. 1. According to SFAS No. 1 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 6-11 The new proposed income statement has separate categories for the disclosure of a company’s operating business, its financing activities, investing activities, and tax payments. Each category also contains an income subtotal. The proposal adopts a single statement of comprehensive income format that combines income statement elements and components of other comprehensive income into a single statement. Items of other comprehensive income are to be presented in a separate section following the income statement elements. This presentation format includes a subtotal of net income and a total of comprehensive income in the period. The Boards the eliminated the current alternative presentation format that allows items of other comprehensive income to be presented either: (1) On a separate statement, (2) On a combined statement of comprehensive income, or (3) On the statement of stockholder’s equity because research studies suggested that investors and other users’ ability to process the information will be enhanced if a uniform format of comprehensive income statement is presented. According to the proposal, all income and expense items will be classified into operating, investing, and financing categories. Within those categories, an entity will disaggregate line items by function. Within those functions, an entity should further disaggregate line items by nature when such presentation will enhance the usefulness of the information in predicting future cash flows. Function refers to the primary activities in which an entity is engaged. For example, an entity’s operating activities consist of selling goods, marketing or administration. Nature refers to the economic characteristics or attributes that distinguish assets, liabilities, and income and expense items that do not respond equally to similar economic events. Examples of disaggregation by nature include disaggregating total sales into wholesale and retail or disaggregating total cost of sales into materials, labor, transport, and energy costs. The desegregations will result in more subtotals than current income statement therefore facilitate the comparison of effects across financial statement. Another difference between the proposed format and current practice is in the treatment of foreign currency transaction gains and losses. Currently, these gains and losses are reported in the income statement at a net amount. Under the proposal, individual foreign currency transactions gains or losses are to be included in the same category as the related asset or liability on the balance sheet. Gains or losses may also arise when a company remeasures its subsidiary’s financial statements from the local currency to its functional currency. The proposal requires companies to identify the components of gains or losses from remeasurement and classify them into the operating, investing or financing categories accordingly. The Boards agreed on retaining the current intraperiod tax allocation method. The Boards did not support allocation of income tax expense or benefit to the operating, investing, financing asset, or financing liability categories because they determined that the cost of doing so would exceed the benefit. Similarly, there are no proposed changes in the current reporting format for discontinued operations, extraordinary items and changes in accounting principles. The exposure draft didn’t provide guidance on which items should be included in the comprehensive income because they are discussed in other exposure drafts. Case 6-12 IAS No. 8 indicates that in making that judgment, the following sources should be considered in descending order: 126
•
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 6-13 The solution to this case depend 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 Solution will depend on the companies selected to analyze.
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. 127
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.
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. 128
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 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 -
b.
c.
d.
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 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. 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. 129
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 may be measured at market value or historical cost, inventories are measured at the lower of cost or market, investments may be measured at the lower of cost or market or historical cost, and plant and equipment or 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.
b.i.
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 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
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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.
b.
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 is SFAC No. 1. 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.
c.
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, 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
e.
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 131
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. b.
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.
c.
Yes. Again, the student should be encouraged to express his/her own opinion. 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. 132
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 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. 1 and 5. SFAC No. 1 stressed 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. 1 and 5 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 942-405-25-4. Most easily found by searching accounting for credit union share accounts. The students’ answers should contain the following: Member Deposits For credit unions and corporate credit unions generally accepted accounting principles (GAAP) require that all member deposit accounts, including member shares, shall be reported unequivocally as liabilities in the statement of financial condition. The following illustration of accounting for member deposits originally developed by the EITF was found in the FASB ASC:
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>
Implementation Guidance
942-405-55-1 [For a credit union to be in compliance with the Codification, it must be unequivocal on the face of the statement of financial condition that savings accounts are a liability. [EITF 89-03, paragraph DISCUSSION, sequence 9.1] ] 942-405-55-2 [A credit union statement of financial condition shall either: [EITF 89-03, paragraph DISCUSSION, sequence 9.2.1] ] a. [Present savings accounts as the first item in the liabilities and equity section [EITF 89-03, paragraph DISCUSSION, sequence 9.2.2.1] ] b. Include savings accounts within a captioned subtotal for total liabilities. [EITF 89-03, paragraph DISCUSSION, sequence 9.2.2.2] ] > Illustrations > > Example 1: Illustrated Statement of Financial Condition 942-405-55-3 [This Example provides an illustration in which it is unequivocal on the face of the statement of financial condition that savings accounts are a liability. [EITF 89-03, paragraph DISCUSSION, sequence 10.1] ] [ Sample Credit Union [EITF 89-03, paragraph Exhibit 89-3A, sequence 15] ] [Statements of Financial Condition [EITF 89-03, paragraph Exhibit 89-3A, sequence 16] ] [December 31, 19X2 and 19X1 [EITF 89-03, paragraph Exhibit 89-3A, sequence 17] ]
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[EITF 89-03, paragraph Exhibit 89-3A, sequence 18] [The accompanying notes are an integral part of these financial statements. [For purposes of these illustrations, the notes to financial statements have not been included in this or the following Example.] [EITF 89-03, paragraph Exhibit 89-3A, sequence 19] ] > > Example 2: Alternative Presentation of Savings Accounts Within the Liabilities Section of the Statement of Financial Condition 942-405-55-4 This Example provides an illustration in which it is unequivocal on the face of the statement of financial condition that savings accounts are a liability. [Sample Credit Union [EITF 89-03, paragraph Exhibit 89-3B, sequence 24] ] [Statements of Financial Condition [EITF 89-03, paragraph Exhibit 89-3B, sequence 25] ] [December 31, 19X2 and 19X1 [EITF 89-03, paragraph Exhibit 89-3B, sequence 26] ]
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FASB ASC 7-2 Search historical cost. The citations to historical cost in the FASB ASC are: 835 Interest > 20 Capitalization of Interest > 05 Overview and Background 05-1 This Subtopic establishes standards of financial accounting and reporting for capitalizing interest cost as a part of the historical cost of acquiring certain assets. The historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. If an asset requires a period of time in which to carry out the activities necessary to bring it to that condition and location, the interest cost incurred during that period as a result of expenditures for the asset is a part of the historical cost of acquiring the asset. 942 Financial Services—Depository and Lending > 310 Receivables > 55 Implementation Guidance and Illustrations Debt-Equity Swap Programs 55-1 Management may decide to dispose (by sale of swap) of loans prior to maturity for a number of reasons, including liquidity needs, tax considerations, portfolio diversification objectives, and management practices of generating loans specifically for disposition, in which case the loans shall be carried at the lower of cost (amortized historical cost less loan write-offs) or fair value. 835 Interest > 20 Capitalization of Interest > 10 Objectives 10-1 The objectives of capitalizing interest are to obtain a measure of acquisition cost that more closely reflects an entity's total investment in the asset and to charge a cost that relates to the acquisition of a resource that will benefit future periods against the revenues of the periods benefited. 10-2 On the premise that the historical cost of acquiring an asset should include all costs necessarily incurred to bring it to the condition and location necessary for its intended use, in principle, the cost 136
incurred in financing expenditures for an asset during a required construction or development period is itself a part of the asset's historical acquisition cost. The cause-and-effect relationship between acquiring an asset and the incurrence of interest cost makes interest cost analogous to a direct cost that is readily and objectively assignable to the acquired asset. Failure to capitalize the interest cost associated with the acquisition of qualifying assets improperly reduces reported earnings during the period of acquisition and increases reported earnings in later periods. 805 Business Combinations > 50 Related Issues > S30 Initial Measurement New Basis of Accounting (Pushdown) > Push-Down Basis of Accounting Required in Certain Limited Circumstances S30-1 See paragraph 805-50-S99-1, SAB Topic 5.J, for SEC Staff views regarding issues pertaining to push-down basis of accounting. > Change of Accounting Basis in Master Limited Partnership Transactions S30-2 See paragraph 805-50-S99-3, SEC Observer Comment: Change of Accounting Basis in Master Limited Partnership Transactions, for SEC Staff views regarding change in basis of accounting issues in master limited partnership transactions. > Measurement of Certain Transfers Between Entities Under Common Control in the Separate Financial Statements of Each Entity 30-3 See paragraph 805-50-S99-4, SEC Observer Comment: Measurement of Certain Transfers Between Entities Under Common Control in the Separate Financial Statements of Each Entity for SEC Staff views on carrying over historical cost to record, in the separate financial statements of each entity, certain transfers between companies under common control or between a parent and its subsidiary FASB ASC 7-3 Search current cost - over 100 hits
FASB ASC 7-4 Search FAS 157 in Cross Reference Found at 820 Fair Value Measurements and Disclosures Summary should include: 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 foe FASB ASC 820 was that previous GAAP contained inconsistent definitions and only limited application guidance for fair value measurements. The most important aspects of FASB ASC 820 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 nonmarket 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. 137
FASB ASC 820 is to be applied to any asset or liability that is measured at fair value under current GAAP 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, FASB ASC 820 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. FASB ASC 820 establishes a fair value hierarchy that prioritizes the inputs used to measure fairn value. The three levels of the fair value hierarchy are: Level 1 - Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. . For example, the unadjusted quoted price of actively traded IBM shares on a nationally recognized stock exchange. Level 2 - Pricing inputs are observable, either directly or indirectly, but are not quoted prices included within Level 1. For example, the use of matrix pricing or discount rates used to value a servicing portfolio that have been corroborated with recent like transactions. Level 3 - Pricing inputs include significant inputs that are generally less observable from objective sources. For example, the use of a financial forecast of projected earnings or cash flows to determine the fair value of a business.
FASB ASC 7-6 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:
a. 230-10-10 Objectives General 230-10-10-1 The primary objective of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an entity during a period. b. 230-10-10-2 The information provided in a statement of cash flows, if used with related disclosures and information in the other financial statements, should help investors, creditors, and others (including donors) to do all of the following: a. Assess the entity's ability to generate positive future net cash flows b. Assess the entity's ability to meet its obligations, its ability to pay dividends, and its needs for external financing c. Assess the reasons for differences between net income and associated cash receipts and payments d. Assess the effects on an entity's financial position of both its cash and noncash investing and financing transactions during the period. Room for Debate 138
Debate 7-1 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 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
1.
Present arguments that the income statement, not the statement of cash flows, is the most important financial statement. SFAC No. 1 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. 1, 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 139
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 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 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.
140
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).
b.
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).
c.
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 7-11 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. 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 trade off 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 141
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 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)
Examples Company A common stock traded and quoted on the New York Stock Exchange. 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:
142
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 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: a. There are few recent transactions. b. Price quotations are not based on current information. c. Price quotations vary substantially either over time or among market makers (for example, some brokered markets). d. 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. e. 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. f. There is a wide bid-ask spread or significant increase in the bid-ask spread. g. 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. c. The circumstances identified that may indicate that a transaction is not orderly include, but are not limited to: a. 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. b. There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant. c. 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). d. The transaction price is an outlier when compared with other recent transactions for the same or similar asset or liability. Case 7-11 The Boards propose to further disaggregate assets and liabilities within each category into short-term and long-term based on a one-year time frame that would replace the current distinction between current and 143
non-current assets and liabilities that uses a one year or the operating cycle criterion. Assets and liabilities presented within each section would be further analyzed as short-term and long-term, unless presenting assets and liabilities in order of liquidity would provide more relevant information. In a presentation based on liquidity, an entity should present its assets and liabilities in increasing or decreasing order of liquidity, and it should include in the notes to its financial statements information about the maturities of its short-term contractual assets and liabilities. Additionally, entities should present information about the maturities of their long-term contractual assets and liabilities in the notes to financial statements. The Boards also propose that cash equivalents be considered similar to short-term investments and presented separately from cash. As discussed in the chapter, cash equivalences currently are aggregated with cash since both FASB and IASB have considered that cash equivalents are highly liquid and to be essentially the same as cash. However, the Boards concluded that excluding cash equivalents from the amount of cash presented in the statement of financial position would better help to achieve the liquidity and financial flexibility objective since short-term investments do not have all the characteristics of currency on hand and are subject to some risk of price change such as those attributable to sudden changes in the credit environment as occurred in 2007-8. Case 7-12 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 7-13 Presentation of Comprehensive Income . The answer to this case depends on the companies selected by the students. Financial Analysis Case The answer to this case depends on the companies selected by the students.
CHAPTER 8
Case 8-1 a.
Trading securities - Securities held for resale Securities available-for-sale - Securities not classified as trading securities or held-to-maturity securities. Securities held-to-maturity - Securities for which the reporting enterprise has both the positive intent, and ability to hold to maturity.
144
Trading securities are reported at fair value, and all unrealized holding gains and losses are also reported at fair value and included in periodic net income. Available-for-sale securities are reported at fair value; however, unrealized holding gains and losses for these securities are not included in periodic net income, rather they are reported as comprehensive income until realized. Held-to-maturity securities are accounted for by the historical cost the security's maturity value, is amortized over the remaining life of the security. b.
Trading securities are reported as current assets on the balance sheet. Individual held-tomaturity and available-for-sale securities are reported as either current assets or investments as appropriate.
c.
The individuals supporting current value maintain that all gains and losses affecting the company during an accounting period that can be measured should be recorded and reported. Since current values are generally available for marketable securities, proponents of current value accounting hold that these current values should be reported on the annual financial statements. The individuals who fear that current value accounting might allow earnings management are concerned about gains trading. A manager using a gains trading strategy would transfer securities that have declined in value to a long-term asset account and retain those securities that have increased in value under the temporary investment category.
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. 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.
c.
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
145
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.
b.
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.
c.
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.
d.
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.
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.
b.
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.
c.
Anth should account for the collection of the specific accounts previously written off as uncollectible as follows: * *
d.
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, 2008 through December 31, 2009, on its December 31, 2008, balance sheet as current assets. Both assets are due on June 30, 2009, which is within one year of the date of the balance sheet.
146
Anth should report interest income from the notes receivable on its income statement for the year ended December 31, 2008. The interest income would be equal to the amount accrued on the notes receivable at the stated rate for twelve months. Interest accrues with the passage of time, and it should be accounted for as an element of income over the life of the notes receivable. 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 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.
c.
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.
d.
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 147
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. 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.
b.
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 amount to be received from sales of products or (2) classifying the bad debts expense as a financial expense.
Case 8-7 a.
During the first year Key should report the securities at $550,000 on the balance sheet under the long-term investment category (Original cost of $500,000 and an increase in market valuation of $50,000. (It is possible that some of the portfolio could be disclosed as a current asset if Key 148
plans on selling some of its investment during the next year.) This $50,000 increase in market valuation would be disclosed on Key’s financial statements as an increase in other comprehensive income. During the second year Key should disclose the securities at $475,000 on the balance sheet under the long-term investment category Since the original cost of the investments remaining at the end of year 1 was $475,000, the cost balance indicates that additional investments of $105,000 (500,000- 80,000-525,000) were purchased in year 2). The decrease in market valuation will be reported on Key's financial statements as a $95,000 decrease in other comprehensive income ($550,000 – 30,000 + 50,000 - 95,000). Additionally, Key should report a gain on the sale of investments of $20,000 during the second year ($100,000 – 80,000). The previously recorded increase in value was reported as an increase in other comprehensive income and is removed from that category and classified as a gain at the time of the sale). b.
If these securities had been categorized as trading securities, the asset valuations and method of reporting on the balance sheet will be the same as Part (a) except that the securities will be disclosed under the current assets section of the balance sheet instead of the long-term investments section. In the first year Key will report an unrealized gain of $50,000 on its income statement ($550,000 - 500,000). In the second year Key will report an unrealized loss of $95,000 on its income statement. Key will not record a gain on the sale of the securities in the second year because this gain was reported as an unrealized gain on Key’s income statement in the first year.
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:
b.
(1)
The cost of using it-restricts its use to goods of high unit value.
(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 149
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, last-in, first-out 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 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.
b.i.
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 years sales. 150
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 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. 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.
It
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.
b.
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. 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 151
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). 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 through the presentation line or searching “current assets and current liabilities.” The students summaries should contain the following: 210 Balance Sheet 10 Overall 05 Overview and Background General 210-10-05-1 The Balance Sheet Topic includes the following two Subtopics: a. Overall b. Offsetting. 210-10-05-2 The balance sheet is commonly referred to as statement of financial position. For purposes of the FASB ASC, both titles are interchangeable. 210-10-05-3 The Offsetting Subtopic provides guidance about offsetting amounts for certain contracts and repurchase and reverse repurchase agreements. 210-10-05-4 The Overall Subtopic provides general guidance on the classification of current assets and current liabilities and discusses the determination of working capital. The balance sheets of most entities show separate classifications of current assets and current liabilities (commonly referred to as classified balance sheets) permitting ready determination of working capital. 210-10-05-5 Financial position, as it is reflected by the records and accounts from which the statement is prepared, is revealed in a presentation of the assets and liabilities of the entity. In the statements of manufacturing, trading, and service entities, these assets and liabilities are generally classified and segregated; if they are classified logically, summations or totals of the current or circulating or working 152
assets (referred to as current assets) and of obligations currently payable (designated as current liabilities) will permit the ready determination of working capital. 210-10-05-6 The ordinary operations of an entity involve a circulation of capital within the current asset group. Cash is expended for materials, finished parts, operating supplies, labor, and other factory services, and such expenditures are accumulated as inventory cost. Inventory costs, upon sale of the products to which such costs attach, are converted into trade receivables and ultimately into cash again. 210-10-05-7 [Paragraph not used] 210-10-05-8 In addition to the classification guidance provided in this Subtopic, other Topics in the FASB ASC also address specific classification matters. 210 Balance Sheet 10 Overall 45 Other Presentation Matters General >
Classification of Current Assets
210-10-45-1 Current assets generally include all of the following: a.
Cash available for current operations and items that are cash equivalents
b.
Inventories of merchandise, raw materials, goods in process, finished goods, operating supplies, and ordinary maintenance material and parts
c. Trade accounts, notes, and acceptances receivable d. Receivables from officers, employees, affiliates, and others, if collectible in the ordinary course of business within a year e. Installment or deferred accounts and notes receivable if they conform generally to normal trade practices and terms within the business f.
g.
Marketable securities representing the investment of cash available for current operations, including investments in debt and equity securities classified as trading securities under Subtopic 320-10 Prepaid expenses such as the following: 1. Insurance 2. Interest 153
3. Rents 4. Taxes 5. Unused royalties 6. Current paid advertising service not yet received 7. Operating supplies. 210-10-45-2 Prepaid expenses are not current assets in the sense that they will be converted into cash but in the sense that, if not paid in advance, they would require the use of current assets during the operating cycle. An asset representing the overfunded status of a single-employer defined benefit pension or postretirement plan shall be classified pursuant to Subtopics 715-30 and 715-60. 210-10-45-3 A one-year time period shall be used as a basis for the segregation of current assets in cases where there are several operating cycles occurring within a year. However, if the period of the operating cycle is more than 12 months, as in, for instance, the tobacco, distillery, and lumber businesses, the longer period shall be used. If a particular entity has no clearly defined operating cycle, the one-year rule shall govern. 210-10-45-4 The concept of the nature of current assets contemplates the exclusion from that classification of such resources as the following: a. Cash and claims to cash that are restricted as to withdrawal or use for other than current operations, are designated for expenditure in the acquisition or construction of noncurrent assets, or are segregated for the liquidation of long-term debts. Even though not actually set aside in special accounts, funds that are clearly to be used in the near future for the liquidation of long-term debts, payments to sinking funds, or for similar purposes shall also, under this concept, be excluded from current assets. However, if such funds are considered to offset maturing debt that has properly been set up as a current liability, they may be included within the current asset classification. b. Investments in securities (whether marketable or not) or advances that have been made for the purposes of control, affiliation, or other continuing business advantage. c. Receivables arising from unusual transactions (such as the sale of capital assets, or loans or advances to affiliates, officers, or employees) that are not expected to be collected within 12 months. d. Cash surrender value of life insurance policies. e. Land and other natural resources. f.
Depreciable assets. 154
g. Long-term prepayments that are fairly chargeable to the operations of several years, or deferred charges such as bonus payments under a long-term lease, costs of rearrangement of factory layout or removal to a new location. >
Classification of Current Liabilities
210-10-45-5 A total of current liabilities shall be presented in classified balance sheets. 210-10-45-6 The concept of current liabilities includes estimated or accrued amounts that are expected to be required to cover expenditures within the year for known obligations the amount of which can be determined only approximately (as in the case of provisions for accruing bonus payments) or where the specific person or persons to whom payment will be made cannot as yet be designated (as in the case of estimated costs to be incurred in connection with guaranteed servicing or repair of products already sold). 210-10-45-7 Section 470-10-45 includes guidance on various debt transactions that may result in current liability classification. These transactions are the following: a. Due on demand loan agreements b. Callable debt agreements c. Short-term obligations expected to be refinanced. >>
Obligations in the Operating Cycle
210-10-45-8 As a balance sheet category, the classification of current liabilities generally includes obligations for items that have entered into the operating cycle, such as the following: a. Payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale. b. Collections received in advance of the delivery of goods or performance of services. Examples of such current liabilities are obligations resulting from advance collections on ticket sales, which will normally be liquidated in the ordinary course of business by the delivery of services. On the contrary, obligations representing long-term deferments of the delivery of goods or services would not be shown as current liabilities. Examples of the latter are the issuance of a long-term warranty or the advance receipt by a lessor of rental for the final period of a 10 year lease as a condition to execution of the lease agreement. c. Debts that arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes. >>
Other Liabilities
210-10-45-9 Other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually 12 months, are also generally included, such as the following: 155
a.
Short-term debts arising from the acquisition of capital assets
b.
Serial maturities of long-term obligations
c.
Amounts required to be expended within one year under sinking fund provisions
d.
Agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons. Loans accompanied by pledge of life insurance policies would be classified as current liabilities if, by their terms or by intent, they are to be repaid within 12 months. The pledging of life insurance policies does not affect the classification of the asset any more than does the pledging of receivables, inventories, real estate, or other assets as collateral for a short-term loan. However, when a loan on a life insurance policy is obtained from the insurance entity with the intent that it will not be paid but will be liquidated by deduction from the proceeds of the policy upon maturity or cancellation, the obligation shall be excluded from current liabilities.
210-10-45-10 A liability representing the underfunded status of a single-employer defined benefit pension or postretirement plan shall be classified pursuant to Subtopics 715-30 and 715-60. 210-10-45-11 If the amounts of the periodic payments of an obligation are, by contract, measured by current transactions, as for example by rents or revenues received in the case of equipment trust certificates or by the depletion of natural resources in the case of property obligations, the portion of the total obligation to be included as a current liability shall be that representing the amount accrued at the balance sheet date. 210-10-45-12 The current liability classification is not intended to include debts to be liquidated by funds that have been accumulated in accounts of a type not properly classified as current assets, or longterm obligations incurred to provide increased amounts of working capital for long periods. FASB ASC 8-2 Offsetting Assets and Liabilities 95 search results can be found by searching for offsetting Assets and liabilities. 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.” FASB ASC 330 Inventory > 10 Overall > 10 Objectives General 10-1 A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues. The original source of this definition was ARB 43, Paragraph Ch. 4. FASB ASC 8-4 Definitions From topic list select Presentation and Balance Sheet. Found under Glossary 156
Current Assets Current assets is used to designate cash and other assets or resources commonly identified as those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business. Current Liabilities Current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. Operating Cycle The average time intervening between the acquisition of materials or services and the final cash realization constitutes an operating cycle. Working Capital Working capital (also called net working capital) is represented by the excess of current assets over current liabilities and identifies the relatively liquid portion of total entity capital that constitutes a margin or buffer for meeting obligations within the ordinary operating cycle of the entity. FASB ASC 8-5 Examples of Current Assets From topic list select Presentation and Balance Sheet. Found under Other Presentation Matter Classification of Current Assets 45-1 Current assets generally include all of the following: a. Cash available for current operations and items that are cash equivalents b. Inventories of merchandise, raw materials, goods in process, finished goods, operating supplies, and ordinary maintenance material and parts c. Trade accounts, notes, and acceptances receivable d. Receivables from officers, employees, affiliates, and others, if collectible in the ordinary course of business within a year e. Installment or deferred accounts and notes receivable if they conform generally to normal trade practices and terms within the business f.
Marketable securities representing the investment of cash available for current operations, including investments in debt and equity securities classified as trading securities under Subtopic 320-10
g. Prepaid expenses such as the following: 1. Insurance 2. Interest 3. Rents 157
4. Taxes 5. Unused royalties 6. Current paid advertising service not yet received 7. Operating supplies. FASB ASC 8-6 Classification of Current Liabilities From topic list select Presentation and Balance Sheet. Found under Other Classification of Current Liabilities 45-5 A total of current liabilities shall be presented in classified balance sheets. 45-6 The concept of current liabilities includes estimated or accrued amounts that are expected to be required to cover expenditures within the year for known obligations the amount of which can be determined only approximately (as in the case of provisions for accruing bonus payments) or where the specific person or persons to whom payment will be made cannot as yet be designated (as in the case of estimated costs to be incurred in connection with guaranteed servicing or repair of products already sold). 45-7 Section 470-10-45 includes guidance on various debt transactions that may result in current liability classification. These transactions are the following: a. Due on demand loan agreements b. Callable debt agreements c. Short-term obligations expected to be refinanced. FASB ASC 8- 7 Compensating Balances Found through Presentation-Balance Sheet – Other – SEC Materials SEC Staff Guidance > > Staff Accounting Bulletins > > > SAB Topic 6.H, Accounting Series Release 148—Disclosures of Compensating Balances and Short-Term Borrowing Arrangements S99-2 The following is the text of SAB Topic 6.H, Accounting Series Release 148—Disclosures of Compensating Balances and Short-Term Borrowing Arrangements. Facts: ASR 148 (as modified) amends Regulation S-X to include: 1. Disclosure of compensating balance arrangements. 2. Segregation of cash for compensating balance arrangements that are legal restrictions on the availability of cash. SAB Topic 6.H.1, Applicability a. Arrangements with other lending institutions. 158
Question: In addition to banks, is ASR 148 applicable to arrangements with factors, commercial finance companies or other lending entities? Interpretive Response: Yes. b. Bank holding companies and brokerage firms. Question: Do the provisions of ASR 148 apply to bank holding companies and to brokerage firms filing under Rule 17a-5? Interpretive Response: Yes; however, brokerage firms are not expected to meet these requirements when filing Form X-17a-5. c. Financial statements of parent company and unconsolidated subsidiaries. Question: Are the provisions of ASR 148 applicable to parent company financial statements in addition to consolidated financial statements? To financial statements of unconsolidated subsidiaries? Interpretive Response: ASR 148 data for consolidated financial statements only will generally be sufficient when a filing includes consolidated and parent company financial statements. Such data are required for each unconsolidated subsidiary or other entity when a filing is required to include complete financial statements of those entities. When the filing includes summarized financial data in a footnote about such entities, the disclosures under ASR 148 relating to the consolidated financial statements will be sufficient. d. Foreign lenders. Question: Are ASR 148 disclosure requirements applicable to arrangements with foreign lenders? Interpretive Response: Yes. SAB Topic 6.H.3, Compensating balances a. Compensating balances for future credit availability. Facts: Rule 5-02.1 of Regulation S-X requires disclosure of compensating balances in order to avoid undisclosed commingling of such balances with other funds having different liquidity characteristics and bearing no determinable relationship to borrowing arrangements. It also requires footnote disclosure distinguishing the amounts of such balances maintained under a formal agreement to assure future credit availability. Question: In disclosing compensating balances maintained to assure future credit availability, is it necessary to segregate compensating balances for an unused portion of a regular line of credit when a total compensating balance amount covering both used and unused amounts of a line of credit is disclosed? Interpretive Response: No. b. Changes in compensating balances. Facts: ASR 148 guidelines indicate the need for additional disclosures where compensating balances were materially greater during the period than at the end of the period. 159
Question: Does this disclosure relate to changes in the arrangement (e. g., the required compensating balance percentage) or changes in borrowing levels? Interpretive Response: Both. c. Float. Facts: ASR 148 states that "compensating balance arrangements... are normally expressed in terms of collected bank ledger balances but the financial statements are presented on the basis of the company's books. In order to make the disclosure of compensating balance amounts... consistent with the cash amounts reflected in the financial statements, the balance figure agreed upon by the bank and the company should be adjusted if possible by the estimated float." Question: In determining the amount of "float" as suggested by ASR 148 guidelines, frequently an adjustment to the bank balance is required for "uncollected funds." On what basis should this adjustment be estimated? Interpretive Response: The adjustment should be estimated based upon the method used by the bank or a reasonable approximation of that method. The following is a sample computation of the amount of compensating balances to be disclosed where uncollected funds are involved. Assumptions: The company has agreed to maintain compensating balances equal to 20% of shortterm borrowings.
SAB Topic 6.H.4, Miscellaneous a. Periods required. Question: For what periods are ASR 148 disclosures required? Interpretive Response: Disclosure of compensating balance arrangements and other disclosures called for in ASR 148 are required for the latest fiscal year but are generally not required for any later interim period unless a material change has occurred since year end. b. 10-Q Disclosures. Question: Are ASR 148 disclosures required in 10-Q's?
160
Interpretive Response: In general, ASR 148 disclosures are not required in Form 10-Q. However, in some instances material changes in borrowing arrangements or borrowing levels may give rise to the need for disclosure either in Form 10-Q or Form 8-K. FASB ASC 8-8 SFAS 115 Cross Reference FAS 115. Found at 320-10 Investments-Debt and Equity Securities. FASB ASC 8-9 ARB 43 and Inventory Found through Cross Reference. 330-10-30-1 The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. 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. It is understood to mean acquisition and production cost, and its determination involves many considerations. Room for Debate Debate 8- 1 Team 1
Defend LIFO
Cost of goods sold if the purchase is postponed until 19x9: 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 19x8: 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 1,446,000 $4,780,000 $ 120,000
Calculation of ending inventory: Purchase in 10,000 x $15 22,000 x $18
$
19x8 150,000 $ 396,000 161
19x9 150,000 396,000
5,000 x $20 45,000 x $20 Ending Inventory Cost of sales Purchase in 40,000 x $17 205,000 x $20 245,000 x $20
$
$ $
The difference: 40,000 x ($20-17)
1,446,000
19x8 680,000 4,100,000 4,780,000 =
$
100,000 900,000 646,000
19x9
$
$
4,900,000 120,000
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 19x8. 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. 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 were purchased in 19x8 or 19x9 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 19x9: Beginning Inventory: First Layer Second Layer Purchases Available Sold Ending Inventory
10,000 x $15 22,000 x $18 250,000 x $20 282,000 (245,000) 37,000 162
$150,000 396,000 5,000,000 $5,546,000 740,000
Cost of Goods Sold
$4,806,000
Cost of goods sold if the purchase is made in 19x8: 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 $
0
Calculation of ending inventory: Purchase in 37,000 x $20 40,000 x $17 Ending Inventory Cost of sales Purchase in 10,000 x $15 22,000 x $18 213,000 x $20
19x8 $ 740,000 680,000 $1,420,000
19x9 $ 740,000
19x8 $ 150,000 396,000 4,260,000 $4,860,000
19x9 $ 150,000 396,000 4,260,000 $4,860,000
$ 740,000
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 day-to-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 163
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 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 vs expense Team 1: Present arguments for capitalizing all of the above costs. Your arguments should utilize the Conceptual Framework definitions and concepts.
164
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 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 165
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 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 The gross method of recording inventory is easy to apply. Purchases are recorded at the gross price. When a discount is taken, it is recorded as discounts taken. However, at the end of the accounting period, net purchases will be overstated unless adjusted for discounts that are expected not to be taken. Also, this method does not take into consideration that the discount theoretically represents interest on the net amount borrowed. Finally, the method does not highlight the cost of not taking discounts. The net method is also easy to apply. Purchases are recorded net of the discount. The theoretical justification is that discounts not taken are due to the passage of time and hence are more like interest on borrowed funds. The net method treats discounts not taken as interest expense. Also, the net method allows for better management control by reporting the cost of borrowing (the discount lost) separately. At the end of the accounting period, an adjustment should be made for the estimated discounts that will be lost. Case 8-12 The solution to this case depends on the companies selected by the students. Requiring the students to turn in the information they download is a good method to use to check their solutions. 166
Case 8-13 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. As 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 8-14 The solution to this case depends on the companies selected by the students. Requiring the students to turn in the information they download is a good method to use to check their solutions.
Financial Analysis Case Answer will depend on company selected
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. 167
b.i.
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.
iii.
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)
$900,000
S/E
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: 168
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
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.
169
c.
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 a.
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.
b.i.
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.
c.
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: i.
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 170
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) 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 years 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. 171
(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.
b.
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.
c.i.
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 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.
172
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 recognized as an extraordinary loss. Subsequent periods should not be burdened with charges arising from costs which are not expected to yield future benefits. 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 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.
b.
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.
c.
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. 173
Case 9-6 a.
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.
b.
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.
c.
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. The salvage value is an estimate of an 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. 174
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 cash-based 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 cashflows, 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 The following costs, if applicable, should be capitalized as a cost of land: a.
(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 buyer (i) Clearing, grading, landscaping and subdividing (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 acquire 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.
d.
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 175
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 were 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. 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.
b. i.
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. 176
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: . 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.
d.
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.
b.
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 presumable be worth less. Hence, this expenditure fits the definition of an asset.
Case 9-11
177
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. Long-term 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.
b.
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.
c.
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.
d.
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.
e.
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 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.
FASB ASC 9-1 Depreciation
178
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. 35-1 This Subsection addresses depreciation of property, plant, and equipment and the post acquisition accounting for an interest in the residual value of a leased asset. > Depreciation 35-2 This guidance addresses the concept of depreciation accounting and the various factors to consider in selecting the related periods and methods to be used in such accounting. 35-3 Depreciation expense in financial statements for an asset shall be determined based on the asset's useful life. 35-4 The cost of a productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles (GAAP) require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting which 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. 35-5 See paragraph 360-10-35-20 for a discussion of depreciation of a new cost basis after recognition of an impairment loss. 35-6 See paragraph 360-10-35-43 for a discussion of cessation of depreciation on long-lived assets classified as held for sale. > > Declining Balance Method 35-7 The declining-balance method is an example of one of the methods that meet the requirements of being systematic and rational. If the expected productivity or revenue-earning power of the asset is relatively greater during the earlier years of its life, or maintenance charges tend to increase during later years, the declining-balance method may provide the most satisfactory allocation of cost. That conclusion also applies to other methods, including the sum-of-the-years'-digits method, that produce substantially similar results. > > Loss or Damage Experience as a Factor in Estimating Depreciable Lives 35-8 In practice, experience regarding loss or damage to depreciable assets is in some cases one of the factors considered in estimating the depreciable lives of a group of depreciable assets, along with such other factors as wear and tear, obsolescence, and maintenance and replacement policies. > > Unacceptable Depreciation Methods 35-9 If the number of years specified by the Accelerated Cost Recovery System of the Internal Revenue Service (IRS) for recovery deductions for an asset does not fall within a reasonable range of the asset's useful life, the recovery deductions shall not be used as depreciation expense for financial reporting. 35-10 Annuity methods of depreciation are not acceptable for entities in general. FASB ASC 360 Property, Plant, and Equipment > 10 Overall > 50 Disclosure General 50-1 Because of the significant effects on financial position and results of operations of the depreciation method or methods used, all of the following disclosures shall be made in the financial statements or in notes thereto: a Depreciation expense for the period 179
b Balances of major classes of depreciable assets, by nature or function, at the balance sheet date c Accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date d A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. FASB ASC 9-2 Asset Impairment A search of “asset impairments” resulted in 130 entries. 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 relevant sections are 410-20, 25, 30 and 40. The answer should include the following at a minimum: 1. Asset retirement obligation. —the liability associated with the ultimate disposal of a long-term asset. 2. Asset retirement cost. —the increase in the capitalized cost of a long-term asset that occurs when the liability for an asset retirement obligation is recognized. 3. Retirement. —an other than temporary removal of a long-term asset from service by sale, abandonment, or other disposal. 4. Promissory estoppel. —a legal concept that holds that a promise made without consideration may be enforced to prevent injustice. For each asset retirement obligation a company is required to initially record the fair value (present value) of the liability to dispose of the asset when a reasonable estimate of its fair value is available. Companies are required to use SFAC No. 7 criteria for recognition of the liability, which is the present value of the asset at the credit adjusted rate. This amount is defined as the amount a third party with a comparable credit standing would charge to assume the obligation. Subsequently, the capitalized asset retirement cost is allocated in a systematic and rational manner as depreciation expense over the estimated useful life of the asset. Additionally, the initial carrying value of the liability is increased each year by use of the interest method using the credit adjusted rate and classified as accretion expense and not interest expense. In the event any of the original assumptions change, a recalculation of the obligation and the subsequent associated expenses is to be recorded as a change in accounting estimate. FASB ASC 9-4 Disclosure of Depreciation Found by accessing the Assets link, selecting Property, plant and equipment and selecting disclosure. 50-1 Because of the significant effects on financial position and results of operations of the depreciation method or methods used, all of the following disclosures shall be made in the financial statements or in notes thereto: a. Depreciation expense for the period b. Balances of major classes of depreciable assets, by nature or function, at the balance sheet date 180
c. Accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date d. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. 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. 908-360-39 Overhaul Costs 30-1 This guidance addresses the following methods of accounting for overhaul expenses: a. Built-in overhaul method b. Deferral method. The direct expensing method is addressed in Subtopic 908-720 (see paragraph 908-720-25-3). > > Built-in Overhaul Method 30-2 The built-in overhaul method is based on segregation of the aggregate aircraft costs into those components that shall be depreciated over the useful life of the aircraft and those that require overhaul at periodic intervals. Thus, the estimated cost of the overhaul component included in the purchase price shall be set up separately from the cost of the airframe and engines. > > Deferral Method 30-3 Under the deferral method, the actual cost of each overhaul shall be capitalized. Debate 9-1 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 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. 181
According to SFAS No. 34, 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 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 nonreciprocal 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.
182
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. WWW Case 9-12 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.
b.
Under current GAAP, an impairment loss is equal to the difference between the book value of the asset and its fair market value.
c.
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.
d.
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 9-13 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 183
equipment. The Board’s purpose in revising the standard was to provide additional guidance on selected matters. b.
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 9-14 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
________________________________________________ CHAPTER 10 ________________________________________________ Case 10-1 a.
Managerial intent plays a significant role in the accounting treatment of investments in equity securities that have readily determinable fair values. When the owner of the securities is unable to exercise significant influence, as in the case of Quip, the accounting treatment is proscribed by FASB ASC 320. If managerial intent is to trade securities to realize short-term gains, they are classified as trading securities. If not they will be classified as available-for-sale securities. For both classifications, the securities are reported as assets in the balance at their fair market value. Unrealized holding gains and losses on securities classified as trading securities are reported on the income statement as current period income. Unrealized holding gains and losses on securities classified as available-for sale securities are reported as a component of stockholders’ equity as other comprehensive income on the balance sheet and in the statement of stockholders’ equity.
b.
The reclassification would result in the recognition of a cumulative unrealized holding gain of $4,000 ($27,000 - 23,000) on the income statement.
c.
If management actually intends to sell the stock in 2011 no ethical issue is involved. However, if the stock was purchased for its dividend return, and Maxey does not actually intend to sell it in 2011, it would be unethical to reclassify the stock in order to report the unrealized gain as income in 2010.
d.
Allowing changes in classifications from available-for -sale to trading can result in income manipulation. It is unlikely that a change in classification would be reported during a period in which the value of the security declined, as was the case for Maxey in 2009. The actual effect 184
on income for the two years was a loss of $1,400 in 2009 and a gain of $5,400 in 2010. However, the reclassification in 2010 hides the 2009 loss. As indicated in part c. above, changes in classifications allow the possibility of income manipulation by management. Case 10-2 a.
For both the current and noncurrent marketable equity securities portfolios, the difference between the selling price and the cost is a realizable gain or loss that should be included in the net income for the year because a gain or loss should be recognized at the culmination of the earning process, namely, in the year when realization (sale) takes place.
b.
Victoria should account for both the current and noncurrent marketable equity securities portfolios at the lower of its aggregate cost or market value, determined at the balance sheet date. Because of the uncertainty of recovery, it is conservative to carry both the current and noncurrent marketable equity securities portfolios at market value when market value is below cost. The amount by which the aggregate cost of the portfolio exceeds the market value should be accounted for as a valuation allowance for both the current and noncurrent marketable equity securities portfolios. For the current marketable equity securities portfolio, the change in the valuation allowance for the year should be included as a reduction in net income for the year because the portfolio is a current asset and the probability of realization of the loss is sufficiently high to justify inclusion in net income. For the noncurrent marketable equity securities portfolio, the accumulated change in the valuation allowance should be included in the equity section of the balance sheet and shown separately as other comprehensive income. In the case of the noncurrent marketable equity securities, it is argued that a decline in market value viewed as temporary should not be reflected in net income because the probability of realization is small.
c.
Victoria should account for the disposition prior to their maturity of the long-term bonds called by their issuer by recognizing the difference between the call price and the net carrying value of the investment as a gain or loss that should be included in net income for the year because the earning process has been completed and realization has taken place.
d.
Victoria should report the purchase price of the additional similar bonds as investment in longterm bonds-a noncurrent asset-and the two months' accrued interest as interest receivable-a current asset. The amount paid by Victoria for the two months' interest accrued between the last interest payment and the date of the purchase should not be included in the investment in longterm bonds because Victoria will receive this amount back when the next interest payment is made by the issuer of the bonds. As a result, interest income will be appropriately recognized for the period from the date of the purchase to the next interest payment date.
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.
185
In 2010, 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, 2010 to December 31, 2010, 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, 2010.
b.
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 available-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."
b.
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 186
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. 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: a. b. c. d.
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.
FASB ASC 320 defines trading securities as securities that are bought and held principally for the purpose of selling them in the near term. Trading generally reflects active and frequent buying and selling, and trading securities are generally acquired to generate profits on short-term differences in market prices. Trading securities include debt securities and equity securities with readily determinable fair market values, and which the owner does not have significant influence or control over the investee. Like trading securities, available-for-sale securities also include debt securities and equity securities with readily determinable fair market values and for which the owner does not have significant influence or control over the investee. However, available-for-sale securities are not bought and help principally for the purpose of selling them in the near term. Investments in securities not classified as trading, should be considered available for sale unless in the case of debt securities the purchaser intends to hold them to maturity. Hence, these securities include 187
investments in securities that are to be held for longer-term price appreciation and other purposes. b.
Trading securities are classified in the balance sheet as current assets. This is because they are purchased to be held only for a short period of time. Management intent regarding the purpose of the buying and holding the securities must be ascertained in order to determine whether to classify them as trading or available-for-sale. Available-for-sale securities may be classified in the balance sheet as either current or long-term. In determining the specific classification, we are to refer to the provisions FASB ASC 210-1020.Thisguidanceindicates that an asset is considered current if it will be consumed or converted into cash within the normal operating cycle of the business or one year whichever is longer.
c.
Unrealized gains and losses are recognized in the income statement for trading securities and as an adjustment to stockholders’ equity (now a component of comprehensive income) for securities that are available-for-sale. That is, holding gains and losses are given the same treatment as realized gains and losses when the security is considered a trading security.
d.
This question has no real answer but is meant to allow students to ponder the issue. Presumably companies have short term securities to speculate in the near term. Long-term securities are held because they provide a cash return and for price appreciation over the long-term. Also, longterm securities may be held in order for the investor to influence or even control investee activities.
e.
If the fair value option is elected for available-for-sale and/or held-to-maturity securities when SFAS No. 159(See FASB ASC 825-10) 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 10-6 Situation 1
When a stock experiences a decline in value that is considered other than temporary, its value is considered impaired. This stock is in a noncurrent portfolio, hence, it is not a trading security. If the security is considered available-for-sale, the loss should be recognized in the income statement for the difference between cost and fair value and the new asset basis would become fair value at the date the loss is recognized.
Situation 2
The trading securities should be considered current assets. The assets should be reported at fair value, and the $2,000 decline in value should be recognized in the income statement. The remainder of the portfolio should be considered current or noncurrent depending on management’s intention. In this event, these securities would be considered available-for-sale. They should be reported in the balance sheet at fair value, and the $5,000 unrealized gain would be reported in stockholders’ equity as an element of comprehensive income.
Situation 3
When a marketable security is reclassified from a trading security to available-for-sale, it will appear in the balance sheet as a current asset, measured at fair value. The accumulated unrealized gain/loss to the date of reclassification would be recognized in net income - i.e., it would be removed from equity. This would mean that current period comprehensive income would include a gain or loss from the beginning of the period to 188
the date of the reclassification and the amount of accumulated adjustment(accumulated other comprehensive income) would be eliminated. Situation 4
equity
This security would be presented in the balance sheet at fair value. The change in fair value from the beginning of the period to the end would be reflected in other comprehensive income. The amount would be equivalent to the accumulated other comprehensive income reported in stockholders’ equity.
Case 10-7 a.
IAS No. 39 allows long-term investments in equity securities to be reported at cost, market value, or lower-of-cost-or market. Revaluations to market which result in gains are treated as equity adjustments (like U.S. GAAP), but revaluations that result in losses in excess of accumulated prior gains are recognized in the income statement (unlike U.S. GAAP). Other than temporary declines are treated in a manner similar to U.S. GAAP. U.S. GAAP does not allow these securities to be reported at cost or at lower-of-cost-or-market.
b.i.
Because IAS No. 39 recognizes holding losses for securities that are revalued in the income statement and SFAS No. 115 (See FASB ASC 320)does not, IAS No. 39 would provide more conservative measures of income. Asset measures would be the same.
ii.
U.S. GAAP is consistent in treatment from period to period and among investments regardless of whether gains or losses occur. IAS No. 39 is not. Hence, SFAS No. 115 (See FASB ASC 320), would provide for better comparability over time. However, IAS No. 30 allows for alternative treatments among companies - cost, market values, or lower-of-cost-or-market. Hence, companies using different approaches would not be comparable. Under SFAS No. 115 (See FASB ASC 320), all companies investing in available-for-sale-securities would account for them in the same ways. Thus, U.S. GAAP would provide greater comparability among reporting entities.
iii. U.S. GAAP requires reporting of fair value in the balance sheet. Since these are marketable securities, fair value measures what can be realized from sale of the assets and thus would be relevant to investors. By allowing three different approaches, it is difficult to argue that international accounting is always relevant. Available-for-sale securities are invested in for their price appreciation and or dividend income over the long-run. Cost of these investments would not be relevant to the decision to hold or sell, hence, it would not provide a relevant measure of the performance of management investment strategies. A similar argument could be made for the use of lower-of-cost-or market. iv.
U.S. GAAP would be more neutral than IASC GAAP. All companies would be required to report investments in available-for-sale securities in the same way and measures of fair value would be unbiased because they are readily determinable in the market. In allowing alternative treatments, IASC No. 39, lets management select the accounting treatment they want thereby allowing the potential for management to bias reported financial information.
v.
US. GAAP would report the fair value of the investments in available-for-sale securities. Again, fair value is relevant to the decision to hold or sell. Hence, this measurement representation would faithfully represent the assets reported because it would measure the service potential of the assets at the balance sheet date. It follows, that if one approach is representationally faithful, 189
others may fall short of providing this quality. Hence, IAS No. 39, would not always result in providing information that is representionally faithful. vi.
Measuring the assets at fair value provides not only the exit value, but also provides the cost it would take to replace these assets. Hence, the asset values under SFAS No. 115, would be consistent with the physical capital maintenance concept. Also, holding gains are losses are not recognized in net income, which is also consistent with the physical capital maintenance concept. IASC No. 39 allows measures other than fair value. These alternative measures are not consistent with physical capital maintenance. Also excess losses are recognized in the income statement for those securities which are revalued. This practice is not consistent with the concept of physical capital maintenance.
Case 10-8 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.
b.
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.
c.
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.
d.
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.
FASB ASC 10-1 Debt and Equity Investments a. Information on accounting for debt and equity securities is found at FASB ASC 320-10 and can be found by searching “debt and equity investments.” The answer should include the following at a minimum:
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At acquisition, an entity shall classify debt securities and equity securities into one of the following three categories: 1. Trading securities. If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because the entity does not intend to sell it in the near term. 2. Available-for-sale securities. Investments in debt securities and equity securities that have readily determinable fair values not classified as trading securities or as held-to-maturity securities shall be classified as available-for-sale securities. 3. Held-to-maturity securities. Investments in debt securities shall be classified as held-tomaturity only if the reporting entity has the positive intent and ability to hold those securities to maturity. 25-2
At acquisition, an investor shall document the classification of debt and equity securities.
> Restrictions on Classification of a Debt Security as Held-to-Maturity 25-3 Amortized cost is relevant only if a security is actually held to maturity. Use of the held-tomaturity category is restrictive because the use of amortized cost must be justified for each investment in a debt security. At acquisition, an entity shall determine if it has the positive intent and ability to hold a security to maturity, which is distinct from the mere absence of an intent to sell. If management's intention to hold a debt security to maturity is uncertain, it is not appropriate to carry that investment at amortized cost. In establishing intent, an entity shall consider pertinent historical experience, such as sales and transfers of debt securities classified as held-to-maturity. A pattern of sales or transfers of those securities is inconsistent with an expressed current intent to hold similar debt securities to maturity. The fair value of restricted stock shall be measured initially based on the quoted price of an otherwise identical unrestricted security of the same issuer, adjusted for the effect of the restriction, in accordance with the provisions of Topic 820. Investments in debt securities and equity securities shall be measured subsequently as follows: 1. Trading securities. Investments in debt securities that are classified as trading and equity securities that have readily determinable fair values that are classified as trading shall be measured subsequently at fair value in the statement of financial position. Unrealized holding gains and losses for trading securities shall be included in earnings. 2. Available-for-sale securities. Investments in debt securities that are classified as available for sale and equity securities that have readily determinable fair values that are classified as available for sale shall be measured subsequently at fair value in the statement of financial position. Unrealized holding gains and losses for available-for-sale securities (including those classified as current assets) shall be excluded from earnings and reported in other comprehensive income until realized except as indicated in the following sentence. All or a portion of the unrealized holding gain and loss of an available-for-sale security that is designated as being hedged in a fair value hedge shall be recognized in earnings during the period of the hedge, pursuant to paragraphs 815-25-35-1 through 35-4. 3. Held-to-maturity securities. Investments in debt securities classified as held to maturity shall be measured subsequently at amortized cost in the statement of financial position. A 191
transaction gain or loss on a held-to-maturity foreign-currency-denominated debt security shall be accounted for pursuant to Subtopic 830-20. Balance Sheet Classification 45-1 An entity shall report its investments in available-for-sale securities and trading securities separately from similar assets that are subsequently measured using another measurement attribute on the face of the statement of financial position. To accomplish that, an entity shall do either of the following: a. Present the aggregate of those fair value and non-fair-value amounts in the same line item and parenthetically disclose the amount of fair value included in the aggregate amount b. Present two separate line items to display the fair value and non-fair-value carrying amounts. 45-2 An entity that presents a classified statement of financial position shall report individual held-tomaturity securities, individual available-for-sale securities, and individual trading securities as either current or noncurrent, as appropriate, under the guidance of Section 210-10-45. For securities classified as available for sale, all reporting entities shall disclose all of the following by major security type as of each date for which a statement of financial position is presented: a. Aggregate fair value b. Total gains for securities with net gains in accumulated other comprehensive income c. Total losses for securities with net losses in accumulated other comprehensive income d. Information about the contractual maturities of those securities as of the date of the most recent statement of financial position presented. 50-5 For securities classified as held to maturity, all reporting entities shall disclose all of the following by major security type as of each date for which a statement of financial position is presented: a. Aggregate fair value b. Gross unrecognized holding gains c. Gross unrecognized holding losses d. Net carrying amount e. Gross gains and losses in accumulated other comprehensive income for any derivatives that hedged the forecasted acquisition of the held-to-maturity securities f.
Information about the contractual maturities of those securities as of the date of the most recent statement of financial position presented. (Maturity information may be combined in appropriate groupings. Securities not due at a single maturity date, such as mortgage-backed securities, may be disclosed separately rather than allocated over several maturity groupings; if allocated, the basis for allocation also shall be disclosed.)
b. Information on accounting for debt and equity securities originally promulgated by the EITF can be found using the Print With Sources function. Examples of the FASB ASC content on debt and equity instruments originally issued by the EITF include:
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Combinations of Structured Notes 320-10-25-19 [The following guidance discusses a specific type of transaction in which structured note securities are issued in combination with other structured note securities as a unit or a pair [EITF 98-15, paragraph ISSUE, sequence 7.2.1] ][for the purpose of achieving a certain strategic investment result for the investor. [EITF 98-15, paragraph ISSUE, sequence 7.1] ][ One strategy involves the purchase of two structured notes with opposite interest rate reset provisions. Under that strategy, the fixed coupon rate or maturity date for each structured note would be determined shortly after issuance depending on movements in market interest rates. Following that reset date, the resulting yields on each of the structured note securities will move in opposite directions; however, the average yield of the two securities will generally reflect the market yield of the combined instruments in effect on the issuance date. See Example 2 (paragraph 320-10-55-20) for a common example of this strategy and of how the structured note transactions can be used to achieve one of many desired accounting results. [EITF 9815, paragraph ISSUE, sequence 7.2.2] ] 320-10-25-20 [If structured notes are acquired for the type of specified investment strategy described in paragraph 320-10-25-19, then the investor shall account for the two structured note securities as a unit until one of the securities is sold, at which time the guidance in paragraph 860-10-35-3 shall be applied. [EITF 98-15, paragraph DISCUSSION, sequence 9.1] ] 320-10-35-3 Paragraphs 320-10-35-23 through 35-26 identify circumstances in which an entity must adjust the basis of its investments in debt and equity securities of an equity method investee for the amount of an equity method loss based on its seniority. [For investments accounted for in accordance with this Subtopic, the adjusted basis resulting from the application of paragraphs 320-10-35-23 through 35-26 becomes the security's basis from which subsequent changes in fair value are measured. [EITF 98-13, paragraph DISCUSSION, sequence 20.2] ] 320-10-35-4 [Dividend and interest income, including amortization of the premium and discount arising at acquisition, for all three categories of investments Fair Value Changes of Foreign-Currency-Denominated Available-for-Sale Debt Securities 320-10-35-36 [The entire change in the fair value of foreign-currency-denominated available-for-sale debt securities shall be reported in other comprehensive income. [EITF 96-15, paragraph DISCUSSION, sequence 16.1] ] 320-10-35-37 [An entity holding a foreign-currency-denominated available-for-sale debt security is required to consider, among other things, changes in market interest rates and foreign exchange rates since acquisition in determining whether an other-than-temporary impairment has occurred. [EITF 9615, paragraph DISCUSSION, sequence 16.2] ] >
Income Recognition for Certain Structured Notes
320-10-35-38 [This guidance addresses the accounting for certain structured notes that are in the form of debt securities, but [EITF 96-12, paragraph ISSUE, sequence 15] ][does not apply to any of the following: [EITF 96-12, paragraph DISCUSSION, sequence 25.1] ] a. [Mortgage loans or other similar debt instruments that do not meet the definition of a security under this Subtopic [EITF 96-12, paragraph DISCUSSION, sequence 25.2.1.1.1.1.1] ]
193
b. [Traditional convertible bonds that are convertible into the stock of the issuer [EITF 96-12, paragraph DISCUSSION, sequence 25.2.1.1.1.1.2] ] c. [Multicurrency debt securities [EITF 96-12, paragraph DISCUSSION, sequence 25.2.1.1.1.2] ] d.
[Debt securities classified as trading [EITF 96-12, paragraph DISCUSSION, sequence 25.2.1.1.2] ]
e.
[Subparagraph not used]
f.
[Debt securities participating directly in the results of an issuer's operations (for example, participating mortgages or similar instruments) [EITF 96-12, paragraph DISCUSSION, sequence 25.2.2.1] ]
g.
[Reverse mortgages [EITF 96-12, paragraph DISCUSSION, sequence 25.2.2.2] ]
h.
[Structured note securities that, by their terms, suggest that it is reasonably possible that the entity could lose all or substantially all of its original investment amount (for other than failure of the borrower to pay the contractual amounts due). (Such securities shall be marked to market with all changes in fair value reported in earnings.) [EITF 96-12, paragraph DISCUSSION, sequence 26.1]
320-10-50-4 [Investments in mutual funds that invest only in U.S. government debt securities [EITF 86-40, paragraph STATUS, sequence 10.2.1] ][ may be shown separately rather than grouped with other equity securities in the disclosures by major security type required by paragraph 942-320-50-2. [EITF 86-40, paragraph STATUS, sequence 10.2.2.2] ] Structured Note Descriptions 320-10-55-10 The following are descriptions of various structured notes, using illustrative terms: a.
[Dual-index floater. A bond with a coupon rate that is determined by the spread between two different indexes and that usually includes an above-market interest rate in Year 1. These bonds may have a teaser fixed rate for the first period of the bond's life, after which the interest rate floats according to a predetermined formula. [EITF 96-12, paragraph Exhibit 96-12A, sequence 44] ]
b.
[Inverse floater. A bond with a coupon rate of interest that varies inversely with changes in specified general interest rate levels or indexes, for example, the London Interbank Offered Rate (LIBOR). [EITF 96-12, paragraph Exhibit 96-12A, sequence 47] ]
c.
[Levered inverse floater. A bond with a coupon that varies indirectly with changes in general interest rate levels and that applies a multiplier (greater than 1.00) to the specified index in its calculation of interest. [EITF 96-12, paragraph Exhibit 96-12A, sequence 50] ]
d.
[Delevered floater. A bond with a coupon rate of interest that lags overall movements in specified general interest rate levels or indexes. [EITF 96-12, paragraph Exhibit 96-12A, sequence 53] ]
e.
[Range floater. A bond in which the investor's coupon is dependent on the number of days that a reference rate stays within a preestablished collar; otherwise, the bond pays either 0% interest or a below-market rate. [EITF 96-12, paragraph Exhibit 96-12A, sequence 56] ] 194
f.
[Lower-of and higher-of floaters. A bond that pays an interest rate stated as the lower of or higher of two different formulas. [EITF 96-12, paragraph Exhibit 96-12A, sequence 60] ]
g.
[Ratchet floater. A bond that pays a floating rate of interest and has an adjustable cap and/or floor that moves in sync with each new reset rate. [EITF 96-12, paragraph Exhibit 96-12A, sequence 63] ]
h.
[Stepped cap-floor floaters. A bond that pays a floating rate of interest, subject to a scheduled cap, scheduled floor, or both. [EITF 96-12, paragraph Exhibit 96-12A, sequence 66] ]
i.
[Floating to floating notes. Varying coupon (first-year LIBOR or U.S. Treasury bill based, second-year prime based). [EITF 96-12, paragraph Exhibit 96-12A, sequence 69] ]
j.
[Floating to fixed notes. Varying coupon (first-year coupon is fixed, second- and third-year coupons are based on LIBOR, U.S. Treasury bills, or prime). [EITF 96-12, paragraph Exhibit 96-12A, sequence 71] ]
k.
[Indexed amortizing notes. A bond that repays principal based on a predetermined amortization schedule or target value. This value is linked to movements within a specific mortgage-backed security or index. The maturity of the bond changes as the related index changes. This instrument includes a varying maturity. [EITF 96-12, paragraph Exhibit 96-12A, sequence 73] ]
l.
[Equity indexed notes. Bond return of interest and/or principal is tied to a specified equity index (for example, the Standard & Poor's S&P 500 Index). This instrument may contain fixed or varying coupon rate and may place all or a portion of principal at risk. [EITF 96-12, paragraph Exhibit 96-12A, sequence 76] ]
m. [Variable principal redemption bond. A bond whose principal redemption value at maturity is dependent on the change in an underlying index over a predetermined observation period. A typical scenario would be a bond that guarantees a minimum par redemption value of 100%, and the potential for a supplemental principal payment at maturity as compensation for the belowmarket rate of interest offered with the instrument (providing that the bond satisfies the indexing requirements as outlined in the terms of the offering). [EITF 96-12, paragraph Exhibit 96-12A, sequence 78] ] n.
[Yield curve note. Fixed coupon, principal varies as follows: [(5-year swap rate – 3-month $LIBOR – 1%) × 40 + 100%] × par (but not less than zero). [EITF 96-12, paragraph Exhibit 96-12A, sequence 81] ]
o.
[Crude oil knock-in notes. 1% coupon, principal guaranteed with upside potential based on the strength of the oil market. [EITF 96-12, paragraph Exhibit 96-12A, sequence 83] ]
p.
[Leveraged gold notes. Coupon is zero, variable principal based on the London Gold Index. These notes are designed to incorporate a collar on gold, whereby the investor buys a call and sells a put, in exchange for the coupon. [EITF 96-12, paragraph Exhibit 96-12A, sequence 85] ]
q.
[Gold-linked bull note. Fixed 3% coupon, principal is guaranteed with upside potential if the price of gold increases. [EITF 96-12, paragraph Exhibit 96-12A, sequence 87] ] 195
r.
[Equity-linked bear note. Fixed 4% coupon, principal is guaranteed with upside potential if a specified Standard & Poor's index falls. [EITF 96-12, paragraph Exhibit 96-12A, sequence 89] ]
s.
[Step-up bonds. Bond provides an introductory above-market yield and the bond then steps up to a new coupon that will be below then-current market rates or, alternatively, the bond may be called. [EITF 96-12, paragraph Exhibit 96-12A, sequence 91] ]
t.
[Multi step-ups. A security that pays investors an introductory above-market yield—reflecting an embedded call option—for a short lockout period, and then is either called or steps up to a higher coupon rate (which will be below then-current market rates). These bonds can also take the form of step-down or variable step-up structures. [EITF 96-12, paragraph Exhibit 96-12A, sequence 93] ]
u.
[Credit-sensitive bond. A bond that has a coupon rate of interest that resets based on changes in an entity's credit rating. [EITF 96-12, paragraph Exhibit 96-12A, sequence 96] ]
v.
[Inflation bond. A bond with a contractual principal amount that is indexed to the inflation rate; the coupon rate is typically below that of traditional bonds of similar maturity. [EITF 96-12, paragraph Exhibit 96-12A, sequence 98] ]
w.
[Disaster bond. A bond that pays a coupon above that of traditional bonds; however, a substantial portion or all of the principal amount is subject to loss if a specified disaster occurs. [EITF 96-12, paragraph Exhibit 96-12A, sequence 100] ]
x.
[Specific equity-linked bond. A bond that pays a coupon slightly below that of traditional bonds of similar maturity; however, the principal amount is linked to the stock market performance of an equity investee of the issuer. The issuer may settle the obligation by delivering the underlying shares of the equity investee or may deliver the equivalent fair value in cash. [EITF 96-12, paragraph Exhibit 96-12A, sequence 102] ]
>>
Retrospective Interest Method–Concept and Procedures
320-10-55-11 Paragraph 320-10-35-40 requires the retrospective interest method to recognize income on certain securities. [The amortized cost amount is calculated as the present value of estimated future cash flows using an effective yield, which is the yield that equates all past actual and current estimates of future cash flow streams to the initial investment. If the effective yield is negative, the amortized cost amount should be calculated using a zero percent effective yield. Thus, the following procedures would be required for each reporting period: [EITF 96-12, paragraph Exhibit 96-12B, sequence 106.2] ] a. [Calculate the effective yield that equates all past actual cash flows and current estimates of future cash flows to the initial investment amount. [EITF 96-12, paragraph Exhibit 96-12B, sequence 107] ] b. [Using the rate calculated in (a), or zero percent if negative, calculate the present value of the estimated future cash flows. That amount represents the amortized cost at the end of the period. [EITF 96-12, paragraph Exhibit 96-12B, sequence 108] ] c. [Adjust the amortized cost balance to the amount calculated in (b) with the offsetting amount recognized as income for the period. [EITF 96-12, paragraph Exhibit 96-12B, sequence 109] ] 196
320-10-55-12 [The preadjusted amortized cost balance should represent the amortized cost balance at the beginning of the period less any cash received on the investment during the period. [EITF 96-12, paragraph Exhibit 96-12B, sequence 110] ] 320-10-55-13 Example 1 (see paragraph 320-10-55-16) illustrates application of the retrospective interest method. >>
Structured Notes Acquired for a Specified Investment Strategy
320-10-55-14 This paragraph and the following paragraph address whether an investor should account for the two structured note securities together as a unit or account for each security separately. [The following indicators should be considered for purposes of identifying whether two securities should be viewed as being purchased for a specified investment strategy. All of these indicators are not required to exist for the securities to be accounted for as a unit. Judgment is required in reaching a determination. [EITF 98-15, paragraph DISCUSSION, sequence 10] ] a.
[The two securities are related in that their fair values will move in opposite directions based on changes in interest rates on a specified date, or after a specified period after issuance. The fair value changes may be caused by a change in the coupon interest rate of the two securities or by altering the maturities of the securities. [EITF 98-15, paragraph DISCUSSION, sequence 11] ]
b. [The two securities are issued contemporaneously and in contemplation of one another or are issued separately but the terms for their remaining lives are as described in (a). [EITF 98-15, paragraph DISCUSSION, sequence 12] ] c.
[The two securities are issued by the same counterparty and/or the same issuer (or issued by different issuers but structured through an intermediary). [EITF 98-15, paragraph DISCUSSION, sequence 13] ]
d.
[The two securities were purchased by the investor for the sole purpose of achieving a desired accounting result, and the transactions considered individually would serve no valid business purpose or would not be entered into otherwise. [EITF 98-15, paragraph DISCUSSION, sequence 14] ]
320-10-55-15 [The substance of the investment strategy provided in Example 2 (see paragraph 320-1055-20) is that the investor has simply purchased a single market-based security that results in neither a gain nor a loss when the interest rate resets and, as such, the accounting should not reflect something different. However, other factors, such as a change in credit ratings or a change in market rates, may cause a change in fair value of the unit. [EITF 98-15, paragraph DISCUSSION, sequence 15] ] > Illustrations > > Example 1: Assumptions and Calculation of Income Recognized Under the Retrospective Interest Method 320-10-55-16 This Example illustrates the guidance in paragraphs 320-10-35-38 through 35-43. This Example has the following assumptions: a.
[The investor purchases a 3-year, $100 par value structured note at par. [EITF 96-12, paragraph Exhibit 96-12B, sequence 112] ]
197
b. [The principal to be repaid at maturity is based on the performance of the Standard & Poor's S&P 500 Index, which, based on current Standard & Poor's S&P Futures indexes, is expected to provide the investor with principal of $106 at the end of Year 3, and the coupon interest on the note is fixed at 6 percent per year. [EITF 96-12, paragraph Exhibit 96-12B, sequence 113] ] c. [ On the acquisition date of the note, the investor expects the following cash flows and income to be recognized over the life of the note. [EITF 96-12, paragraph Exhibit 96-12B, sequence 114] ]
[EITF 96-12, paragraph Exhibit 96-12B, sequence 115] [ These cash flows produce an effective yield of 7.85 percent. [EITF 96-12, paragraph Exhibit 96-12B, sequence 116] ] 320-10-55-17 [At the end of Year 1, assume the investor expects to receive only $80 in principal at the end of Year 3, which results in a negative effective yield of 0.71 percent over the life of the note (assume that the investor concludes that an other-than-temporary impairment has not occurred). Accordingly, the amortized cost amount must be reduced to the present value of the estimated future cash flows using a zero percent effective yield, or $92, at the end of Year 1. The income recognized in Year 1 is negative $2 (the amortized cost amount at the end of Year 1 in the table below of $92 less the amortized cost amount at the beginning of the year of $100 plus cash received during the year of $6). The cash flow and income recognition table as of the end of Year 1 is as follows. [EITF 96-12, paragraph Exhibit 96-12B, sequence 117] ]
[EITF 96-12, paragraph Exhibit 96-12B, sequence 118] 320-10-55-18 [These cash flows produce an effective yield of negative 0.71 percent. [EITF 96-12, paragraph Exhibit 96-12B, sequence 119] ] 320-10-55-19 [At the end of Year 2, assume the S&P 500 Index market reverses and the investor now expects to receive the same cash flows that it expected upon acquisition of the note. Using the first table above, the investor would increase the amortized cost amount of the note to $103.85 at the end of Year 198
2, which would result in recognizing income of $17.85 in Year 2 (amortized cost from the first table at the end of Year 2 of $103.85 less the amortized cost from the second table at the end of Year 1 of $92 plus cash received in Year 2 of $6). [EITF 96-12, paragraph Exhibit 96-12B, sequence 120] ] >>
Example 2: Structured Notes Acquired for a Specified Investment Strategy
320-10-55-20 This Example illustrates the guidance in paragraphs 320-10-25-19 through 25-20. [ An entity purchases two separate structured notes with opposite interest rate characteristics. The terms of the bonds are described below. [EITF 98-15, paragraph Exhibit 98-15A, sequence 21] ]
[EITF 98-15, paragraph Exhibit 98-15A, sequence 22.1] 320-10-55-21 [If accounted for as separate instruments, the entity could classify the bonds as availablefor-sale. [EITF 98-15, paragraph Exhibit 98-15A, sequence 22.2.1] ][(Note that these securities would have to be accounted for as a unit rather than as separate instruments.) [EITF 98-15, paragraph Exhibit 98-15A, sequence 23] ][After the interest rates on the bonds reset, the entity will sell the bond that is in a loss position recognizing a loss in earnings of $475 million (assuming that the current interest rate is 8 percent). The bond that is in a gain position will have a $475 million unrealized gain in other comprehensive income that will be recognized in earnings as a yield adjustment over the remaining 10year life of the instrument (assuming no further changes in value). [EITF 98-15, paragraph Exhibit 9815A, sequence 22.2.2] ] FASB ASC 10-2 Research and Development Research and development implementation issues can be found by searching “research and development implementation.”To find EITF pronouncements, use the Print with Sources function. That search resulted in the following FASB issues (There are also some SEC implementation guidance issues): 730 Research and Development> 10 Overall > 55 Implementation Guidance and Illustrations 810 Consolidations >Research and Development Arrangements>55Implementation Guidance and Illustrations 912 Contractors-Federal Government>730 >55 Research and Development Arrangements>55Implementation Guidance and Illustrations 985 Software > 20 Costs of Software to Be Sold, Leased, or Marketed > 55 Implementation Guidance and Illustrations. 199
The EITF Implementation guidelines are: Scope Application to Certain Nonrefundable Advance Payments 730-10-55-3 Pending Content: Transition Date: December 15, 2007Transition Guidance: 730-20-65-1 [Nonrefundable advance payments for future research and development activities for materials, equipment, facilities, and purchased intangible assets that have an alternative future use (in research and development projects or otherwise) are within the scope of this Subtopic. [EITF 07-03, paragraph 3, sequence 3.2] ][Subtopic 730-20 (Research and Development>Overall) provides guidance on accounting for nonrefundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities [EITF 07-03, paragraph 4, sequence 4.1] ][ pursuant to an executory contractual arrangement. [EITF 07-03, paragraph 3, sequence 3.1.1] ] FASB ASC 10-3 Best-Efforts-Basis, Research-and-Development-Cost-Sharing Arrangements Search contractors-federal government-research and development 912-730-25 Best-Efforts-Basis, Research-and-Development-Cost-Sharing Arrangements 25-1 Best-efforts-basis, research-and-development-cost-sharing arrangements within the scope of this Subtopic (see paragraph 912-730-15-2) shall be recognized as research and development expense as incurred in conformity with Topic 730. Because of the cost-sharing nature of these fixed-price, bestefforts-basis, research-and-development-cost-sharing arrangements, the amounts funded by the customer shall be recognized as an offset to the contractor's aggregate research and development expense rather than as contract revenues. Example 1 (see paragraphs 912-730-55-1 through 55-3) illustrates the application of this guidance. FASB ASC 10-4 Direct-Response Advertising Search Direct-Response Advertising 340-20 Overview and Background 05-1This Subtopic addresses the accounting and reporting for capitalized advertising costs. 05-2Specifically, for direct-response advertising that may result in reported assets, this Subtopic provides guidance on: a. How such assets shall be measured initially b. How the amounts ascribed to such assets shall be amortized c. How the realizability of such assets shall be assessed d. The financial statement disclosures that shall be made about advertising. 340-20-25 Recognition 200
> Assets Reported Based on Costs of Advertising Directed to All Prospective Customers 25-1For the kinds of activities capitalized under the guidance in this Subtopic, there is a reliable and demonstrated relationship between total costs and future benefits that is a direct result of incurring those costs. For example, reporting entities capitalizing advertising in conformity with this Subtopic would have reliable evidence that they must, for example, send out 1 million pieces of direct-mail advertising in order to get 10,000 responses. The cost of obtaining those 10,000 responses is the cost of sending out the million pieces of mail. The effort is the million pieces mailed, and documented operating history enables those reporting entities to make reliable predictions about the relationship between the total number of pieces of advertising mailed and the total future revenues obtained. > Criteria to Capitalize Direct-Response Advertising Costs 25-2Expenditures for some advertising costs are made subsequent to recognizing revenues related to those costs. For example, some entities assume an obligation to reimburse their customers for some or all of the customers' advertising costs (cooperative advertising). Generally, revenues related to the transactions creating those obligations are earned and recognized before the expenditures are made. For purposes of applying the guidance in this Subtopic, those obligations shall be accrued and the advertising costs expensed when the related revenues are recognized. 25-3As indicated in paragraph 720-35-25-1, the accounting policy selected from the two alternatives, which are whether to expense advertising costs as incurred or the first time the advertising takes place, shall be applied consistently to similar kinds of advertising activities. 25-4The costs of direct-response advertising shall be capitalized if both of the following conditions are met: a. The primary purpose of the advertising is to elicit sales to customers who could be shown to have responded specifically to the advertising. Paragraph 340-20-25-6 discusses the conditions that must exist in order to conclude that the advertising's purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising. b. The direct-response advertising results in probable future benefits. Paragraph 340-20-25-9 discusses the conditions that must exist in order to conclude that direct-response advertising results in probable future benefits. > > Primary Purpose to Elicit Sales to Customers Responding to the Advertising 25-5As noted above, the first condition for capitalizing direct response advertising is that the primary purpose of the advertising is to elicit sales to customers who could be shown to have responded specifically to the advertising. 25-6In order to conclude that advertising elicits sales to customers who could be shown to have responded specifically to the advertising, there must be a means of documenting that response, including a record that can identify the name of the customer and the advertising that elicited the direct response. Examples of such documentation include the following: a. Files indicating the customer names and the related direct-response advertisement b. A coded order form, coupon, or response card, included with an advertisement, indicating the customer name c. A log of customers who have made phone calls to a number appearing in an advertisement, linking those calls to the advertisement. > > Probable Future Benefits Of Direct-Response Advertising 25-7As noted above, the second condition for capitalizing direct response advertising is that the directresponse advertising results in probable future benefits. 25-8The probable future benefits of direct-response advertising activities are probable future revenues arising from that advertising in excess of future costs to be incurred in realizing those revenues. 25-9Demonstrating that direct-response advertising will result in future benefits requires persuasive evidence that its effects will be similar to the effects of responses to past direct-response advertising 201
activities of the entity that resulted in future benefits. Such evidence shall include verifiable historical patterns of results for the entity. Attributes to consider in determining whether the responses will be similar include the following: a. The demographics of the audience b. The method of advertising c. The product d. The economic conditions. 25-10Industry statistics would not be considered objective evidence that direct-response advertising will result in future benefits in the absence of the specific entity's operating history. If the entity does not have an operating history for a particular product or service but does have operating histories for other new products or services, statistics for the other products or services may be used if it can be demonstrated that the statistics for the other products or services are likely to be highly correlated to the statistics of the particular product or service being evaluated. For example, test market results for a new product or service may be used to support the view that the results of advertising for current new products or services are likely to be highly correlated with the results of advertising for new products or services previously sold by the entity. In the absence of the expectation of a high degree of correlation, a success rate based on historical ratios of successful products or services to total products or services introduced to the marketplace would not be a sufficient basis for reporting a portion of the costs of current-period advertising as resulting in assets. > Direct-Response Advertising that Does Not Result in Probable Future Benefits 25-11Direct-response advertising costs that are not capitalized because it cannot be demonstrated that the direct-response advertising will result in future benefits shall not be retroactively capitalized in subsequent periods if historical evidence in those subsequent periods indicates that the advertising did in fact result in future benefits. > Basis of Measurement 25-12Based on the potential customers and the probable customer response rates, direct-response advertising that is expected to produce future revenues generally is undertaken before the customers' identity is known. Such advertising is undertaken with the expectation that not all targets of the directresponse advertising will provide benefits but that the benefits created by the customers who do respond to the advertising will justify the total advertising costs. Accordingly, the cost of the direct-response advertising directed to all prospective customers, not only the cost related to the portion of the potential customers that are expected to respond to the advertising, shall be used to measure the amounts of such reported assets. > Period and Extent of Expected Future Benefits 25-13There is no overriding guidance that would either permit or prohibit reporting the costs of directresponse advertising as assets based on the inclusion of future revenues from renewals or repeat sales. Reporting entities with an established operating history, such as certain entities in subscription businesses, may be able to measure such amounts with the required degree of reliability and, if so, shall report assets based on renewal amounts. The reporting entity must exercise judgment about both of the following: a. The existence of the degree of reliability required to determine the probability of renewals b. Whether those renewals result from the direct-response advertising being accounted for. In order to conclude that the renewals result from the direct-response advertising being accounted for, the renewals must not result from significant direct-response advertising that took place subsequent to the direct-response advertising being accounted for. 25-14As discussed in paragraph 340-20-35-1, each significant advertising effort establishes a separate standalone cost pool. Examples of situations in which that required degree of reliability may exist, without significant direct-response advertising subsequent to the direct-response advertising being accounted for, include the following: 202
a. The sale of subscriptions may be offered only through direct-response advertising. The entity may have objective evidence that, historically, a quantifiable percentage of subscriptions is renewed at the end of each subscription period without a significant advertising effort. After the subscription is purchased, in what is deemed to be an insignificant advertising effort, renewal subscriptions are offered for sale by mailing a renewal card to those who have subscriptions that will lapse soon. The amount of direct-response advertising reported as assets and amortized in future periods ordinarily would be based on the expected total revenue to be realized over both the initial and the renewal subscription periods. b. A series of products, such as pieces in a chess set, may be offered for sale only through directresponse advertising. After the first piece is purchased, the remaining pieces are offered for sale by mailing a response card to those who purchased the first piece in what is deemed to be an insignificant advertising effort. The entity may have objective evidence that, historically, each customer who buys the first piece will buy a quantifiable percentage of the remaining pieces. If each of the pieces is bought separately, the amount of direct-response advertising reported as assets and amortized in future periods ordinarily would be based on total revenue from all sales, including estimated future sales. If significant marketing efforts are required to generate subsequent revenues through renewal or repeat sales, those subsequent revenues would not qualify as revenues resulting from the direct-response advertising that resulted in the initial sale and initial standalone cost pool. For instance, in the chess set example in (b), if a pamphlet describing the chess set, its monetary and aesthetic value, and the history of the game of chess is sent to those who purchased the first piece, the amount of direct-response advertising reported as assets and amortized in future periods would be based on sales of the first piece rather than on the total of all sales including estimated future sales. However, subsequent direct-response advertising may result in the capitalization of the costs of that subsequent advertising, with its costs accumulated in a standalone cost pool, if the conditions for capitalization in this Subtopic are met. > Acquisition Costs of Assets 25-15The costs of materials bought from a supplier in the production of advertising materials shall be reported as costs of assets from direct-response advertising if those materials can be directly attributed to specific direct-response advertising. An example of such costs and activities is the cost of paper bought from a third party used to produce catalogues. > Tangible Assets Used for Several Advertising Campaigns 25-16Tangible assets, such as blimps or billboards, may be used for several advertising campaigns. The costs of such assets shall be capitalized. > Revenues to Consider When Evaluating Future Benefits 25-17For purposes of considering the probable future benefits of direct-response advertising, revenues associated with such advertising are as follows: a. Primary: Revenues from sales to customers receiving and responding to the direct-response advertising b. Secondary: Revenues that are not from sales to customers receiving and responding to the directresponse advertising. For example, most publishers receive revenue from customers that subscribe to the publications; these subscription revenues are primary revenues. Publishers also receive secondary revenues such as advertisements in the publications (referred to as placement fees). Placement fee revenues are affected by several factors, including the total number of subscribers to the publication and the selling efforts devoted to obtaining the placement fees. 25-18When determining probable future revenues, those revenues shall be limited to revenues from sales to customers receiving and responding to the direct-response advertising (primary revenues). When 203
evaluating whether the direct-response advertising results in probable future benefits (see paragraph 34020-25-4(b)), probable future benefits shall include only primary revenues. 340-20-30 Initial Measurement > Basis of Measurement 30-1See paragraph 340-20-25-12 for a discussion of the inclusion of the cost of the direct-response advertising directed to all prospective customers, in the measurement of the amounts of such reported assets. > Costs of Direct-Response Advertising Eligible for Capitalization 30-2Costs of direct-response advertising that shall be included in amounts reported as assets include only the following: a. Incremental direct costs of direct-response advertising incurred in transactions with independent third parties. Examples of those costs may include the following: 1. Costs of idea development 2. Writing advertising copy 3. Artwork 4. Printing 5. Magazine space 6. Mailing. b. Payroll and payroll-related costs for the direct-response advertising activities of employees who are directly associated with and devote time to the advertising reported as assets. Examples of those activities may include the following: 1. Idea development 2. Writing advertising copy 3. Artwork 4. Printing 5. Mailing. The costs directly related to those advertising activities shall include only that portion of employees' total compensation and payroll-related fringe benefits directly related to time spent performing such activities. 340-20-35 Subsequent Measurement > Method of Amortization 35-1For purposes of calculating amortization and assessing realizability, which are discussed in this Section, each significant advertising effort establishes a separate standalone cost pool. 204
35-2The amounts at which direct-response advertising is reported as assets shall be amortized on a costpool-by-cost-pool basis over the period during which the future benefits are expected to be received using the method described in the following paragraph. 35-3The amortization shall be the amount computed using the ratio that current period revenues for the direct-response advertising cost pool bear to the total of current and estimated future period revenues for that direct-response advertising cost pool. The amounts in this calculation shall not be discounted to net present value. The estimated amounts of future revenues for that cost pool may increase or decrease over time, and the ratio shall be recalculated at each reporting date. Changes in estimated future revenues for a direct-response advertising cost pool shall be reflected in the amortization calculation for current and future periods. Therefore, such changes in estimates would not result in reporting amounts expensed in prior periods as assets in the current or subsequent periods. 35-4The realizability of the amounts of direct-response advertising reported as assets shall be evaluated at each balance-sheet date by comparing the carrying amounts of such assets on a cost-pool-by-cost-pool basis to the probable remaining future net revenues expected to result directly from such advertising. (For this evaluation, future net revenues are gross revenues less the probable future costs of all goods and activities necessary to earn those revenues, except amortization of direct-response advertising. Examples of such future costs are the costs of goods sold, sales commissions, and payroll and payrollrelated costs associated with the future revenues.) If the carrying amounts of such advertising exceed the remaining future net revenues that probably will be realized from such advertising, the excess shall be reported as advertising expense of the current period. The reduced carrying amounts shall not be adjusted upward if estimates of future net revenues are subsequently increased. 35-5There is no arbitrary limit of the period over which the direct-response advertising shall be amortized. However, the reliability of accounting estimates decreases as the length of the period for which such estimates are made increases. Therefore, the period over which the benefits of directresponse advertising are amortized often is no longer than the greater of one year or one operating cycle. However, under certain circumstances, an entity may be able to demonstrate that the duration of the probable future benefits is greater than the longer of one year or one operating cycle. For example, while the response to advertising usually occurs shortly after the advertising takes place, in mail-order catalogue advertising, it can take place over a longer period. > Tangible Assets Used for Several Advertising Campaigns 35-6The costs of tangible assets used for several advertising campaigns shall be depreciated or amortized using a systematic and rational method over their expected useful lives. That depreciation or amortization may be a cost of advertising if the tangible asset is used for advertising. > Assessment of Realizability 35-7When amortizing and assessing the realizability of the direct-response advertising reported as assets, future revenues shall be limited to primary revenues, as discussed in this Section. 340-20-45 Other Presentation Matters > Presentation of Qualifying Direct-Response Advertising Assets 45-1If the costs of direct-response advertising meet the recognition criteria as capitalized assets of paragraph 340-20-25-4, then they shall be reported as assets net of accumulated amortization. For guidance on interim reporting of advertising costs, see paragraph 270-10-45-9(d). 340-20-50 Disclosure 50-1The notes to the financial statements shall disclose all of the following: a. The accounting policy selected from the two alternatives in paragraph 720-35-25-1 for reporting advertising, indicating whether such costs are expensed as incurred or the first time the advertising takes place 205
b. A description of the direct-response advertising reported as assets (if any), the accounting policy for it, and the amortization period c. The total amount charged to advertising expense for each income statement presented, with separate disclosure of amounts, if any, representing a write-down to net realizable value d. The total amount of advertising reported as assets in each balance sheet presented. FASB ASC 10-5 Accumulated Losses on Equity Method Investments 323-10-35-20 through 22 35-20The investor ordinarily shall discontinue applying the equity method if the investment (and net advances) is reduced to zero and shall not provide for additional losses unless the investor has guaranteed obligations of the investee or is otherwise committed to provide further financial support for the investee. 35-21An investor shall, however, provide for additional losses if the imminent return to profitable operations by an investee appears to be assured. For example, a material, nonrecurring loss of an isolated nature may reduce an investment below zero even though the underlying profitable operating pattern of an investee is unimpaired. 35-22If the investee subsequently reports net income, the investor shall resume applying the equity method only after its share of that net income equals the share of net losses not recognized during the period the equity method was suspended.
Room for Debate Debate 10-1 Team 1 Arguments supporting the provisions of SFAS No. 115 Decision usefulness is the overriding objective of financial accounting. According to SFAC No. 1, financial statement should provide information that is useful to present and potential investors, creditors and others in making rational investment, credit and other decisions. The information provided should help users in assessing the amount, timing, and uncertainty of enterprise future cash flows so that they can assess the enterprise’s ability to meet obligations when due and other operating needs, to reinvest in operations, and to pay cash dividends. It should provide information regarding enterprise resources, claims to resources and how those resources are used in operations and other enterprise activities. The provisions of SFAS No. 115 are intended to require preparers to report the economic substance of investments in securities. If those securities are purchased to realize short-term price appreciations, they are considered trading securities. They should be reported at fair value because this is the amount immediately realizable. Since the intent is to sell the securities within a relatively short time period, the holding gains and losses are also immediately realizable and should be reported as such. Fair value is also relevant to users when securities that are available for sale. Fair value measures what the assets are worth in the market. Fair value provides information regarding the working capital that is available to pay current liabilities. For those securities that are to be held to maturity, there is no intent to sell, hence, fair value is not relevant.
206
The classifications of securities and their accounting treatments under SFAS No. 115 also provide information that is reliable. Reliability implies that the information presented is representationally faithful. According to SFAC No. 2, representational faithfulness 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. Fair value provides representationally faithful measures of securities. The securities are capable of realizing fair value. Also, because fair value for these securities is readily determinable in the market place, it is neutral. Presenting marketable securities at fair value in the balance sheet is consistent with the economist’s view of wealth and thus, the changes in fair value, holding gains and losses, should enter into the calculation of income. SFAS No. 115 is consistent with the economist’s view of income, a view which is closer to physical capital maintenance then financial capital maintenance, because holding gains and losses for trading securities are included in income. Moreover, holding gains and losses for available-for-sale securities are now included in comprehensive income. The measurement of the assets in the balance sheet at fair value is consistent with the physical capital maintenance concept of income because if the assets were replaced they would be replaced at fair value. However, the inclusion of holding gains and losses in income is inconsistent with physical capital maintenance, but consistent with financial capital maintenance as interpreted by the FASB. Finally, the provisions of SFAS No. 115 partially eliminates the unevenhanded treatment of gains and losses afforded by the lower-of-cost-or-market method required under its predecessor, SFAS No. 12. Under SFAS No. 12, management could manage earnings by stating that they intend to hold a security long-term or short-term. Gains and losses were recognized in income when the securities were shortterm, but accumulated in equity when securities were long-term. As a result, a company could increase net income be including a security that had appreciated in value as short-term rather than long-term, but would not decrease net income if a security which declined in value were classified as long-term. Also, management was apparently selecting which securities to sell based on whether gains or losses would appear in the income statement. Team 2
Arguments describing the deficiencies of SFAS No. 115
One could argue that the cost method is the appropriate approach to account for any asset, including investments in the securities of other entities. Use of fair value to record assets is inconsistent with the stewardship role of accounting. Accordingly, the accountant should report the money investment of owners and how that money was spent to generate more money. Advocates of this argument contend that historical cost is the significant and relevant measure, at least to owners. Historical cost is relevant in providing investors with information on how capital was used in the business. In that sense it is relevant to users. Moreover, historical cost is reliable. It provides an objective, neutral, unbiased measurement base. One could also argue that lower-of-cost-or market is preferred as the only reasonable departure from historical cost. This argument is based on the notion that when the asset declines in value it has lost utility (service potential) and should be written down. However, writing the asset back up above historical cost violates the historical cost principle. Moreover, it also violates the notion of conservatism. On the other hand one could approve of fair value accounting for SFAS No. 115 and still criticize the pronouncement as not going far enough. First, the scope limitation of SFAS No. 115 allows companies that are not subject to its provisions to continue practices which are different from companies who must 207
comply. These differences would limit comparability between companies who continue the specialized practices and those who comply with the provisions of SFAS No. 115, because their financial statements would reflect different accounting approaches. Companies utilizing specialized practices would recognize gains and losses in their income statements that would not be recognized by companies complying with SFAS No. 115. As a result it may be difficult to explain similarities or differences between these companies’ reported net incomes and earnings per share or even between amounts reported as gains and losses in their respective income statements. Second, the classification of securities as available-for-sale still allows management to manipulate net income. If a security declines in value, management can say that the security is not intended to be a trading security and thereby avoid the negative impact on net income. If a security increases in value, management can increase net income by designating the security as trading. Third, the use of amortized cost for debt securities can result in a lack of comparability between companies who classify these securities as held-to-maturity and those who classify them as trading or available-for-sale. A similar argument can be made for differences in income between companies that classify securities as trading versus companies that classify similar securities as available-for-sale. Finally, the use of amortized cost can be criticized as not reporting the economic value of the asset to the company. For example, if the value increases the company could realize more by selling than by holding the asset. This kind of information is obscured by the use of amortized cost. Debate 10-2 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
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 208
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 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 10-3 The Fair Value Option Team 1 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 209
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 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 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. 210
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 10-9 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.
b.
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)
c.
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 98-5 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.
d.
If the cost of intangibles benefit 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 10-10 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. Case 10-11 The solution to this case is dependent upon the company 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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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.
b.
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.
c.
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 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 nor 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 212
is accumulated by charges to interest expense and credits to the bond liability, the effective amount of the liability gradually approaches maturity value. It should be noted that bond issue costs are disregarded in computing the effective amount of the bond liability. Though they are usually added to the discount or deducted from the premium, bond issue costs should properly be treated as an asset. Such costs are incurred in the process of acquiring borrowed funds and should be amortized over the period during which the funds are used. $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 $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, previously SFAS No. 15) 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: 213
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 12/31/10 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, previously SFAS No. 114. 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. 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 2010 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. 214
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 previously, SFAS No. 15 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 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 currentGAAP. 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 2011. The debt would again be lower. Debt balance under current GAAP (100,000 - 25,000) Debt balance under creditor treatment 215
$75,000
Beginning balance Interest at 10% Payment received Difference
$75,815 7,582 25,000
Retained earnings under current GAAP Beginning balance Interest expense
$83,397 58,397 $16,603
0
$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 quasiequity. 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 treatment is considered practicable because there is no current consensus on how to independently or objectively value the option.
216
b.
FASB Statement No. 150 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.
c.
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.
d.
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 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 11-4 217
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.
b.
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.
c.
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 218
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. 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.
c.
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 and therefore should not be classified as extraordinary.
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. b.
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 219
warehouse has been uninsured. Disclosure in the notes to the financial statements is, however, permitted. c.
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 the accrued liability and crediting the asset account--movie tickets inventory--for 40 percent of the coupons.
Case 11-7 a.i.
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 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. 220
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.i.
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. 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.
a.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, 2011, to Apri1, 2011).
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. 221
b.
The bond issue costs incurred in preparing and selling the bond issue could be accounted for as a noncurrent asset--deferred charge. The bond issue costs would then be amortized over the period the bonds will be outstanding, that is, the period from date of sale (April 1, 2011) to the maturity date (March 1, 2016). Alternatively, under Statements of Financial Accounting Concepts, the bond issue costs incurred in preparing and selling the bond issue could be either accounted for as an expense in 2011, or as a reduction of the noncurrent liability--term bonds payable--and accounted for the same as debt discount. The latter approach would reduce the carrying value of the debit. The effect would be an increase in interest expense.
c.
To determine the amount of interest expense for the term bonds for 2011, the net carrying value of the term bonds on April 1, 2011, would be multiplied by the effective interest rate (yield) of 10 percent for 9/12 of the year. (April 1, 2011 to December 31, 2011) To determine the amount of interest expense for the serial bonds for 2011, the net carrying value of the serial bonds on November 1, 2011, would be multiplied by the effective interest rate (yield) of 11 percent and by one sixth (November 1, 2011. to December 31, 2011).
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. 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 222
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 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 self-insuring 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
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The disclosure of liabilities for not-for-profit entities as found at FASB ASC 958-405. It is found by searching “liabilities and not-for-profit entities.” The students’ answers should be based on the following: 958 Not-for-Profit Entities 405 Liabilities 958-405-05 Overview and Background General 958-405-05-1 This Subtopic provides guidance about promises to give made by not-for-profit entities (NFPs). NFPs also shall comply with the applicable standards in Subtopic 720-25. This Subtopic also identifies the Sections within the Not-For-Profit Entities Topic that provide guidance on accounting for liabilities. 958-405-15 Scope and Scope Exceptions General Note for Financial Instruments: Some of the items subject to the guidance in this Subtopic are financial instruments. For guidance on matters related broadly to all financial instruments, (including the fair value option, accounting for registration payment arrangements, and broad financial instrument disclosure requirements), see Topic 825. See Section 825-10-15 for guidance on the scope of the Financial Instruments Topic. General >
Overall Guidance
958-405-15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see Section 958-10-15. 958-405-20 Glossary Agent An entity that acts for and on behalf of another. Although the term agency has a legal definition, the term is used broadly to encompass not only legal agency, but also the relationships described in Topic 958. A recipient entity acts as an agent for and on behalf of a donor if it receives assets from the donor and agrees to use those assets on behalf of or transfer those assets, the return on investment of those assets, or both to a specified beneficiary. A recipient entity acts as an agent for and on behalf of a beneficiary if it agrees to solicit assets from potential donors specifically for the beneficiary’s use and to distribute those assets to the beneficiary. A recipient entity also acts as an agent if a beneficiary can compel the recipient entity to make distributions to it or on its behalf. Fair Value 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. Functional Classification A method of grouping expenses according to the purpose for which costs are incurred. The primary functional classifications are program services and supporting activities. 224
Intermediary Although in general usage the term intermediary encompasses a broad range of situations in which an entity acts between two or more other parties, in this usage, it refers to situations in which a recipient entity acts as a facilitator for the transfer of assets between a potential donor and a potential beneficiary (donee) but is neither an agent or trustee nor a donee and donor. Not-for-Profit Entity An entity that possesses the following characteristics, in varying degrees, that distinguish it from a business entity: a. Contributions of significant amounts of resources from resource providers who do not expect commensurate or proportionate pecuniary return b. Operating purposes other than to provide goods or services at a profit c. Absence of ownership interests like those of business entities. Entities that clearly fall outside this definition include the following: a. All investor-owned entities b. Entities that provide dividends, lower costs, or other economic benefits directly and proportionately to their owners, members, or participants, such as mutual insurance entities, credit unions, farm and rural electric cooperatives, and employee benefit plans. Promise to Give A written or oral agreement to contribute cash or other assets to another entity. A promise carries rights and obligations—the recipient of a promise to give has a right to expect that the promised assets will be transferred in the future, and the maker has a social and moral obligation, and generally a legal obligation, to make the promised transfer. A promise to give may be either conditional or unconditional. Unconditional Promise to Give A promise to give that depends only on passage of time or demand by the promisee for performance. 958-405-25 Recognition General Note for Fair Value Option: Some of the items subject to the guidance in this Subtopic may qualify for application of the Fair Value Option Subsections of Subtopic 825-10. Those Subsections (see paragraph 825-10-05-5) address circumstances in which entities may choose, at specified election dates, to measure eligible items at fair value (the fair value option). See Section 825-10-15 for guidance on the scope of the Fair Value Option Subsections of the Financial Instruments Topic. General 958-405-25-1 For recognition guidance on liabilities that result from transfers of donated assets to intermediaries and agents, see paragraphs 958-605-25-23 through 25-24.
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958-405-25-2 Deferred revenues that relate to exchange transactions (advance payments for services not yet rendered or goods not delivered) are reported as liabilities. 958-405-25-3 A not-for-profit entity (NFP) that is a social or country club may issue membership interests, such as capital shares. If those interests are wholly or partially refundable when the member dies, moves away, resigns his or her membership, or at a fixed date, Subtopic 480-10 provides guidance. 958-405-30 Initial Measurement General 958-405-30-1 For initial measurement guidance on liabilities that result from transfers of donated assets to intermediaries and agents, see paragraph 958-605-30-13. 958-405-30-2 For initial measurement guidance on liabilities that result from making promises to give, see paragraphs 720-25-30-1 through 30-2. 958-405-35 Subsequent Measurement General >
Liability for Promises to Give
958-405-35-1 If the present value of the amounts to be paid is used to measure fair value of an unconditional promise to give at initial recognition, in conformity with paragraphs 835-30-25-10 through 25-11, the discount rate shall be determined at the time the unconditional promise to give is initially recognized and shall not be revised, unless the promise to give is subsequently remeasured at fair value pursuant to the Fair Value Option Subsections of Subtopic 825-10. 958-405-45 Other Presentation Matters General >
Liability for Promises to Give
958-405-45-1 The amortization of any discount related to unconditional promises to give shall be reported in the same functional classification of expenses in which the promise to give was initially reported. 958-405-50 Disclosure General >
Liability for Promises to Give
958-405-50-1 In addition to disclosures required by Section 450-20-50, the notes to financial statements shall include a schedule of unconditional promises to give that shows the total amount separated into amounts payable in each of the next five years, the aggregate amount due in more than 226
five years, and for unconditional promises to give that are reported using present value techniques, the unamortized discount. 958-405-60 Relationships General >
Health Care Entities
958-405-60-1 For guidance for not-for-profit entities (NFPs) that have entered into settlement agreements with the U.S. government regarding allegations of Medicare fraud that impose an obligation on the entity to engage an independent review entity to test and report on compliance with Medicare requirements each year for five years, see Section 954-405-25. >
Classification of Assets and Liabilities
958-210-45-4 A statement of financial position, including accompanying notes to financial statements, provides relevant information about liquidity, financial flexibility, and the interrelationship of an NFP's assets and liabilities. That information generally is provided by aggregating assets and liabilities that possess similar characteristics into reasonably homogeneous groups that include the effects of donorimposed restrictions as well as other contractual restrictions. 958-210-45-5 Classifying and aggregating items with similar characteristics into reasonably homogeneous groups and separating items with differing characteristics is a basic reporting practice that increases the usefulness of information. For example, entities generally report individual items of assets in homogeneous groups, such as cash and cash equivalents; accounts and notes receivable from patients, students, members, and other recipients of services; inventories of materials and supplies; deposits and prepayments for rent, insurance, and other services; marketable securities and other investment assets held for long-term purposes; and land, buildings, equipment, and other long-lived assets used to provide goods and services. Likewise, cash collections of receivables from patients, students, or other service recipients may differ significantly in continuity, stability, and risk from cash collections of pledges made to a special-purpose fundraising campaign. Classifying and reporting those receivables and collections of receivables as separate groups of assets and of cash inflows facilitates financial statement analysis aimed at objectives such as predicting amounts, timing, and uncertainty of future cash flows. 958-210-45-6 Assets may be restricted by donors. For example, land could be restricted to use as a public park. Generally, however, restrictions apply to net assets, not to specific assets. Assets need not be disaggregated on the basis of the presence of donor-imposed restrictions on their use; for example, cash available for unrestricted current use need not be reported separately from cash received with donorimposed restrictions that is also available for current use. However, cash or other assets received with a donor-imposed restriction that limits their use to long-term purposes shall not be classified with cash or other assets that are unrestricted and available for current use. The kind of asset whose use is limited shall be described in the notes to the financial statements if its nature is not clear from the description on the face of the statement of financial position. FASB ASC 11-2 Indirect Guarantees
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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 students’ answers should be based on the following: 460 Guarantees 10 Overall 50 Disclosure General > Information About Each Guarantee or Group of Similar Guarantees > > Loss Contingencies 460-10-50-1 The following requirement applies to all guarantees, including guarantees that are outside the scope of paragraph 460-10-15-4; however, it does not apply to guarantees described in paragraph 460-10-15-7(a). 460-10-50-2 An entity shall disclose certain loss contingencies even though the possibility of loss may be remote. The common characteristic of those contingencies is a guarantee that provides a right to proceed against an outside party in the event that the guarantor is called on to satisfy the guarantee. Examples include the following: a. Guarantees of indebtedness of others, including indirect guarantees of indebtedness of others b. Obligations of commercial banks under standby letters of credit c. Guarantees to repurchase receivables (or, in some cases, to repurchase the related property) that have been sold or otherwise assigned d. Other agreements that in substance have the same guarantee characteristic. 460-10-50-3 The disclosure shall include the nature and amount of the guarantee. Consideration should be given to disclosing, if estimable, the value of any recovery that could be expected to result, such as from the guarantor's right to proceed against an outside party. >>
Disclosures About a Guarantor's Obligation
460-10-50-4 A guarantor shall disclose all of the following information about each guarantee, or each group of similar guarantees, even if the likelihood of the guarantor’s having to make any payments under the guarantee is remote: a. The nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the guarantor to perform under the guarantee b. The following information about the maximum potential amount of future payments under the guarantee, as appropriate: 228
1. The maximum potential amount of future payments (undiscounted) that the guarantor could be required to make under the guarantee, which shall not be reduced by the effect of any amounts that may possibly be recovered under recourse or collateralization provisions in the guarantee (which are addressed under (d) and (e)) 2.
If the terms of the guarantee provide for no limitation to the maximum potential future payments under the guarantee, that fact
3.
If the guarantor is unable to develop an estimate of the maximum potential amount of future payments under its guarantee, the reasons why it cannot estimate the maximum potential amount.
c. The current carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee (including the amount, if any, recognized under Section 450-20-30), regardless of whether the guarantee is freestanding or embedded in another contract d. The nature of any recourse provisions that would enable the guarantor to recover from third parties any of the amounts paid under the guarantee e. The nature of any assets held either as collateral or by third parties that, upon the occurrence of any triggering event or condition under the guarantee, the guarantor can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee f.
If estimable, the approximate extent to which the proceeds from liquidation of assets held either as collateral or by third parties would be expected to cover the maximum potential amount of future payments under the guarantee.
See the Product Warranties Subsection of Section 460–10–50 for an exception to the requirements of (b). Pending Content: Transition Date: November 15, 2008Transition Guidance: 815-10-65-2 A guarantor shall disclose all of the following information about each guarantee, or each group of similar guarantees, even if the likelihood of the guarantor’s having to make any payments under the guarantee is remote: a.
The nature of the guarantee, including all of the following: 1. The approximate term of the guarantee 2. How the guarantee arose 3. The events or circumstances that would require the guarantor to perform under the guarantee 4.
The current status (that is, as of the date of the statement of financial position) of the payment/performance risk of the guarantee (for example, the current status of the payment/performance risk of a credit-risk-related guarantee could be based on either 229
recently issued external credit ratings or current internal groupings used by the guarantor to manage its risk) 5. If the entity uses internal groupings for purposes of item (a)(4), how those groupings are determined and used for managing risk. b. All of the following information about the maximum potential amount of future payments under : 1. The maximum potential amount of future payments (undiscounted) that the guarantor could be required to make under the guarantee, which shall not be reduced by the effect of any amounts that may possibly be recovered under recourse or collateralization provisions in the guarantee (which are addressed under (d) and (e)) 2.
If the terms of the guarantee provide for no limitation to the maximum potential future payments under the guarantee, that fact
3.
If the guarantor is unable to develop an estimate of the maximum potential amount of future payments under its guarantee, the reasons why it cannot estimate the maximum potential amount.
c. The current carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee (including the amount, if any, recognized under Section 450-20-30), regardless of whether the guarantee is freestanding or embedded in another contract d. The nature of any recourse provisions that would enable the guarantor to recover from third parties any of the amounts paid under the guarantee e. The nature of any assets held either as collateral or by third parties that, upon the occurrence of any triggering event or condition under the guarantee, the guarantor can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee f.
If estimable, the approximate extent to which the proceeds from liquidation of assets held either as collateral or by third parties would be expected to cover the maximum potential amount of future payments under the guarantee.
See the Product Warranties Subsection of Section 460–10–50 for an exception to the requirements of (b). > Effect of the Guarantee Disclosure Requirements on the Disclosure Requirements of Other Topics 460-10-50-5 The disclosures required by this Subsection do not eliminate or affect the following disclosure requirements: a. The requirements in the General Subsection of Section 825–10–50 that certain entities disclose the fair value of their financial guarantees issued
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b. The requirements in paragraphs 450-20-50-3 through 50-4 that an entity disclose a contingent loss that has a reasonable possibility of occurring c. The requirements in the Disclosure Sections of Topic 815, which apply to guarantees that are accounted for as derivatives d. The requirements in Section 275-10-50 that an entity disclose information about risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term. See Example 1 (paragraph 460-10-55-25) for an illustration of the required disclosure. The pronouncement that clarified the issue was FIN 45. Found by using the Print with Sources function [A guarantor shall disclose all of the following information about each guarantee, or each group of similar guarantees, even if the likelihood of the guarantor’s having to make any payments under the guarantee is remote: [FIN 45, paragraph 13, sequence 80.1] ] a. [The nature of the guarantee, including all of the following: [FIN 45, paragraph 13, sequence 81.1] ] 1. [The approximate term of the guarantee [FIN 45, paragraph 13, sequence 81.2.1] ] 2. [How the guarantee arose [FIN 45, paragraph 13, sequence 81.2.2.1] ] 3. [The events or circumstances that would require the guarantor to perform under the guarantee [FIN 45, paragraph 13, sequence 81.2.2.2] ] 4. [The current status (that is, as of the date of the statement of financial position) of the payment/performance risk of the guarantee (for example, the current status of the payment/performance risk of a credit-risk-related guarantee could be based on either recently issued external credit ratings or current internal groupings used by the guarantor to manage its risk) [FIN 45, paragraph 13, sequence 81.2.2.2.2.1.1] ] 5. [If the entity uses internal groupings for purposes of item (a)(4), how those groupings are determined and used for managing risk. [FIN 45, paragraph 13, sequence 81.2.2.2.2.1.2] ] b. All of the following information about the maximum potential amount of future payments under the guarantee: 1. [The maximum potential amount of future payments (undiscounted) that the guarantor could be required to make under the guarantee, which [FIN 45, paragraph 13, sequence 82.1] ][ shall not be reduced by the effect of any amounts that may possibly be recovered under recourse or collateralization provisions in the guarantee (which are addressed under (d) and (e)) [FIN 45, paragraph 13, sequence 82.2.1] ] 2. [If the terms of the guarantee provide for no limitation to the maximum potential future payments under the guarantee, that fact [FIN 45, paragraph 13, sequence 82.2.2.1] ] 3. If the guarantor is unable to develop an estimate of the maximum potential amount of future payments under its guarantee, the reasons why it cannot estimate the maximum potential amount. [FIN 45, paragraph 13, sequence 82.2.2.2.1] ] c. [The current carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee (including the amount, if any, recognized under Section 450-20-30), regardless of whether the guarantee is freestanding or embedded in another contract [FIN 45, paragraph 13, sequence 83] ] d. [The nature of any recourse provisions that would enable the guarantor to recover from third parties any of the amounts paid under the guarantee [FIN 45, paragraph 13, sequence 84.1] ] 231
e.
[The nature of any assets held either as collateral or by third parties that, upon the occurrence of any triggering event or condition under the guarantee, the guarantor can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee [FIN 45, paragraph 13, sequence 84.2.1] ] f. [If estimable, the approximate extent to which the proceeds from liquidation of assets held either as collateral or by third parties would be expected to cover the maximum potential amount of future payments under the guarantee. [FIN 45, paragraph 13, sequence 84.2.2] ] [See the Product Warranties Subsection of Section 460–10–50 for an exception to the requirements of (b). [FIN 45, paragraph 13, sequence 82.2.2.2.2] ] > Effect of the Guarantee Disclosure Requirements on the Disclosure Requirements of Other Topics 460-10-50-5 [The disclosures required by this Subsection do not eliminate or affect the following disclosure requirements: [FIN 45, paragraph 15, sequence 88.1] ] a. [The requirements in the General Subsection of Section 825–10–50 that certain entities disclose the fair value of their financial guarantees issued [FIN 45, paragraph 15, sequence 88.2] ] b. [The requirements in paragraphs 450-20-50-3 through 50-4 that an entity disclose a contingent loss that has a reasonable possibility of occurring [FIN 45, paragraph 2, sequence 35.2.2.2] ] c. [The requirements in the Disclosure Sections of Topic 815, which apply to guarantees that are accounted for as derivatives [FIN 45, paragraph A20, sequence 161.2.1] ] d. The requirements in Section 275-10-50 that an entity disclose information about risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term. See Example 1 (paragraph 460-10-55-25) for an illustration of the required disclosure. 460-10-50-6 [Some guarantees are issued to benefit entities that are related parties such as joint ventures, equity method investees, and certain entities for which the controlling financial interest cannot be assessed by analyzing voting interests. In those cases, the disclosures required by this Topic are incremental to the disclosures required by Topic 850. [FIN 45, paragraph 16, sequence 89] ] 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. Use the Print with Sources function. The students’ answers should be based on the following: > Implementation Guidance 55-1This Section provides guidance on the following implementation matters: a. Determining whether a contract is within the scope of this Subtopic b. Unit of accounting—a transferable option is considered freestanding, not embedded c. Definition of derivative instrument d. Instruments not within scope e. Scope application to certain contracts f. Other presentation matters g. Synthetic guaranteed investment contracts 232
h. Certain contracts on a consolidated subsidiary’s equity. Transition Date: December 15, 2008 Transition Guidance: 815-10-65-4 This Section provides guidance on the following implementation matters: a. Determining whether a contract is within the scope of this Subtopic b. Unit of accounting—a transferable option is considered freestanding, not embedded c. Definition of derivative instrument d. Instruments not within scope e. Scope application to certain contracts f. Other presentation matters g. Synthetic guaranteed investment contracts. h. [Subparagraph not used] > > Determining Whether a Contract Is within the Scope of this Subtopic 55-2The following diagram depicts the process for determining whether a freestanding contract is within the scope of this Subtopic. The diagram is a visual supplement to the written standards Sections. It shall not be interpreted to alter any requirements of this Subtopic nor shall it be considered a substitute for the requirements. The relevant paragraphs are identified in the parenthetical note after the question.
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234
> > Unit of Accounting > > > A Transferable Option Is Considered Freestanding, Not Embedded 55-3Certain structured transactions involving the issuance of a bond incorporate transferable options to call or put the bond. As such, those options are potentially exercisable by a party other than the debtor or the investor. For example, certain put bond structures involving three separate parties—the debtor, the investor, and an investment bank—may incorporate options that are ultimately held by the investment bank, giving that party the right to call the bond from the investor. For example, a call option that is transferable either by the debtor to a third party and thus is potentially exercisable by a party other than the debtor or by the original investor based on the legal agreements governing the debt issuance can result in the investor having different counterparties for the option and the original debt instrument. Accordingly, even if incorporated into the terms of the original debt agreement, such an option may not be considered an embedded derivative by either the debtor or the investor because it can be separated from the bond and effectively sold to a third party. > > Definition of Derivative Instrument 55-4This guidance addresses the following matters: a. Notional amount—identifying a commodity contract's notional amount b. Initial net investment—initial exchange under currency swap not an initial net investment c. Net settlement. > > > Notional Amount—Identifying a Commodity Contract's Notional Amount 55-5Many commodity contracts specify a fixed number of units of a commodity to be bought or sold under the pricing terms of the contract (for example, a fixed price). However, some contracts do not specify a fixed number of units. For example, consider the following four contracts that require one party to buy the following indicated quantities: a. Contract 1: As many units as required to satisfy its actual needs (that is, to be used or consumed) for the commodity during the period of the contract (a requirements contract). The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale). b.
Contract 2: Only as many units as needed to satisfy its actual needs up to a maximum of 100 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
c. Contract 3: A minimum of 60 units and as many units needed to satisfy its actual needs in excess of 60 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale). d.
Contract 4: A minimum of 60 units and as many units needed to satisfy its actual needs in excess of 60 units up to a maximum of 100 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
55-6Generally, the anticipated number of units covered by a requirements contract is equal to the buyer’s needs. When a requirements contract is negotiated between the seller and buyer, both parties typically have the same general understanding of the buyer’s estimated needs. Given the buyer’s often exclusive reliance on the seller to supply all its needs of the commodity, it is imperative from the buyer’s perspective that the supplier be knowledgeable with respect to anticipated volumes. In fact, the pricing provisions within requirements contracts are directly influenced by the estimated volumes. 235
55-7This guidance focuses solely on whether the contracts under consideration have a notional amount pursuant to the definition in this Subtopic. These types of contracts may not satisfy certain of the other required criteria in this Subtopic for them to meet the definition of a derivative instrument. The conclusion that a requirements contract has a notional amount as defined in this Subtopic can be reached only if a reliable means to determine such a quantity exists. Application of this guidance to specific contracts is as follows: a. Contract 1—requirements contract. The identification of a requirements contract’s notional amount may require the consideration of volumes or formulas contained in attachments or appendixes to the contract or other legally binding side agreements. The determination of a requirements contract’s notional amount must be performed over the life of the contract and could result in the fluctuation of the notional amount if, for instance, the default provisions reference a rolling cumulative average of historical usage. If the notional amount is not determinable, making the quantification of such an amount highly subjective and relatively unreliable (for example, if a contract does not contain settlement and default provisions that explicitly reference quantities or provide a formula based on historical usage), such contracts are considered not to contain a notional amount as that term is used in this Subtopic. One technique to quantify and validate the notional amount in a requirements contract is to base the estimated volumes on the contract’s settlement and default provisions. Often the default provisions of requirements contracts will specifically refer to anticipated quantities to utilize in the calculation of penalty amounts in the event of nonperformance. Other default provisions stipulate penalty amounts in the event of nonperformance based on average historical usage quantities of the buyer. If those amounts are determinable, they shall be considered the notional amount of the contract. b. Contract 2—requirements contract with a specified maximum quantity. Whether the contract has a notional amount depends. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 2; however, the notional amount cannot exceed 100 units. c.
Contract 3—requirements contract with a specified minimum quantity. The contract has a notional amount. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 3; however, the notional amount of Contract 3 cannot be less than 60 units. A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units. Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument under this Subtopic.
d. Contract 4—requirements contract with a specified maximum and minimum quantities. The contract has a notional amount. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 4; however, the notional amount of Contract 4 cannot be less than 60 units or greater than 100 units. A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units. Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument under this Subtopic.
> > > Initial Net Investment—Initial Exchange Under Currency Swap Is Not an Initial Net Investment 55-8The definition of a derivative instrument includes contracts that require gross exchanges of currencies (for example, currency swaps that require an exchange of different currencies at both inception and maturity). The initial exchange of currencies of equal fair values in those 236
arrangements does not constitute an initial net investment in the contract. Instead, it is the exchange of one kind of cash for another kind of cash of equal value. The balance of the agreement, a forward contract that obligates and entitles both parties to exchange specified currencies, on specified dates, at specified prices, is a derivative instrument.
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Net Settlement
55-9This guidance addresses the following matters: a. Asymmetrical default provision does not constitute net settlement. b. Determining whether a structured payout constitutes net settlement. > > > > Asymmetrical Default Provision Does Not Constitute Net Settlement 55-10Many commodity forward contracts contain default provisions that require the defaulting party (the party that fails to make or take physical delivery of the commodity) to reimburse the nondefaulting party for any loss incurred as illustrated in the following examples: a. If the buyer under the forward contract (Buyer) defaults (that is, does not take physical delivery of the commodity), the seller under that contract (Seller) will have to find another buyer in the market to take delivery. If the price received by Seller in the market is less than the contract price, Seller incurs a loss equal to the quantity of the commodity that would have been delivered under the forward contract multiplied by the difference between the contract price and the current market price. Buyer must pay Seller a penalty for nonperformance equal to that loss. b.
If Seller defaults (that is, does not deliver the commodity physically), Buyer will have to find another seller in the market. If the price paid by Buyer in the market is more than the contract price, Seller must pay Buyer a penalty for nonperformance equal to the quantity of the commodity that would have been delivered under the forward contract multiplied by the difference between the contract price and the current market price.
55-11For example, Buyer agreed to purchase 100 units of a commodity from Seller at $1.00 per unit: a. Assume Buyer defaults on the forward contract by not taking delivery and Seller must sell the 100 units in the market at the prevailing market price of $.75 per unit. To compensate Seller for the loss incurred due to Buyer’s default, Buyer must pay Seller a penalty of $25.00—that is, 100 units × ($1.00 – $.75). b. Similarly, assume that Seller defaults and Buyer must buy the 100 units it needs in the market at the prevailing market price of $1.30 per unit. To compensate Buyer for the loss incurred due to Seller’s default, Seller must pay Buyer a penalty of $30.00—that is, 100 units × ($1.30 – $1.00). 55-12Note that an asymmetrical default provision is designed to compensate the nondefaulting party for a loss incurred. The defaulting party cannot demand payment from the nondefaulting party to realize the changes in market price that would be favorable to the defaulting party if the contract were honored. 55-13Under the forward contract in the example, if Buyer defaults when the market price is $1.10, Seller will be able to sell the units of the commodity into the market at $1.10 and realize a $10.00 greater gain than it would have under the contract. In that circumstance, the defaulting Buyer is not required to pay a penalty for nonperformance to Seller, nor is Seller required to pass the $10.00 extra gain to the defaulting Buyer. 55-14Similarly, if Seller defaults when the market price is $.80, Buyer will be able to buy the units of the commodity in the market and pay $20.00 less than under the contract. In that circumstance, the defaulting Seller is not required to pay a penalty for nonperformance to Buyer, nor is Buyer required to pass the $20.00 savings on to the defaulting Seller. 237
55-15In a forward contract with only an asymmetrical default provision, neither Buyer nor Seller can realize the benefits of changes in the price of the commodity through default on the contract. That is, Buyer cannot realize favorable changes in the intrinsic value of the forward contract except in both of the following circumstances: a. By taking delivery of the physical commodity b. In the event of default by Seller (which is an event beyond the control of Buyer). 55-16Similarly, Seller cannot realize favorable changes in the intrinsic value of the forward contract except in either of the following circumstances: a. By making delivery of the physical commodity b. In the event of default by Buyer, which is an event beyond the control of Seller. 55-17However, a pattern of having the asymmetrical default provision applied in contracts between certain counterparties would indicate the existence of a tacit agreement between those parties that the party in a loss position would always elect the default provision, thereby resulting in the understanding that there would always be net settlement. In that situation, those kinds of commodity contracts would meet the characteristic described as net settlement in paragraph 815-10-15-100. 55-18In contrast, a contract that permits only one party to elect net settlement of the contract (by default or otherwise), and thus participate in either favorable changes only or both favorable and unfavorable price changes in the underlying, meets the derivative characteristic described in paragraph 815-10-1583(c) and discussed in paragraph 815-10-15-100 for all parties to that contract. Such a default provision allows one party to elect net settlement of the contract under any pricing circumstance and consequently does not require delivery of an asset that is associated with the underlying. That default provision differs from the asymmetrical default provision in the example contract in paragraph 815-10-55-10 because it is not limited to compensating only the nondefaulting party for a loss incurred and is not solely within the control of the defaulting party. > > > > Determining Whether a Structured Payout Constitutes Net Settlement 55-19Paragraph 815-10-15-104 explains that, upon settlement of a contract, in lieu of immediate net cash settlement of the gain or loss under the contract, the holder may receive a financial instrument involving terms that would provide for the gain or loss under the contract to be received or paid over a specified time period. Such a structured payout of the gain on a contract could also be described as an abnormally high yield on a required investment or borrowing in which the overall return is related to the amount of that contract’s gain, in which case the contract would be considered to have met the characteristic of net settlement in paragraph 815-10-15-100. 55-20Assume, instead, that, upon settlement of a contract, in lieu of immediate net cash settlement of the gain or loss under the contract, the holder is required to invest funds in or borrow funds from the other party so that the party in a gain position under the contract can obtain the value of that gain only over time as a traditional adjustment of the yield on the amount invested or the interest element on the amount borrowed. (A fixed-rate mortgage loan commitment is an example of a contract that requires the party in a gain position under the contract to borrow funds at a below-market interest rate at the time of the borrowing to obtain the benefit of that gain.) Paragraph 815-10-15-105 indicates that such a contract does not meet the characteristic of net settlement in paragraph 815-10-15-100. 55-21In contrast, paragraph 815-10-15-106 explains that a contract that requires one party to the contract to invest funds in or borrow funds from the other party so that the party in a gain position under the contract can obtain the value of that gain over time as a nontraditional adjustment of the yield on the amount invested or the interest element on the amount borrowed may meet the characteristic of net settlement in paragraph 815-10-15-100. For example, if a contract required the party in a gain position under the contract to invest $100 in the other party’s debt instrument that paid an abnormally high 238
interest rate of 5,000 percent per day for a term whose length is dependent on the changes in the contract’s underlying, an analysis of those terms would lead to the conclusion that the contract’s settlement terms were in substance a structured payout of the contract’s gain and thus that contract would be considered to have met the characteristic of net settlement in that paragraph. > > Instruments Not Within Scope 55-22This guidance addresses the following matters: a. Normal purchases and normal sales—application to power purchase or sales agreements b. Dual-trigger financial guarantee contracts c. Certain insurance contracts—dual-trigger property and casualty insurance contracts d. Derivative instrument that impedes sale accounting e. Loan commitment types. > > > Normal Purchases and Normal Sales—Application to Power Purchase or Sales Agreements 55-23This guidance addresses the following matters: a. Contracts that combine a forward contract and a purchased option contract b. Distinguishing between options that are capacity contracts and financial options on electricity. > > > > Contracts that Combine a Forward Contract and a Purchased Option Contract 55-24Paragraph 815-10-15-44 states that the inclusion of a purchased option that would, if exercised, require delivery of the related asset at an established price under the contract within a single contract that meets the definition of a derivative instrument disqualifies the entire contract from being eligible to qualify for the normal purchases and normal sales scope exception in this Subsection except as provided in paragraphs 815-10-15-45 through 15-51 with respect to certain power purchase or sales agreements. Although the guidance that follows discusses such circumstances in the context of utilities and independent power producers, it applies to all entities that enter into contracts that combine a forward contract and a purchased option contract, not just to utilities and independent power producers. Some utilities and independent power producers have fuel supply contracts that require delivery of a contractual minimum quantity of fuel at a fixed price and have an option that permits the holder to take specified additional amounts of fuel at the same fixed price at various times. Essentially, that option to take more fuel is a purchased option that is combined with the forward contract in a single supply contract. Typically, the option to take additional fuel is built into the contract to ensure that the buyer has a supply of fuel to produce the electricity during peak demands; however, the buyer may have the ability to sell to third parties the additional fuel purchased through exercise of the purchased option. Due to the difficulty in estimating peak electricity load and thus the amount of fuel needed to generate the required electricity, those fuel supply contracts are common in the electric utility industry (though similar supply contracts may exist in other industries). 55-25Those fuel supply contracts are not requirements contracts that are addressed in paragraphs 81510-55-5 through 55-7. Many of those contracts meet the definition of a derivative instrument because they have a notional amount and an underlying, require no or a smaller initial net investment, and provide for net settlement (for example, through their default provisions or by requiring delivery of an asset that is readily convertible to cash). The fuel supply contract cannot qualify for the normal purchases and normal sales exception because of the optionality regarding the quantity of fuel to be delivered under the contract. 239
55-26An entity shall not bifurcate the forward contract component and the option component of a fuel supply contract that in its entirety meets the definition of a derivative instrument and then assert that the forward contract component is eligible to qualify for the normal purchases and normal sales exception. 55-27An entity may wish to enter into two separate contracts—a forward contract and an option—that economically achieve the same results as the single derivative instrument and determine whether the normal purchases and normal sales scope exception (as discussed beginning in paragraph 815-10-15-22) applies to the separate forward contract. 55-28Similar to the contractual options discussed in Example 10 (see paragraph 815-10-55-121), this guidance addresses option components that would require delivery of the related asset at an established price under the contract. 55-29If the option component does not provide any benefit to the holder beyond the assurance of a guaranteed supply of the underlying commodity for use in the normal course of business and that option component only permits the holder to purchase additional quantities at the market price at the date of delivery (that is, that option component will always have a fair value of zero), that option component would not require delivery of the related asset at an established price under the contract. 55-30If an entity’s single supply contract included at its inception both a forward contract and an option and, in subsequent renegotiations, that contract is negated and replaced by two separate contracts (a forward contract for a specific quantity that will be purchased and an option for additional quantities whose purchase is conditional upon exercise of the option), the new forward contract would be eligible to qualify for the normal purchases and normal sales exception (as discussed beginning in paragraph 815-10-15-22), whereas the new option would not be eligible for that exception. From its inception the new separate option would be accounted for under this Subtopic. > > > > Distinguishing Between Options that Are Capacity Contracts and Financial Options on Electricity 55-31The following table lists characteristics of an option that is a capacity contract and a traditional option. The characteristics listed may be relevant to the application of paragraph 815-10-15-45(a)(2). Other characteristics not listed may also be relevant.
240
> > > Dual-Trigger Financial Guarantee Contracts 55-32Entity ABC extends credit to consumers through credit cards and personal loans of various sorts. Entity ABC is exposed to credit losses from its managed asset portfolio, including owned and securitized receivables. Entity ABC would like to purchase an insurance policy to protect itself against high levels of consumer default. 55-33The proposed insurance policy will entitle Entity ABC to collect claims to the extent that its credit losses exceed a specified minimum level but limited to the amount by which the credit losses on a customized pool or index of consumer loans exceed that same specified minimum level. Thus, Entity ABC will collect claims based on the lesser of the following: a. Entity ABC's actual credit losses b. The credit losses on a customized pool or index of consumer loans.
241
55-34Although the insurer’s payment to Entity ABC may be affected by credit losses on a customized pool, the payment nevertheless represents compensation for actual credit losses Entity ABC incurred. Entity ABC purchases this insurance to obtain a lower premium because claims are limited by external charge-off rates and the insurer is not exposed to Entity ABC's underwriting performance. 55-35This type of control may also exist in property and casualty reinsurance policies. For example, an insurance entity may purchase reinsurance that covers actual hurricane losses in excess of a specified level in their block of business, but the coverage does not apply to losses in excess of a geographically diversified index of hurricane losses. 55-36Financial guarantee insurance contracts are not subject to this Subtopic only if all of the conditions in paragraph 815-10-15-58 are met. The description of the financial guarantee insurance contract in paragraph 815-10-55-32 is insufficient for determining whether those conditions are met. The following provisions of that contract represent a type of deductible and do not affect the application of the conditions in paragraph 815-10-15-58: a. The provision that limits any claims to the extent that Entity ABC's actual credit losses exceed a specified minimum level b. The provision that limits any payments for those claims to the amount by which the credit losses on a customized pool or index of consumer loans exceed that same specified minimum level. > > > Certain Insurance Contracts—Dual-Trigger Property and Casualty Insurance Contracts 55-37A common characteristic of dual-trigger policies is that the payment of a claim is triggered by the occurrence of two events (that is, the occurrence of both an insurable event and changes in a separate pre-identified variable). Because the likelihood of both events occurring is less than the likelihood of only one of the events occurring, the dual-trigger policy premiums are lower than traditional policies that insure only one of the risks. The policyholder is often purchasing the policy to provide for coverage against a catastrophe because if both events occur, the combined impact may be disastrous to its business. 55-38Paragraph 815-10-55-40 addresses seven contracts that illustrate the characteristics of dual-trigger policies offered to different types of policyholders that have different risk management needs. All seven contracts qualify for either the exception in paragraph 815-10-15-53(b) for traditional property and casualty contracts or the exception in paragraph 815-10-15-59(b) for non-exchange-traded contracts involving nonfinancial assets. Therefore, the dual-trigger variable in those contracts is not separated and accounted for separately as a derivative instrument. 55-39In contrast, paragraph 815-15-55-12 states that, if a contract issued by an insurance entity involves essentially assured amounts of cash flows based on insurable events that are highly probable of occurrence (as discussed in paragraph 815-10-15-55[c]), an embedded derivative related to changes in the separate pre-identified variable for that portion of the contract would be required to be separately accounted for as a derivative instrument. 55-40Following are descriptions of seven contracts: a. Contract A—electric utility. A dual-trigger policy pays for a level of actual losses caused by the following two events occurring simultaneously: 1. A power outage resulting from equipment failure or storm-related damage causes more than 500 megawatts of lost power. 2. The spot market price for power exceeds $65 per megawatt hour during the storm or equipment-failure period. The contract pays the difference between the strike price and the actual market price for the lost power (that is, the cost of replacement power). 242
b. Contract B—trucking delivery entity. A dual-trigger policy pays extra expenses associated with rerouting trucks over a certain time period if snowfall exceeds a specified level during that time period. The snowfall causes delays and creates the need to reroute trucks to meet delivery demands. c. Contract C—hospital.A dual-trigger policy pays actual medical malpractice claims above a specified level only if the value of the hospital’s equity portfolio falls below a specified level during the same period. d. Contract D—iron ore mining entity. A dual-trigger policy pays a specified level of workers’ compensation claims (not to exceed actual claims) if the claims exceed a specified level at the same time iron ore prices decrease below a specified level. e. Contract E—golf resort in Florida. A dual-trigger policy pays property damage from hurricanes incurred by a specific golf resort in Florida; however, the losses are covered only if other golf courses in the region incur hurricane-related losses and the claims cannot exceed the average property damages incurred by the other golf resorts in the county. f.
Contract F—cherry orchard in Michigan. A dual-trigger policy pays crop losses incurred due to bad weather during growing season, and the claims are at risk of being reduced based on changes in the inflation rate in Brazil. The cherry producer has no operations in Brazil or any transactions in Brazilian currency. However, a Brazilian cherry producer exports cherries to the United States and is a competitor of the Michigan cherry producer.
g. Contract G—property-casualty reinsurance contract. Reinsurance contracts, which indemnify the holder of the contract (the reinsured) against loss or liability relating to insurance risk, are accounted for under the provisions of Topic 944. Reinsurance contract provisions often adjust the amount at risk or the price of the amount at risk for a number of events or circumstances, such as loss experience or premium volume, while continuing to provide indemnification related to insurance risk. One type of reinsurance contract, an excess contract, provides the reinsured with indemnification against a finite amount of insured losses in excess of a defined level of insured losses retained by the reinsured. Example 11 (see paragraph 815-10-55-132) illustrates a reinsurance contract with a provision that adjusts the retention amount downward based on the performance of a specified equity index. > > > Derivative Instrument that Impedes Sales Accounting 55-41The following guidance illustrates application of the scope exception (as discussed beginning in paragraph 815-10-15-63) for a derivative instrument that impedes sales accounting to situations in which the transferor accounts for the transfer as a financing: a. If a transferor transfers financial assets but retains a call option on those assets, the net settlement criterion (as discussed beginning in paragraph 815-10-15-119) may be satisfied because the assets transferred are readily obtainable; however, the transfer may fail the isolation criterion in paragraph 860-10-40-5(a) because of significant continued involvement by the transferor. In that example, because the transferor is required to continue to recognize the assets transferred, recognition of the call option on those assets would effectively result in recording the assets twice. Therefore, the derivative instrument is not subject to the scope of this Subtopic. b. In the situation described in (a), the transferor may have sold to the transferee a put option. Exercise of the put option by the transferee would result in the transferor repurchasing certain assets that it has transferred, but which it still records as assets in its balance sheet. Because the transferor is required to recognize the borrowing, recognition of the put option would result in 243
recording the liability twice. Therefore, the derivative instrument is not subject to the scope of this Subtopic. c. A transferor may transfer fixed-rate financial assets to a transferee and guarantee a variable-rate return. If the transfer is accounted for as a sale and an interest-rate swap is entered into as part of the contractual provisions of the transfer, the transferor records the interest rate swap as one of the financial components. In that case, the interest rate swap should be accounted for separately in accordance with this Subtopic. However, if the transfer is accounted for as a financing, the transferor records on its balance sheet the issuance of variable-rate debt and continues to report the fixed-rate financial assets; no derivative instrument is recognized under this Subtopic. d. In a securitization transaction, a transferor transfers $100 of fixed-rate financial assets and the contractual terms of the beneficial interests incorporate an interest rate swap with a notional principal of $1 million. If the transfer is accounted for as a sale and the interest rate swap is entered into as part of the contractual provisions of the transfer, the transferor identifies and records the interest rate swap as one of the financial components. In that case, the interest rate swap would be accounted for separately in accordance with this Subtopic. However, if the transfer is accounted for as a financing, the transferor records in its balance sheet a $100 variable-rate borrowing and continues to report the $100 of fixed-rate financial assets. In this instance, because the liability is leveraged, requiring computation of interest flows based on a $1 million notional amount, the liability (which does not meet the definition of a derivative instrument in its entirety) is a hybrid instrument that contains an embedded derivative—such as an interest rate swap with a notional amount of $999,900. That embedded derivative is not clearly and closely related to the host contract under Section 815-15-25 (see paragraph 815-1525-1[c]) because it could result in a rate of return on the counterparty’s asset that is at least double the initial rate and that is at least twice what otherwise would be the then-current market return for a contract that has the same terms as the host contract and that involves a debtor with credit quality similar to the issuer’s credit quality at inception. Therefore, the derivative instrument must be recorded separately under paragraph 815-15-25-1. 55-42[Paragraph not used] > > Scope Application to Certain Contracts 55-43This guidance illustrates the application of Section 815-10-15 in the following situations: a. Contract with payment provision b. Credit derivatives c. Equity options issued to employees d. Equity instruments (including options) issued to nonemployees e. Repurchase agreements and wash sales f. Short sales (sales of borrowed securities) g. Take-or-pay contracts. > > > Contract with Payment Provision 55-44If the contract contains a payment provision that requires the issuer to pay to the holder a specified dollar amount based on a financial variable, the contract is subject to the requirements of this Subtopic. 244
> > > Credit Derivatives 55-45Many different types of contracts are indexed to the creditworthiness of a specified entity or group of entities, but not all of them are derivative instruments. Credit-indexed contracts that have certain characteristics described in paragraph 815-10-15-58 are guarantees and are not subject to the requirements of this Subtopic. Credit-indexed contracts (often referred to as credit derivatives) that do not have the characteristics necessary to qualify for the exception in that paragraph are subject to the requirements of this Subtopic. One example of the latter is a credit-indexed contract that requires a payment due to changes in the creditworthiness of a specified entity even if neither party incurs a loss due to the change (other than a loss caused by the payment under the credit-indexed contract). > > > Equity Options Issued to Employees 55-46Some entities issue stock options to their employees in which the underlying shares are stock of an unrelated entity. Consider the following example: a. Entity A awards an option to an employee. b. The terms of the option award provide that, if the employee remains employed by Entity A for 3 years, the employee may exercise the option and purchase 1 share of common stock of Entity B, a publicly traded entity, for $10 from Entity A. c. Entity B is unrelated to Entity A and, therefore, is not a subsidiary or accounted for by the equity method. 55-47The option award in this example is not within the scope of Topic 718 because the underlying stock is not an equity instrument of the employer-grantor. 55-48The option award is not subject to Topic 718. Rather, the option award in the above example meets the definition of a derivative instrument in this Subtopic and, therefore, should be accounted for by the employer as a derivative instrument under this Subtopic. After vesting, the option award would continue to be accounted for as a derivative instrument under this Subtopic. > > > Equity Instruments (Including Options) Issued to Nonemployees > > > > Issuer's Accounting 55-49For the issuer, equity instruments (including stock options) that are granted to nonemployees as compensation for goods and services in share-based payment transactions are subject to this Subtopic once performance has occurred (as discussed in Subtopic 505-50) and provided that the scope exception in paragraph 815-10-15-74(a) does not apply. From the perspective of the issuer, equity instruments (including stock options) granted to a nonemployee for goods and services in share-based payment transactions are not included in the scope of this Subtopic if performance has not yet occurred. Any equity instrument granted in a share-based payment transaction subject to Subtopic 505-50 for the reporting entity is not considered to be a derivative instrument subject to this Subtopic by that entity during the period that the equity instrument is subject to Subtopic 505-50. 55-50Paragraphs 718-10-35-9 through 35-14 contain the concept that equity instruments that are granted in share-based payment transactions may initially be subject to that Subtopic, but after certain events or circumstances, those equity instruments may cease being subject to that Subtopic. The terms of an award that ceases to be subject to Topic 718 in accordance with paragraphs 718-10-35-9 through 35-14 should be analyzed to determine whether the award is subject to this Subtopic. 55-51Subtopic 505-50 provides guidance for accounting by the issuer for certain share-based compensation arrangements granted to nonemployees for goods and services, including guidance regarding counterparty performance commitments and conditions in share-based payment transactions. 55-52Pursuant to paragraph 815-40-15-3(c), the guidance in Subtopic 815-40 applies to contracts issued to acquire goods or services from nonemployees when performance has occurred. 55-53Thus, an equity instrument (including a stock option) granted to a nonemployee for goods and services in a share-based payment transaction would typically cease being subject to Subtopic 505-50 245
after performance has occurred. At that point, the scope exception in paragraph 815-10-15-74(b) would no longer apply. The issuer would then need to determine whether that equity instrument meets the definition of a derivative instrument and is within the scope of this Subtopic by analyzing the terms of the instrument. The scope exception in paragraph 815-10-15-74(a) may apply. > > > > Holder's Accounting 55-54The exception in paragraph 815-10-15-74(b) does not apply to the holder of those derivative instruments. 55-55Thus, paragraph 815-10-15-75(a) explains that equity instruments (including stock options) received by nonemployees as compensation for goods and services are included in the scope of this Subtopic assuming the contract has all the characteristics of a derivative instrument. > > > Repurchase Agreements and Wash Sales 55-56Repurchase agreements and wash sales that are accounted for as sales (as described in paragraphs 860-10-55-55 and 860-10-55-57) and in which the transferor is both obligated and entitled to repurchase the transferred asset at a fixed or determinable price contain two separate features, one of which may be a derivative instrument. The initial exchange of financial assets for cash is a sale-purchase transaction— generally not a transaction that involves a derivative instrument. However, the accompanying forward contract that gives the transferor the right and obligation to repurchase the transferred asset involves an underlying and a notional amount (the price of the security and its denomination), and it does not require an initial net investment in the contract. Consequently, if the forward contract requires delivery of a security that is readily convertible to cash or otherwise meets the net settlement criterion as discussed beginning in paragraph 815-10-15-99, it is subject to the requirements of this Subtopic. > > > Short Sales (Sales of Borrowed Securities) 55-57The following discussion applies only to short sales with the characteristics described. Some groups of transactions that are referred to as short sales may have different characteristics. If so, a different analysis would be appropriate, and other derivative instruments may be involved. Short sales (sales of borrowed securities) typically involve all of the following activities: a. Selling a security (by the short seller to the purchaser) b. Borrowing a security (by the short seller from the lender) c. Delivering the borrowed security (by the short seller to the purchaser) d. Purchasing a security (by the short seller from the market) e. Delivering the purchased security (by the short seller to the lender). Those five activities involve three separate contracts. 55-58A contract that distinguishes a short sale involves activities in (b) and (e) in the preceding paragraph, borrowing a security and replacing it by delivering an identical security. Such a contract has two of the three characteristics of a derivative instrument. The settlement is based on an underlying (the price of the security) and a notional amount (the face amount of the security or the number of shares), and the settlement is made by delivery of a security that is readily convertible to cash. However, the other characteristic, no initial net investment or an initial net investment that is smaller by more than a nominal amount than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, is not present. (See paragraphs 815-10-15-94 through 1596.) The borrowed security is the lender's initial net investment in the contract. Consequently, the contract relating to activities in (b) and in (e) in the preceding paragraph is not a derivative instrument. 55-59The other two contracts (one for activities in paragraph 815-10-55-57[a] and in paragraph 815-1055-57[c] and the other for activity in paragraph 815-10-55-57[d]) are routine and do not generally involve derivative instruments. However, if a forward purchase or forward sale is involved, and the 246
contract does not qualify for the exception in paragraphs 815-10-15-15 through 15-17, it is subject to the requirements of this Subtopic. > > > Take-or-Pay Contracts 55-60Whether a take-or-pay contract is subject to this Subtopic depends on its terms. For example, if the product to be delivered is not readily convertible to cash and there is no net settlement option, the contract fails to meet the net settlement criterion in paragraph 815-10-15-83(c) and is not subject to the requirements of this Subtopic. In certain circumstances, a take-or-pay contract may represent or contain a lease that should be accounted for in accordance with Topic 840. (Paragraph 815-10-15-79 explains that leases subject to that Topic are not subject to this Subtopic.) 55-61[Paragraph not used] > > Other Presentation Matters > > > Income Statement Presentation of Realized Gains And Losses 55-62Determining whether realized gains and losses on physically settled derivative instruments not held for trading purposes should be reported in the income statement on a gross or net basis is a matter of judgment that depends on the relevant facts and circumstances. Consideration of the facts and circumstances should be made in the context of the various activities of the entity rather than based solely on the terms of the individual contracts. In evaluating the facts and circumstances for purposes of determining whether an arrangement should be reported on a gross or net basis, all of the following may be considered: a. The economic substance of the transaction b. The guidance set forth in Topic 845 relative to nonmonetary exchanges c. The gross vs. net reporting indicators provided in Subtopic 605-45. > > Synthetic Guaranteed Investment Contracts 55-63From the perspective of the issuer of the contract, synthetic guaranteed investment contracts are derivative instruments as defined in this Subtopic. Synthetic guaranteed investment contracts contain an underlying, the formula by which interest is calculated, and a notional amount. The interplay between the fair value of a portfolio of segregated assets and a notional amount together determine the amount of the settlement(s), if any, due from the contract issuer, after considering all contract terms. Depending on the specifics of the contract, a synthetic guaranteed investment contract requires either no initial investment or the payment of a risk charge or fee (covering either the entire contract or, more typically, an initial period of the contract). The terms of a synthetic guaranteed investment contract require net settlement because the issuer of the contract makes a payment to the holder equal to the net amount due. For a background discussion of synthetic guaranteed investment contracts, including a comparison with traditional and benefit-responsive guaranteed investment contracts, see paragraph 815-10-05-8. Example 17 (see paragraph 815-10-55-169) illustrates contractual terms of a synthetic guaranteed investment contracts. > > Certain Contracts on a Consolidated Subsidiary’s Equity 55-64Paragraph 810-10-25-19 addresses freestanding derivative instruments entered into by a parent entity that are indexed to, and potentially settled in, the stock of a consolidated subsidiary and that are not within the scope of this Subtopic or Topic 480 (see paragraph 810-10-25-18). Transition Date: December 15, 2008 Transition Guidance: 815-10-65-4 [Paragraph not used] 55-65For derivative instruments indexed to, and potentially settled in, the stock of a consolidated subsidiary that are within the scope of this Subtopic, if the parent entity ultimately receives shares of the 247
consolidated subsidiary in a net-share or physical settlement, the cost of acquiring those shares would include the amount paid at settlement plus (minus) the parent's gain (loss) on the derivative instrument. That cost should be accounted for by the parent entity as a step acquisition in accordance with paragraphs 805-10-25-9 through 25-10. If the parent entity ultimately delivers shares of the consolidated subsidiary as part of net share or physical settlement, a gain or loss should be recognized in accordance with paragraph 323-10-35-35. In determining the amount of gain or loss recognized under that paragraph, the asset or liability balance of the derivative instrument at the settlement date should be reflected as a decrease or an increase, respectively, in the selling price of the shares delivered. Implementation Guidance 55-1 This Section provides guidance on the following implementation matters: a. Determining whether a contract is within the scope of this Subtopic b.
Unit of accounting—a transferable option is considered freestanding, not embedded
c. Definition of derivative instrument d. Instruments not within scope e. Scope application to certain contracts f.
Other presentation matters
g. Synthetic guaranteed investment contracts h. Certain contracts on a consolidated subsidiary’s equity. Some examples of the EITF pronouncements addressing derivatives are: 815-10-15-141 [The guidance in the Certain Contracts on Debt and Equity Securities Subsections applies only to those forward contracts and purchased options having all of the following characteristics: [EITF 96-11, paragraph ISSUE, sequence 13.1.1] ] a.
[The contract is entered into to purchase securities that will be accounted for under Topic 320. [EITF 96-11, paragraph DISCUSSION, sequence 15.1.2.2.1] ]
b. [The contract's terms require physical settlement of the contract by delivery of the securities. [EITF 96-11, paragraph ISSUE, sequence 13.1.2] ] c.
[The contract is not a derivative instrument otherwise subject to this Subtopic. [EITF 96-11, paragraph STATUS, sequence 23.1.1] ]
d. [The contract, if a purchased option, has no intrinsic value at acquisition. [EITF 96-11, paragraph DISCUSSION, sequence 15.1.2.1] ] 815-10-15-142 [The guidance in the Certain Contracts on Debt and Equity Securities Subsections does not apply to contracts involving securities not within the scope of Topic 320. [EITF 96-11, paragraph STATUS, sequence 23.2] ] FASB ASC 11-4 The Fair Value Option and Health Care Businesses 248
Search fair value option and not-for-profit 825-10-15-7 15-7 Not-for-profit entities (NFPs) shall apply the provisions of the Fair Value Option Subsections with the following modifications: a. References to an income statement shall be replaced with references to a statement of activities, statement of changes in net assets, or statement of operations. b.
References to earnings shall be replaced with references to changes in net assets, except as indicated in (c).
c. aragraph 954-825-45-1 explains that health care entities subject to Topic 954 shall report unrealized gains and losses on items for which the fair value option has been elected within the performance indicator or as a part of discontinued operations, as appropriate. Unlike other NFPs, health care entities subject to that Topic present performance indicators analogous to income from continuing operations. Consistent with the provisions of Subtopic 958-10, NFPs may present such gains and losses either within or outside other intermediate measures of operations unless such gains or losses are part of discontinued operations. This includes intermediate measures of operations presented by NFPs other than health care entities and any additional intermediate measures of operations presented within the performance indicator by not-for-profit health care entities. d. The disclosure requirements in paragraph 825-10-50-30 shall apply not only with respect to the effect on performance indicators or other intermediate measures of operations, if presented, but also with respect to the effect on the change in each of the net asset classes (unrestricted, temporarily restricted, and permanently restricted), as applicable. FASB ASC 11-5 The Use Of Zero Coupon Bonds In A Troubled Debt Restructuring Search troubled debt and zero coupon 310-40-55 Use of Zero Coupon Bonds in a Troubled Debt Restructuring 55-6 This implementation guidance addresses the following circumstance: In connection with a troubled debt restructuring, a debtor, with the creditor's approval, sells the collateral, which has a fair value less than the creditor's net investment in the related loan, and invests the proceeds in a series of zero coupon bonds that are received and held by the creditor as collateral for the newly restructured loan. The bonds will mature at a value equal to each year's debt service requirement under the newly restructured terms. Specifically, the issue is whether the sale of collateral, the purchase of the zero coupon bonds, and their receipt by the creditor as collateral require the creditor to recognize a loss equal to the amount by which the net investment in the loan exceeds the fair value of the zero coupon bonds. 55-7 The excess of the recorded investment in the receivable satisfied over the fair value less cost to sell (as that term is used in paragraph 360-10-35-43) of assets received is a loss to be recognized. 55-8 Such losses, to the extent they are not offset against allowances for uncollectible accounts or other valuation accounts, shall be included in measuring net income for the period. 249
55-9
However, if the creditor has the right to sell or pledge the collateral: Paragraph 860-30-45-1 requires that the debtor reclassify the collateral and report it in its statement of financial position separately from other assets not so encumbered. Paragraphs 860-30-50-1 through 50-2 requires the creditor to disclose the fair value of that collateral and of the portion that it has sold or repledged.
FASB ASC 11-6 Accounting for Loss Contingencies by Regulated Entities Search regulated operations and loss contingencies 980-450-25 25-1 Paragraph 450-20-25-2 specifies criteria for recording estimated losses from loss contingencies. A regulator may direct a regulated entity to include an amount for a contingency in allowable costs for rate-making purposes even though the amount does not meet those criteria for recording. If the regulator requires the entity to remain accountable for any amounts charged pursuant to such rates and not yet expended for the intended purpose, the resulting increased charges to customers create a liability (see paragraph 980-405-25-1(b)).
FASB ASC 11-7 Hedging and Gas Balancing Arrangements Search gas balancing arrangement 932-815-55 > Gas-Balancing Arrangements 55-1 A gas-balancing arrangement is a situation where Entities A and B are partners in a gas well. During the current period, Entity B may decide not to sell any gas because it does not have a purchaser or because market conditions are unfavorable. Accordingly, Entity A (the overtaker) agrees to take all the gas production for the period and sells it to its customer. In the future, Entity B has the right to take more gas than its interest would otherwise allow to make up for Entity A's overtake. Alternatively, A may make payment in kind (using gas from a different well) or pay cash to Entity B. Room for Debate Debate 11-1 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, 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 250
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 converts what otherwise would be an equity instrument into a liability because the essence of a liability is the obligation to transfer 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. 251
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
SFAS No. 159 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. 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 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. 1). 252
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 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 value-added 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 straightdebt. 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 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.
253
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 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.
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
$200,000 (37,500) 42,500 $205,000 x 40% $ 82,000 254
Decrease in deferred tax asset Decrease in deferred tax liability (42,500 x 40%) Income tax expense b.
15,000 (17,000) $ 80,000
The projected amount of income tax expense that would be recognized if Whitley purchases the equipment in 2010 is calculated as follows: Income tax expense, calculated in a. Increase in deferred tax liability (50,000 x 40%) Income tax expense
c.
$ 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 2010. 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. 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 2010. 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 a.
There is no clear solution to this exercise, it can be used to generate class discussion about the qualitative criteria. The following represents the opinion of the authors. Nondiscounting (1) 255
Discounting (2)
Neither (3)
1. Relevance a. Timeliness b. Predictive & feedback value
X
2. Reliability a. Representational Faithfulness b. Verifiability & neutrality
X
X X
X X
3. Understandability
X
X
4. Comparability b.i.
ii.
Relevance. Because the objective of financial statements is to provide decision relevant information, discounted deferred taxes may be more relevant than nondiscounted deferred taxes. The FASB has determined that the asset liability approach measures future tax consequences. It follows that deferred tax liabilities measure future cash outflows. Consistent with liability measurements of other future expected cash outflows the present value of the expected future tax consequences has decision usefulness and is therefore relevant. a.
Timeliness. The concept of timeliness, as a qualitative criterion, means that the information provided in financial statements is presented within a time frame to be decision relevant. The measurement method (discounting vs nondiscounting) does not affect the timeliness of either approach.
b.
Predictive and feedback value. If we believe that deferred taxes are future tax consequences, and that they should be measured in a manner that is consistent with other liabilities in order to be decision relevant, then it follows that discounting provides better predictive and feedback value because it provides an appropriate measure of actions taken and as such should improve decision maker abilities to predict the results of future actions.
Reliability. When assessing the reliability of accounting representations, the degree of representational faithfulness must be weighed against verifiability and neutrality. Again, if future cash outflows (liabilities) are better represented by their present value, then discounting deferred taxes has representational faithfulness. a.
Representational faithfulness. Representational faithfulness implies that the financial information reported reflects what it is purported to represent. Because deferred tax liabilities measure future cash flows, the time value of money would imply that a part of the future cash flow is for interest and therefore, the present value of those cash flows provides a representationally faithful measure of the liability.
b. Verifiability and Neutrality. It could be argued that the selection of an interest rate appropriate to discount deferred tax liabilities is subjective or even arbitrary. If so, there would be a much greater degree of consensus among independent measurers if the deferred taxes were not discounted. Also, because subjectivity inherent in the selection 256
of an interest rate would be avoided, nondiscounted deferred taxes would be more neutral.
c.
iii.
Understandability. Presuming that users understand the nature of deferred taxes and present value, neither method would provide financial statements that would be more understandable than the other.
iv.
Comparability. Because other, significant liabilities are measured at present value, financial statements containing discounted deferred tax liabilities should provide greater comparability across time and among companies. The amounts of the various reported liabilities would be more comparable as well as aggregated data across firms. 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.
d.
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.
Case 12-3 a.
Intraperiod income tax allocation is necessary to obtain an appropriate relationship between income tax expense and each element of earnings (continuing operations, discontinued operations and extraordinary items, or between income tax expense and prior-period adjustments. Income tax expense attributable to earnings before extraordinary items is computed based solely on the earnings before extraordinary items to prevent distortion of the results of continuing operations. The extraordinary items are shown net of the corresponding income tax consequences. Any prior-period adjustment is shown net of the corresponding income tax consequences as an adjustment to beginning retained earnings.
b.
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.
c.
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 257
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. 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.i.
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 difference. 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. 258
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.
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.
b.
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.
c.
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 method.
SFAS No. 109 defends 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 nonowner 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 259
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 a.
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).
b.
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. 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 260
3. 4. 5. 6. 7.
8. b.
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. 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. Tax allocation hides economic differences between a company that employs tax savings strategies from one that does not. Reporting tax expense equal to taxes paid provides a better predictor of future cash flows because many deferred taxes will never be paid. Tax allocation presumes implicit forecasts of future profits, a practice which is inconsistent with conservatism. 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. The cost of doing interperiod tax allocation exceeds the benefits, if any, derived. 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.
2.
3. 4.
c.
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. 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 give to the impact of the future, as well as to historical transactions. Partial allocation enhances assessments of future cash flows. The deferred taxes reported would be more reflective of expected cash flow. 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 items reported in the income statement with their tax cash flow effects. The following arguments support this position.
1. 2. 3.
4.
Individual temporary differences do reverse. They are temporary, not permanent. Thus, the focus should be on individual items not on groups of items. 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. 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. 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 12-7 261
a. i. Gross Profit on Sales Operating Expenses Rent Expense Taxable Income Tax rate Taxes paid
20x7 $350,000 210,000 60,000 $ 80,000 x30% $24,000
20x8 $349,000 210,000 0 $139,000 x30% $ 41,700
20x9 $351,000 210,000 0 $141,000 x30% $ 42,300
Net Income
56,000
97,300
98,700
20x7 $350,000 210,000 20,000 $120,000 36,000 $ 84,000
20x8 $349,000 210,000 20,000 $119,000 35,700 $ 83,300
20x9 $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
b.
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.
c.i.
20x7 $350,000 210,000 20,000 $120,000 36,000 $ 84,000
Gross Profit on Sales Operating Expenses Rent Expense Income before taxes Tax Expense Net Income
20x8 $349,000 210,000 20,000 $119,000 39,870 $ 79,130
20x8 Tax expense: $139,000 x 33% = 20,000 x 30% =
20x9 $351,000 210,000 20,000 $121,000 40,530 $ 84,700
$45,870 ( 6,000) $39,870
20x9 Tax expense: $141,000 x 33% = 20,000 x 30% =
ii. Gross Profit on Sales Operating Expenses Rent Expense Income before taxes
20x7 $350,000 210,000 20,000 $120,000
$46,530 ( 6,000) $40,530 20x8 $349,000 210,000 20,000 $119,000 262
20x9 $351,000 210,000 20,000 $121,000
Tax Expense Net Income
36,000 $ 84,000
40,470 $ 79,130
39,930 $ 81,070
20x7
Deferred Tax Liab = 40,000 x 30%
=
$12,000
20x8
Deferred Tax Liab = 20,000 x 33% Decrease Taxes paid
=
20x9
Deferred Tax Liab = Decrease Taxes paid
6,600 $(5,400) 45,870 $40,470 0 ( 6,600) $46,530 $39,930
a. 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. FASB ASC 12-1 Tax Effect of Translation Adjustment Accounting for foreign currency translation adjustments is located at FASB ASC 830-30-45. It is found through the Broad Transactions ling at Foreign Currency Matters The students’ summaries should include the following: Other Presentation Matters 45-1The guidance in this Section discusses how a reporting entity translates foreign currency statements and analyzes changes in the cumulative translation adjustment. It also addresses two related reporting matters. The guidance is organized as follows: a. Translation of foreign currency statements b.
Analysis of changes in cumulative translation adjustment
c. Reporting other comprehensive income—income tax consequences of rate changes d. Transaction gains and losses not extraordinary. > Translation of Foreign Currency Statements 45-2This guidance on translation of foreign currency statements is organized as follows: a. Translation using current exchange rate b. Elimination of intra-entity profits c. Translation after a business combination d. Reporting translation adjustments 263
e. Subsequent change in exchange rate f.
Cumulative translation adjustments attributable to noncontrolling interests.
> > Translation Using Current Exchange Rate 45-3All elements of financial statements shall be translated by using a current exchange rate as follows: a. For assets and liabilities, the exchange rate at the balance sheet date shall be used. b. For revenues, expenses, gains, and losses, the exchange rate at the dates on which those elements are recognized shall be used. This guidance also applies to accounting allocations (for example, depreciation, cost of sales, and amortization of deferred revenues and expenses) and requires translation at the current exchange rates applicable to the dates those allocations are included in revenues and expenses (that is, not the rates on the dates the related items originated). 45-4For purposes of translation of financial statements referred to in this Subtopic, the current exchange rate is the rate as of the end of the period covered by the financial statements or as of the dates of recognition in those statements in the case of revenues, expenses, gains, and losses. > > Reporting Translation Adjustments 45-12 If an entity's functional currency is a foreign currency, translation adjustments result from the process of translating that entity's financial statements into the reporting currency. Translation adjustments shall not be included in determining net income but shall be reported in other comprehensive income. Consequently, translation adjustments are accumulated and reported in a separate component of equity. Reported as such, translation adjustments do not affect pretax accounting income and most such adjustments also do not affect taxable income. Adjustments that do not affect either accounting income or taxable income do not create temporary differences. However, reporting those adjustments as a component of equity does have the effect of increasing or decreasing equity, that is, increasing or decreasing an enterprise's net assets. Potential future tax effects related to those adjustments would partially offset the increase or decrease in net assets FASB ASC 740-20-45 stipulates: > Allocation of Income Tax Expense or Benefit for the Year 45-1 This guidance addresses the requirements to allocate total income tax expense or benefit. Subtopic 740-10 defines the requirements for computing total income tax expense or benefit for an entity. As defined by those requirements, total income tax expense or benefit includes current and deferred income taxes. After determining total income tax expense or benefit under those requirements, the intraperiod tax allocation guidance is used to allocate total income tax expense or benefit to different components of comprehensive income and shareholders' equity. 45-2 Income tax expense or benefit for the year shall be allocated among: a. Continuing operations b. Discontinued operations c. Extraordinary items d. Other comprehensive income e. Items charged or credited directly to shareholders' equity. 264
FASB ASC 740-20-55 provides an example: > > Example 4: Allocation to Other Comprehensive Income 55-18 Income taxes are sometimes allocated directly to shareholders' equity or to other comprehensive income. This Example illustrates the allocation of income taxes for translation adjustments under the requirements of Subtopic 830-30 to other comprehensive income. In this Example, FC represents units of foreign currency. 55-19 A foreign subsidiary has earnings of FC 600 for Year 2. Its net assets (and unremitted earnings) are FC 1,000 and FC 1,600 at the end of Years 1 and 2, respectively. 55-20 The foreign currency is the functional currency. For Year 2, translated amounts are as follows.
55-21 A $260 translation adjustment ($1,200 + $660 - $1,600) is reported in other comprehensive income and accumulated in shareholders' equity for Year 2. 55-22 The U.S. parent expects that all of the foreign subsidiary's unremitted earnings will be remitted in the foreseeable future, and under the requirements of Subtopic 740-30, a deferred U.S. tax liability is recognized for those unremitted earnings. 55-23 The U.S. parent accrues the deferred tax liability at a 20 percent tax rate (that is, net of foreign tax credits, foreign tax credit carryforwards, and so forth). An analysis of the net investment in the foreign subsidiary and the related deferred tax liability for Year 2 is as follows.
55-24 For Year 2, $132 of deferred taxes are charged against earnings, and $52 of deferred taxes are reported in other comprehensive income and accumulated in shareholders' equity. FASB ASC 740-30-25outlines the requirements for reporting temporary differences on undistributed earnings. > Undistributed Earnings of Subsidiaries and Corporate Joint Ventures 25-1 This Section provides guidance on the accounting for specific temporary differences related to investments in subsidiaries and corporate joint ventures, including differences arising from undistributed earnings. In certain situations, these temporary differences may be accounted for differently from the accounting that otherwise requires comprehensive recognition of deferred income taxes for temporary differences. 25-2 Including undistributed earnings of a subsidiary (which would include the undistributed earnings of a domestic international sales corporation eligible for tax deferral) in the pretax accounting income of a parent entity either through consolidation or accounting for the investment by the equity method results in a temporary difference. 25-3 It shall be presumed that all undistributed earnings of a subsidiary will be transferred to the parent entity. Accordingly, the undistributed earnings of a subsidiary included in consolidated income 265
shall be accounted for as a temporary difference unless the tax law provides a means by which the investment in a domestic subsidiary can be recovered tax free. Therefore, temporary differences relating to translation adjustments shall be accounted for in the same way as temporary differences relating to accounting income. FASB ASC 12-2 Interpretations of SFAS No. 109 Found by accessing topic 740 and using the Print with Sources function. Examples of the EITF pronouncements addressing the overall topic of income taxes are: 740-10-05-5 [There are two basic principles related to accounting for income taxes, each of which considers uncertainty through the application of recognition and measurement criteria: [EITF 91-08, paragraph STATUS, sequence 15.1.1] ] a. [To recognize the estimated taxes payable or refundable on tax returns for the current year as a tax liability or asset [EITF 91-08, paragraph STATUS, sequence 15.1.2.1] ] b. [To recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards. [EITF 91-08, paragraph STATUS, sequence 15.1.2.2] ] Freestanding Contract [A freestanding contract is entered into either: [EITF 00-19, paragraph ISSUE, sequence 28.2.1] ] a. [Separate and apart from any of the entity's other financial instruments or equity transactions [EITF 00-19, paragraph ISSUE, sequence 28.2.2.1] ] b. [In conjunction with some other transaction and is legally detachable and separately exercisable. [EITF 00-19, paragraph ISSUE, sequence 28.2.2.2] ] Government National Mortgage Association Rolls [The term Government National Mortgage Association (GNMA) rolls has been used broadly to refer to a variety of transactions involving mortgage-backed securities, frequently those issued by the GNMA. [EITF 84-20, paragraph ISSUE, sequence 14.1] ][ There are four basic types of transactions: [EITF 84-20, paragraph ISSUE, sequence 14.2] ] a. [Type 1. Reverse repurchase agreements for which the exact same security is received at the end of the repurchase period (vanilla repo) [EITF 84-20, paragraph ISSUE, sequence 15] ] b. [Type 2. Fixed coupon dollar reverse repurchase agreements (dollar repo) [EITF 84-20, paragraph ISSUE, sequence 16] ] c. [Type 3. Fixed coupon dollar reverse repurchase agreements that are rolled at their maturities, that is, renewed in lieu of taking delivery of an underlying security (GNMA roll) [EITF 84-20, paragraph ISSUE, sequence 17] ] d. [Type 4. Forward commitment dollar rolls (also referred to as to-be-announced GNMA forward contracts or to-be-announced GNMA rolls), for which the underlying security does not yet exist. [EITF 84-20, paragraph ISSUE, sequence 18] ] 740-10-15-4 The guidance in this Topic does not apply to the following transactions and activities: a. [A franchise tax to the extent it is based on capital and there is no additional tax based on income. If there is an additional tax based on income, that excess is considered an income tax and is subject to the guidance in this Topic. [EITF 91-08, paragraph DISCUSSION, sequence 13.2] ]See Example 17 (paragraph 740-10-55-139) for an example of the determination of whether a franchise tax is an income tax. b. [ A withholding tax for the benefit of the recipients of a dividend. A tax that is assessed on an entity based on dividends distributed is, in effect, a withholding tax for the benefit of recipients of the dividend and is not an income tax if both of the following conditions are met: [EITF 9509, paragraph DISCUSSION, sequence 8] ] 266
1.
[The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not reduce future income taxes the entity would otherwise pay. [EITF 9509, paragraph DISCUSSION, sequence 9] ] 2. [Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by the entity and that credit is realizable either as a refund or as a reduction of taxes otherwise due, regardless of the tax status of the shareholders. [EITF 95-09, paragraph DISCUSSION, sequence 10] ] See the guidance in paragraphs 740-10-55-72 through 55-74 dealing with determining whether a payment made to a taxing authority based on dividends distributed is an income tax. Basis Differences that Are Not Temporary Differences 740-10-25-31 [Tax-to-tax differences are not temporary differences. Recognition of a deferred tax asset for tax-to-tax differences is prohibited as tax-to-tax differences are not one of the exceptions identified in paragraph 740-10-25-3. [EITF D-031, paragraph , sequence 8.2] ][ An example of a tax-to-tax difference is an excess of [EITF D-031, paragraph , sequence 7.1] ][ the parent entity's tax basis of the stock of an acquired entity over [EITF D-031, paragraph , sequence 7.2.1] ][the tax basis of the net assets of the acquired entity. [EITF D-031, paragraph , sequence 7.2.2.1] ] Forward Commitment Dollar Rolls 815-10-25-15 [Forward commitment dollar rolls [EITF 84-20, paragraph ISSUE, sequence 18] ][that are not otherwise subject to this Subtopic's provisions shall be recognized as either assets or liabilities depending on the rights or obligations under the contracts. [EITF 84-20, paragraph STATUS, sequence 35.2] ] > Derivative Financial Instruments Subject to a Registration Payment Arrangement 815-10-25-16 [Paragraphs 825-20-25-2 and 825-20-30-2 require that a financial instrument subject to a registration payment arrangement be recognized and measured in accordance with other applicable GAAP (for example, this Subtopic) without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement. [FSP EITF00-19-2, paragraph 8, sequence 13.1] ][That is, those paragraphs require that an entity recognize and measure a registration payment arrangement as a separate unit of account from the financial instrument(s) subject to that arrangement. [FSP EITF00-19-2, paragraph 8, sequence 13.2] ] Certain Contracts on Debt and Equity Securities 815-10-25-17 [Forward contracts and purchased options within the scope of this Subsection (see the Certain Contracts on Debt and Equity Securities Subsection of Section 815–10–15) [EITF 96-11, paragraph DISCUSSION, sequence 15.1.1] ][ shall, at inception, be designated as held to maturity, available for sale, or trading in a manner consistent with the accounting prescribed by Topic 320 for that category of securities. [EITF 96-11, paragraph DISCUSSION, sequence 15.1.2.2.2] ][ Such forward and option contracts are not eligible to be hedging instruments. [EITF 96-11, paragraph STATUS, sequence 23.1.2] ] 740-10-25-51 [The tax effect of asset purchases that are not business combinations in which the amount paid differs from the tax basis of the asset shall not result in immediate income statement recognition. [EITF 98-11, paragraph DISCUSSION, sequence 15.1] ][The simultaneous equations method shall be used to record the assigned value of the asset and the related deferred tax asset or liability. (See Example 25, Cases A and B [paragraphs 740-10-55-171 through 55-182] for illustrations of the simultaneous equations method.) For purposes of applying this requirement, the following applies: [EITF 98-11, paragraph DISCUSSION, sequence 15.2] ] a. [ An acquired financial asset shall be recorded at fair value, an acquired asset held for disposal shall be recorded at fair value less cost to sell, and deferred tax assets shall be recorded at the amount required by this Topic. [EITF 98-11, paragraph DISCUSSION, sequence 16] ] b. [ An excess of the amounts assigned to the acquired assets over the consideration paid shall be allocated pro rata to reduce the values assigned to noncurrent assets acquired (except financial 267
assets, assets held for disposal, and deferred tax assets). If the allocation reduces the noncurrent assets to zero, the remainder shall be classified as a deferred credit. (See Example 25, Cases C and D [paragraphs 740-10-55-183 though 55-191] for illustrations of transactions that result in a deferred credit.) The deferred credit is not a temporary difference under this Subtopic. [EITF 98-11, paragraph DISCUSSION, sequence 17] ] c. [ A reduction in the valuation allowance of the acquiring entity that is directly attributable to the asset acquisition shall be accounted for as an adjustment of the purchase price in accordance with paragraph 266 of FASB Statement 109, Accounting for Income Taxes, before that Statement’s amendment by FASB Statement 141 (revised 2007). (See Example 25, Case E [paragraph 740-10-55-192] for an illustration of the simultaneous equations method when a preexisting valuation allowance will be reduced as a result of acquiring the asset.) [EITF 98-11, paragraph DISCUSSION, sequence 18.1] ][Subsequent accounting for an acquired valuation allowance (for example, the subsequent recognition of an acquired deferred tax asset by elimination of a valuation allowance established at the date of acquisition of the asset) would be in accordance with paragraph 30 of FASB Statement 109, Accounting for Income Taxes, before that Statement’s amendment by FASB Statement 141 (revised 2007), which would reduce to zero other noncurrent intangible assets related to that acquisition, if any, and recognize any remaining reductions in the valuation allowance in income. [EITF 98-11, paragraph DISCUSSION, sequence 18.2] ] FASB ASC 12-3 Undistributed Earning of a Subsidiary Search income taxes and undistributed earnings 740-30-25 25-17 The presumption in paragraph 740-30-25-3 that all undistributed earnings will be transferred to the parent entity may be overcome, and no income taxes shall be accrued by the parent entity, for entities and periods identified in the following paragraph if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation. A parent entity shall have evidence of specific plans for reinvestment of undistributed earnings of a subsidiary which demonstrate that remittance of the earnings will be postponed indefinitely. These criteria required to overcome the presumption are sometimes referred to as the indefinite reversal criteria. Experience of the entities and definite future programs of operations and remittances are examples of the types of evidence required to substantiate the parent entity's representation of indefinite postponement of remittances from a subsidiary. The indefinite reversal criteria shall not be applied to the inside basis differences of foreign subsidiaries. FASB ASC 12-4 Deferred Tax Benefits for the Oil and Gas Industry Search oil and income taxes 932-740-30 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 268
Search steamship and income taxes 995-740-50 50-1 This guidance establishes disclosure requirements applicable to unrecognized deferred tax liabilities of U.S. steamship entities arising from deposits in statutory reserve funds. 50-2 All of the following information shall be disclosed whenever a deferred tax liability is not recognized because of the exception to comprehensive recognition of deferred taxes for deposits in statutory reserve funds by U.S. steamship entities: a. A description of the types of temporary differences for which a deferred tax liability has not been recognized and the types of events that would cause those temporary differences to become taxable b. The cumulative amount of each type of temporary difference c. The amount of the deferred tax liability for temporary differences attributable to the statutory reserve funds of a U.S. steamship entity that is not recognized in accordance with paragraph 995740-25-2. FASB ASC 12-6 Deferred Taxes in the Casino Industry Search casino and income tax 924-740-25 a. Recognition of casino receivables is used for financial statements and the when-collected method is used for income tax reporting. b. Costs are deferred for financial statements and are charged to expense for income tax reporting. c. Progressive slot jackpots are accrued based on meter readings for financial statements and are charged against revenue when paid for income tax reporting. Room for Debate Debate 12-1 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 269
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. 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. 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 270
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. SFAS No. 109stated 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 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 non-interest 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. 271
Team 2. 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. 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 272
that does not. According to SFAC No. 1, financial statements should provide information that is useful for the reader to evaluate 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. SFAS No. 1 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-benefit constraint described in SFAC No. 2. 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 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. 273
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 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 results 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 12-8 274
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 12-9 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. Case 12-10 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 were 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-likely-than-not recognition threshold. This evaluation should presume that the IRS would have full knowledge of all relevant information. 2. 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 12-11 IASC Income Tax Project The main changes contained in the proposed new IAS No 12 are: a. A change in the definition of tax basis. Tax basis would be defined as: the measurement under applicable substantively enacted tax law of an asset, liability or other item. b. A specification that the tax basis of an asset is determined by the tax deductions that would be available if the entity recovered the carrying amount of the asset by sale. c. The introduction of an initial step to determine deferred tax assets and liabilities so that no deferred tax arises if there will be no effect on taxable income when the entity recovers or settles its carrying amount. 275
d. New definitions of tax credit and investment tax credit as: i. Tax credit is a tax benefit that takes the form of an amount that reduces income tax payable. ii. Investment tax credit is a tax credit that relates directly to the acquisition of depreciable assets. e. Removal of the initial recognition exception in IAS No. 12. f. Changes to the exception in IAS No. 12 from the temporary difference approach relating to a deferred tax asset or liability arising from investments in subsidiaries, branches, associates and joint ventures. g. A proposal to recognize deferred tax assets in full, less, if applicable, a valuation allowance to reduce the net carrying amount to the highest amount that is more likely than not to be realizable against taxable income. h. A proposal that current and deferred tax assets and liabilities should be measured using the probability-weighted average amounts of possible outcomes assuming that the tax authorities will examine the amounts reported to them by the entity and have full knowledge of all relevant information. i. Clarification that the term ‘substantively enacted’ as it relates to income tax legislation means that future events required by the enactment process historically have not affected the outcome and are unlikely to do so. j. A change to the requirements relating to the tax effects of distributions to shareholders. An entity would measure current and deferred tax assets and liabilities using the rate expected to apply when the tax asset or liability is realized or settled, including the effect of the entity’s expectations of future distributions. k. Adoption of the FASB ASC requirements for the allocation of income tax expense to the components of comprehensive income and equity. In particular, some changes in tax effects that were initially recognized outside continuing operations would be recognized in continuing operations. l. The classification of deferred tax assets and liabilities as either current or non-current on the basis of the financial reporting classification of the related non-tax asset or liability. m. A clarification that indicates the classification of interest and penalties is an accounting policy choice and hence must be applied consistently, and introduction of a requirement to disclose the chosen policy. Financial Analysis Case
Answers will vary depending on the company selected.
CHAPTER 13 Case 13-1 a.
There is not enough information presented in the case to determine earnings, but the effect of the leasing alternatives on earnings can be determined. Dagger capitalizes the lease, causing the following earnings effects: 276
The present value of the $20,000 payments, discounted at 8% is $86,242 (20,000 x 4.3121). Because this amount is less that the fair value of the asset, $96,000, the asset and associated liability will be recorded at $86,242. Depreciation and interest for 2011 will be: Interest expense [(86,242 - 20,000) x 8%] Depreciation expense (86,242 / 5) Before tax decrease in earnings
$ 5,299.36 17,248.40 $22,547.76
Bayshore treats the lease as an operating lease. The $20,000 payment will be expensed. Thus, for 2011, Bayshore will report $2,547.76 (22,547.76 - 20,000) more earnings before tax than will Dagger. b.
Total lease related expenses reported by Dagger in 2011 are calculated in a. as $22,547.76. Dagger will deduct 20,000.00 for tax purposes, creating a temporary difference of $2,547.76 - a future deductible amount. The result is a deferred tax asset for 2011 of $1,019.10 ($2,547.76 x 40%). Because Bayshore treats the lease as an operating lease for both tax and accounting purposes, there are no temporary differences and no deferred taxes.
c.
For 2011, Dagger will have no cash flows from operating activities relating to the lease other than the tax shield from the $20,000 lease payment. If the indirect method is employed to report cash flows from operating activities, the interest expense and depreciation expense would be added to net income, and the increase in the deferred tax asset would be subtracted. Bayshore would report a $20,000 operating cash outflow under the direct method of reporting cash flows from operating activities. Because this amount is reported as an expense in the income statement, no adjustment would be needed under the indirect method.
d.
Because Dagger treats the lease as a capital lease, the leased asset is presumed purchased. According to SFAS No. 95 (FASB ASC 230), cash outflows incurred to purchase a productive resource are considered investing activities. Hence, the initial $20,000 payment will be reported as an investing outflow. The amount financed ($66,242) will appear as supplementary information because it represents an investing and financing activity not affecting cash. Because Bayshore treats the lease as an operating lease, the leased asset is not presumed purchased. Hence, the $20,000 initial lease payment is not an investing outflow. Bayshore would report nothing related to the lease as an investing activity.
e.
Bayshore will not report any financing activities in 2011 due to the lease. In 2011, Dagger will report the amount of payment which reduces the loan balance ($20,000 $5,299.36) as a financing outflow.
f.
The only cash flow for either company in 2011 is $20,000. Hence, the effect on total cash flows for both companies in 2011 is $20,000.
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g.
Reporting the lease as an operating lease has the disadvantage of keeping assets off the balance sheet and the advantage of not reporting the associated liability. An advantage is a smoothed effect on the income statement. Also, less expense is recognized earlier. An adverse effect, is that operating cash flows are lower each year by the difference between the lease payment and any interest payment made. In this case, it also reduces the positive effect of deferred taxes from the balance sheet and income statement. Reporting the lease as a capital lease increases assets. In this case, fixed assets are increased and there is a deferred tax asset. However, the liability must be recognized. Also, expense recognition, net of deferred tax effects, is accelerated in the income statement. At the same time, operating cash flows are improved because they only include payments for interest. Additionally Dagger will report depreciation on the leased asset on its income statement.
Case 13-2 a.
Pippen has a capital lease. Although there is no transfer of ownership, no bargain purchase option, and the lease term is not 75% of the economic life of the asset, the present value of the minimum lease payments is 90% of fair value. Pippen would calculate the present value utilizing a rate of 10%. Under the assumption that the lease payments occur at the beginning of each period, the present value of the minimum lease payments would be $93,649 (10,000 x 9.3649). 90% of fair value would be only $83,363 (92,625 x 90%).
b.
If Grant treats the lease as a capital lease, it would be reported as a sales-type lease. Since the description of the lease does not mention that the residual value is guaranteed, the presumption should be that it is not. Grant's gross investment is $202,750 (10,000 x 20 + 2,750). This amount would be recorded as lease payments receivable and reduced by the initial $10,000 payment to 192,750. The initial net investment is the fair value of the asset, $92,625. The difference between the gross investment and the net investment is unearned income, $110,125. The net investment adjusted for loan payments and interest is reported in the balance sheet at year end. Interest is calculated on the net investment using the effective interest rate of the lessor. For a sales type lease, the effective rate and the implicit rate for the lessor are always the same. Hence, interest revenue of $9,915 (82,625 x 12%) would be recorded. The accompanying debit would be to unearned income. If the residual value is guaranteed, Sales of $92,625 and cost of goods sold of $75,000 would be recognized. If the residual value is not guaranteed, both sales and cost of goods sold would be reduced by the present value of the expected salvage value of $2,750, discounted at 12%. This has no effect on gross profit, the amount reported for the net investment, or the calculation of interest.
c.
If the lease is a sales type lease, Grant would not report any depreciation expense for 2011. Income before tax would increase by the amount of gross profit, $17,625 ($92,625-$75,000) and by the amount of interest revenue. If there are initial direct costs, they would be shown as a selling expense.
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The balance sheet would report the gross investment minus payments received and the remaining unearned income. Because sales are operating activities, the cash inflow of $10,000 would be an operating inflow that would be reported under the direct method of reporting operating cash flows. If the indirect method were used to report cash flows from operating activities, the increase in the net investment (from zero to its year end balance) would be subtracted from net income. d.
Grant should report the lease as a sales-type lease because the 90% test is met. Fair value less $2,750 x 0.1037
$92,625 ( 285) $92,340 = 90% x 92,625
In addition, to qualify as a sales type lease, the certainty criteria also must be meet. There must be no important uncertainties surrounding the collectibility of the receivable or any anticipated future cash outflows of the lessor. If the two certainty criteria are not met, Grant should report the lease as an operating lease. e.
The financial statement impacts of treating the lease as a sales type lease when the salvage value is not guaranteed are discussed above in b.
f.
If Grant treats the lease as an operating lease, lease income of $10,000 will be reported. If there are initial direct costs, 1/20 of those costs will be subtracted from lease income. The balance sheet would report the cost of the leased asset, $75,000 less accumulated depreciation calculated on a straight-line basis over its useful life of 30 years and any unamortized initial direct costs. The statement of cash flows would report an inflow of $10,000 and if there are initial direct costs, their outflow. Both cash flows would appear as operating activities.
Case 13-3 a.
When a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, it should be capitalized by the lessee. The economic effect of such a lease on the lessee is similar, in many respects, to that of an installment purchase.
b.
Lani should account for this lease at its inception as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding that portion of the payments representing executory costs, together with any profit thereon. However, if the amount so determined exceeds the fair value of the leased machine at the inception of the lease, the amount recorded as the asset and obligation should be the machine's fair value.
c.
Lani will incur interest expense equal to the interest rate used to capitalize the lease at its inception multiplied by the appropriate net carrying value of the liability.
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In addition, Lani will incur an expense relating to amortization of the capitalized cost of the leased asset. This amortization should be based on the estimated useful life of the leased asset and amortized in a manner consistent with Lani's normal depreciation policy for owned assets. d.
The asset recorded under the capital lease and the accumulated amortization should be reported on Lani's December 31, 2010, balance sheet classified as noncurrent and should be separately identified by Lani in its balance sheet or footnotes thereto. The related obligation recorded under the capital lease should be reported on Lani's December 31, 2010, balance sheet appropriately classified into current and noncurrent categories and should be separately identified by Lani in its balance sheet.
Case 13-4 a.
Doherty Company has entered into a capital lease if at its inception the lease meets one or more of the following criteria. 1. The lease transfers ownership of the equipment to Doherty Company by the end of the lease term. 2. The lease contains a bargain purchase option. 3. The lease term is equal to 75 percent or more of the estimated economic life of the leased equipment. 4. The present value of the minimum lease payments at the beginning of the lease term-excluding that portion of the payments representing executory cost such as insurance, maintenance, and taxes to be paid by Lambert Company, including any profit thereon-equals or exceeds 90 percent of the amount by which the fair value of the equipment leased to Lambert Company at the inception of the lease exceeds any related investment tax credit that the Lambert Company retains and expects to realize. The criteria in items 3 and 4 do not apply if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased equipment, including earlier years of use.
b.
Lambert Company has entered into a sales type lease or direct financing lease if at its inception the lease meets one or more of the criteria listed in a., above and in addition meets both of the following criteria: 1. The collectibility of the minimum lease payment is reasonably predictable. 2. No important uncertainties surround the amount of unreimbursible costs yet to be incurred by the Lambert Company under the lease.
c.
In a sales-type lease, manufacturer's or dealer's profit is recognized and represents the excess of the fair value of the leased property over the cost at the inception of the lease. In a direct financing lease, the cost and the fair value of the leased property are the same at the inception of the lease. Thus, the lessor had not manufacturer's or dealer's profit; instead, the lessor has only interest income that will he earned over the life of the lease. 280
Case 13-5 a.
A lease should be classified as a capital lease when it transfers substantially all of the benefits and risks inherent to the ownership of property by meeting any one of the four criteria established by SFAS 13 for classifying a lease as a capital lease. Lease J should be classified as a capital lease because the lease term is equal to 80 percent of the estimated economic life of the equipment, which exceeds the 75 percent or more criterion. Lease K should be classified as a capital lease because the lease contains a bargain purchase option. Lease L should be classified as an operating lease because it does not meet any of the four criteria for classifying a lease as a capital lease.
b.
For Lease J. Borman Company should record as a liability at the inception of the lease an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon. However, if the amount so determined exceeds the fair value of the equipment at the inception of the lease, the amount recorded as a liability should be the fair value. For Lease K, Borman Company should record as a liability at the inception of the lease an amount determined in the same manner as for Lease J. and the payment called for in the bargain purchase option should be included in the minimum lease payments. For Lease L, Borman Company should not record a liability at the inception of the lease.
c.
For Lease J. Borman Company should allocate each minimum lease payment between a reduction of the liability and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the liability. For Lease K, Borman Company should allocate each minimum lease payment in the same manner as for Lease J. For Lease L, Borman Company should charge minimum lease (rental) payments to rental expense as they become payable.
Case 13-6 1.a.
A lessee would account for a capital lease as an asset and an obligation at the inception of the lease. Rental payments during the year would be allocated between a reduction in the obligation and interest expense. Because the lease transfers ownership of the leased asset to the leasee, the asset would be amortized in a manner consistent with the lessee's normal depreciation policy for owned assets. That is, the leassee depreciates the leased asset over its useful life.
b.
No asset or obligation would be recorded at the inception of the lease. Normally, rental on an operating lease would be charged to expense over the lease term as it becomes payable. If rental payments are not made on a straight-line basis, rental expense nevertheless would be recognized 281
on a straight-line basis unless another systematic or rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis would be used. 2.a.
The gross investment in the lease is the same for both a sales-type and a direct-financing lease. The gross investment in the lease is the minimum lease-payments (net of amounts, if any, included therein for executory costs such as maintenance, taxes, and insurance to be paid by the lessor, together with any profit thereon) plus the unguaranteed residual value accruing to the benefit of the lessor.
b.
For both a sales-type lease and a direct-financing lease, the unearned interest income would be amortized to income over the lease term by use of the interest method to produce a constant periodic rate of return on the net investment in the lease. However, other methods of income recognition may be used if the results obtained are not materially different from the interest method.
c.
In a sales-type lease, the excess of the sales price over the carrying amount of the leased equipment is considered manufacturer's or dealer's profit and would be included in income in the period when the lease transaction is recorded. In a direct-financing lease, there is no manufacturer's or dealer's profit. The income on the lease transaction is composed solely of interest.
Case 13-7 a.i.
Because the present value of the minimum lease payments is greater than 90 percent of the fair value of the asset at the inception of the lease, Milton should record this as a capital lease.
ii.
Since the given facts state that Milton (lessee) does not have access to information that would enable determination of James (lessor) implicit rate for this lease, Milton should determine the present value of the minimum lease payments using the incremental borrowing rate (10 percent) that Milton would have to pay for a like amount of debt obtained through normal third-party sources (bank or other direct financing). Because the present value is less than 100 percent of fair market value, it should be used as the recorded value of the asset.
iii.
The amount recorded as an asset on Milton's books should be shown in the fixed assets section of the statement of financial position as "Fixed Assets Acquired Through Lease" or another similar title. Of course, at the same time as the asset is recorded, a corresponding liability ("Obligations Under Capital Leases") is recognized in the same amount. This liability is classified as both current and noncurrent, with the current portion being that amount that will be paid on the principal amount during the next year. The machine acquired by the lease is matched with revenue through depreciation over the life of the lease, since ownership of the machine is not expressly conveyed to Milton in terms of the lease at its inception. The minimum lease payments represent a payment of principal and interest at each payment date. Interest expense is computed at the rate at which the minimum lease payments were discounted and represents a fixed interest rate applied to the declining balance of the debt. Executory costs (such as insurance, maintenance, or taxes) paid by Milton are charged to an appropriate expense, accrual, or deferral account as incurred or paid.
iv.
For this lease, Milton must disclose the future minimum lease payments in the aggregate and for each of the succeeding fiscal years, with a separate deduction for the total amount for imputed 282
interest necessary to reduce the net minimum lease payments to present value of the liability (as shown on the statement of financial Position). b.i.
Based upon the given facts, James has entered into a direct financing lease. There is no dealer or manufacturer profit included in the transaction; the discounted present value of the minimum lease payments is in excess of 90 percent of the fair value of the asset at the inception of the lease agreement; collectibility of minimum lease payments is reasonably assured; and there are no important uncertainties surrounding unreimbursible costs to be paid by the lessor.
ii.
James should record the gross amounts of minimum lease payments and the unguaranteed residual value of the machine at the end of the lease as minimum lease payment receivable and remove the machine given up from the books by a credit to the applicable asset account. The balancing amount in this entry is recorded as unearned revenue.
iii.
During the life of the lease, James will record payments received as a reduction in the receivable. Unearned revenue is recognized as earned interest revenue by applying the implicit interest rate to the declining balance of a gross minimum lease payments receivable reduced by payments received and the balance of unearned revenue. The implicit rate is the rate of interest that, when applied to the gross minimum lease payments (net of executory costs and any profit thereon) and the unguaranteed residual value of the machine at the end of the lease, will discount the sum of the payments and unguaranteed residual value to the fair value of the machine at the date of the lease agreement. This method of earnings recognition is termed the interest method of amortization of unearned revenue. James must make the following disclosures with respect to this lease:
iv.
a.
The components of the net investment in direct financing leases, which are (1) the future minimum lease payments to be received, (2) any unguaranteed residual values accruing to the benefit of the lessor, an (3) the amounts of unearned revenue.
b.
Future minimum lease payments to be received for each of the remaining fiscal years (not to exceed five) as of the date of the latest statement of financial position presented.
Case 13-8 a.
The economic effects of a long-term capital lease on the lessee are similar to that of an equipment purchase using installment debt. Such a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, and obligates the lessee in a manner similar to that created when funds are borrowed. To enhance comparability between a firm that purchases an asset on a long-term basis and a firm that leases an asset under substantially equivalent terms, the lease should be capitalized.
b.
A lessee should account for a capital lease at its inception as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding any portion of payments representing executory costs, together with any profit thereon. However, if the present value exceeds the fair value of the leased property at the inception of the lease, the amount recorded for the asset and obligation should be the fair value.
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c.
A lessee should allocate each minimum lease payment between a reduction of the obligation and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the obligation.
d.
Von should classify the first lease as a capital lease because the lease term is more than 75 percent of the estimated economic life of the machine. Von should classify the second lease as a capital lease because the lease contains a bargain purchase option.
FASB ASC 13-1 Initial Direct Cost Incurred by the Lessor Search Initial direct costs 1. >
Initial Direct Costs
840-20-25-17 Initial direct costs include only those costs incurred by the lessor that have both of the following characteristics: a. They are costs to originate a lease incurred in transactions with independent third parties that meet both of the following conditions: 1. The costs result directly from and are essential to acquire that lease. 2. The costs would not have been incurred had that leasing transaction not occurred. b. They are costs directly related to only the following activities performed by the lessor for that lease: 1. Evaluating the prospective lessee's financial condition 2. Evaluating and recording guarantees, collateral, and other security arrangements 3. Negotiating lease terms 4. Preparing and processing lease documents 5. Closing the transaction. 2. 840-30-25-6 The lessor in a sales-type lease that does not involve real estate shall recognize its gross investment in the lease, unearned income, and the sales price. The cost or carrying amount, if different, of the leased property, plus any initial direct costs minus the present value of the unguaranteed residual value accruing to the benefit of the lessor, shall be charged by the lessor against income in the same period. 3. 840-20- 25-16
Initial direct costs shall be deferred by the lessor.
FASB ASC 13-2 Interpretations for Lease Accounting Found by using the print with sources function Examples of EITF pronouncements from the overall topic of leases are: Environmental Indemnities 840-10-05-7 [Some lessors have required that the lessee indemnify them or their lenders against loss or damage arising from environmental contamination caused by the lessee during the term of the lease, as well as from preexisting environmental contamination (that is, contamination that occurred before lease inception). [EITF 97-01, paragraph DISCUSSION, sequence 23.1] ][In some situations, the lessor might have the right to put the property to the lessee under those circumstances. [EITF 97-01, paragraph DISCUSSION, sequence 23.2.1] ]See related guidance beginning in paragraph 840-10-25-13.
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Non-Performance-Related Default Covenants
840-10-05-8 [Some lease agreements contain default provisions that are unrelated to the lessee's use of the property, such as financial covenants (for example, maintenance of certain financial ratios related to the financial condition of the lessee). [EITF 97-01, paragraph DISCUSSION, sequence 29.1] ][The remedies for default might include the right of the lessor to put the property to the lessee or a requirement that the lessee make a payment to the lessor. [EITF 97-01, paragraph DISCUSSION, sequence 29.2.1] ]See related guidance beginning in paragraph 840-10-25-13. Maintenance Deposits 840-10-05-9A [Under certain equipment lease agreements, a lessee is legally or contractually responsible for repair and maintenance of the leased asset throughout the lease term. Additionally, certain lease agreements include provisions requiring the lessee to make deposits to the lessor to financially protect the lessor in the event the lessee does not properly maintain the leased asset. [EITF 08–03, paragraph 2, sequence 2.1] ][ Lease agreements often refer to these deposits as maintenance reserves or supplemental rent. However, the lessor is required to reimburse the deposits to the lessee upon the completion of maintenance activities that the lessee is contractually required to perform under the lease agreement. [EITF 08–03, paragraph 2, sequence 2.2] ] 840-10-05-9B [Under a typical arrangement, maintenance deposits are calculated based on a performance measure, such as hours of use of the leased asset, and are contractually required under the terms of the lease agreement to be used to reimburse the lessee for required maintenance of the leased asset upon the completion of that maintenance. The lessor is contractually required to reimburse the lessee for the maintenance costs paid by the lessee, to the extent of the amounts on deposit. [EITF 08– 03, paragraph 3, sequence 3] ] 840-10-05-9C [In some cases, the total cost of cumulative maintenance events over the term of the lease is less than the cumulative deposits, resulting in excess amounts on deposit at the expiration of the lease. In those cases, some lease agreements provide that the lessor is entitled to retain such excess amounts; whereas other agreements specifically provide that, at the expiration of the lease agreement, such excess amounts are returned to the lessee (refundable maintenance deposit). [EITF 08–03, paragraph 4, sequence 4.1] ] Paragraph 840-10-25-39A provides related guidance. Arrangements that Qualify as Leases 840-10-15-6 [An arrangement conveys the right to use property, plant, or equipment if the arrangement conveys to the purchaser (lessee) the right to control the use of the underlying property, plant, or equipment. [EITF 01-08, paragraph DISCUSSION, sequence 43.1] ][ The right to control the use of the underlying property, plant, or equipment is conveyed if any of the following conditions is met: [EITF 01-08, paragraph DISCUSSION, sequence 43.2] ] a. [The purchaser has the ability or right to operate the property, plant, or equipment or direct others to operate the property, plant, or equipment in a manner it determines while obtaining or controlling more than a minor amount of the output or other utility of the property, plant, or equipment. [EITF 01-08, paragraph DISCUSSION, sequence 44] ][ The purchaser's ability to operate the property, plant, or equipment may be evidenced by (but is not limited to) the purchaser's ability to hire, fire, or replace the property's operator or the purchaser's ability to specify significant operating policies and procedures in the arrangement with the owner-seller having no ability to change such policies and procedures. [EITF 01-08, paragraph DISCUSSION, sequence 45.1.1] ][ A requirement to follow prudent operating 285
practices (or other similar requirements) generally does not convey the right to control the underlying property, plant, or equipment. [EITF 01-08, paragraph DISCUSSION, sequence 45.1.2] ][ Similarly, a contractual requirement designed to enable the purchaser to monitor or ensure the seller's compliance with performance, safety, pollution control, or other general standards generally does not establish control over the underlying property, plant, or equipment. [EITF 01-08, paragraph DISCUSSION, sequence 45.2] ] b.
[The purchaser has the ability or right to control physical access to the underlying property, plant, or equipment while obtaining or controlling more than a minor amount of the output or other utility of the property, plant, or equipment. [EITF 01-08, paragraph DISCUSSION, sequence 46] ]
c. [Facts and circumstances indicate that it is remote that one or more parties other than the purchaser will take more than a minor amount of the output or other utility that will be produced or generated by the property, plant, or equipment during the term of the arrangement, and the price that the purchaser (lessee) will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output. [EITF 01-08, paragraph DISCUSSION, sequence 47] ] FASB ASC 13-3 Time Sharing Search time sharing and reversionary 978-40-25 25-1 Paragraph 840-10-25-1(a) requires that title must be transferred in order to recognize a sale of real estate. For purposes of recognizing profit on time-sharing transactions under Subtopic 360-20, it is necessary that such transfer be nonreversionary. A contract-for-deed arrangement meets this criterion. 25-2 If the title transfer is reversionary, the seller shall account for the transaction as if it were an operating lease. FASB ASC 13-4 Sale and Leasebacks in Regulated Industries Search Sale and Leasebacks in Regulated Industries 25-1 Accounting for sale-leaseback transactions in accordance with the guidance in Subtopic 840-40 may result in a difference between the timing of income and expense recognition required by that Subtopic and the timing of income and expense recognition for rate-making purposes. 980-840-25-2 That difference shall be accounted for as follows: a. If the difference in timing of income and expense recognition constitutes all or a part of a phasein plan, it shall be accounted for in accordance with Subtopic 980-340. b. Otherwise, the timing of income and expense recognition related to the sale-leaseback transaction shall be modified as necessary to conform to the Regulated Operations Topic. That modification required for a transaction that is accounted for by the deposit method or as a financing is further described in the following paragraph and paragraphs 980-840-35-1 through 35-2. FASB ASC 13-5 When an Arrangement Qualifies as a Lease Search Arrangement and Lease 286
840-10-15-6 An arrangement conveys the right to use property, plant, or equipment if the arrangement conveys to the purchaser (lessee) the right to control the use of the underlying property, plant, or equipment. The right to control the use of the underlying property, plant, or equipment is conveyed if any of the following conditions is met: a. The purchaser has the ability or right to operate the property, plant, or equipment or direct others to operate the property, plant, or equipment in a manner it determines while obtaining or controlling more than a minor amount of the output or other utility of the property, plant, or equipment. The purchaser's ability to operate the property, plant, or equipment may be evidenced by (but is not limited to) the purchaser's ability to hire, fire, or replace the property's operator or the purchaser's ability to specify significant operating policies and procedures in the arrangement with the owner-seller having no ability to change such policies and procedures. A requirement to follow prudent operating practices (or other similar requirements) generally does not convey the right to control the underlying property, plant, or equipment. Similarly, a contractual requirement designed to enable the purchaser to monitor or ensure the seller's compliance with performance, safety, pollution control, or other general standards generally does not establish control over the underlying property, plant, or equipment. b. The purchaser has the ability or right to control physical access to the underlying property, plant, or equipment while obtaining or controlling more than a minor amount of the output or other utility of the property, plant, or equipment. c. Facts and circumstances indicate that it is remote that one or more parties other than the purchaser will take more than a minor amount of the output or other utility that will be produced or generated by the property, plant, or equipment during the term of the arrangement, and the price that the purchaser (lessee) will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output. FASB ASC 13-6 Lease Fiscal Funding Clause Search fiscal funding clause 840-10-20 Fiscal Funding Clause A provision by which the lease is cancelable if the legislature or other funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the lease agreement 840-10-25-3 The existence of a fiscal funding clause in a lease agreement requires an assessment of the likelihood of lease cancellation through exercise of the fiscal funding clause. If the likelihood of exercise of the fiscal funding clause is assessed as being remote, a lease agreement containing such a clause shall be considered a noncancelable lease; otherwise, the lease shall be considered cancelable and thus classified as an operating lease FASB ASC 13-7 Terminal Space and Airport Facilities Search Terminal Space and Airport Facilities 840-10-25-25 Because of special provisions normally present in leases involving terminal space and other airport facilities owned by a governmental unit or authority, the economic life of such facilities for purposes of classifying the lease is essentially indeterminate. Likewise, the concept of fair value is not 287
applicable to such leases. Because such leases also do not provide for a transfer of ownership or a bargain purchase option, they shall be classified as operating leases. Leases of other facilities owned by a governmental unit or authority wherein the rights of the parties are essentially the same as in a lease of airport facilities shall also be classified as operating leases. Examples of such leases may be those involving facilities at ports and bus terminals. The guidance in this paragraph is intended to apply to leases only if all of the following conditions are met: a. The leased property is owned by a governmental unit or authority. b. The leased property is part of a larger facility, such as an airport, operated by or on behalf of the lessor. c. The leased property is a permanent structure or a part of a permanent structure, such as a building, that normally could not be moved to a new location. d. The lessor, or in some circumstances a higher governmental authority, has the explicit right under the lease agreement or existing statutes or regulations applicable to the leased property to terminate the lease at any time during the lease term, such as by closing the facility containing the leased property or by taking possession of the facility. e. The lease neither transfers ownership of the leased property to the lessee nor allows the lessee to purchase or otherwise acquire ownership of the leased property. f.
The leased property or equivalent property in the same service area cannot be purchased nor can such property be leased from a nongovernmental unit or authority. Equivalent property in the same service area is property that would allow continuation of essentially the same service or activity as afforded by the leased property without any appreciable difference in economic results to the lessee.
Leases of property not meeting all of the conditions in paragraph 840-10-25-25 are subject to the same criteria for classifying leases under this Subtopic that are applicable to leases not involving government owned property. Room for Debate Debate 13-1 Team 1 Argue for the capitalization of leases which do not meet the SFAS No. 13 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 SFAS No. 13 criteria for capitalization as an asset. 288
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 SFAS No. 13 criteria for capitalization 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 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 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. SFAS No. 13 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 289
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 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 an assets a lease that transfers substantially all of the benefits and risks incident to the ownership of property from the lesssor 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 13-9 An asset is expected to provide future benefits in use. These benefits are controlled by the lessee. The benefits result from a prior transaction or event. A capital lease is in substance a purchase of an asset. The lessee controls the use of the asset during the lease term. The assets provides benefits in use during the lease term. The inception of the lease resulting from the lease contract is a transaction or event that results in the lessee acquiring the expected future benefits. Liabilities are probable future sacrifices of economic resources of an entity resulting from a prior transaction or event. The lease transaction obligates the lessee to make lease payments. The payments will occur over the lease term and will be future sacrifices of economic resources of the lessee. Hence, a lease obligation, particularly one that is noncancellable meets the definition of a liability. A capital lease is in substance a purchase of an asset. The lease agreement must meet at least one of the four capital lease criteria. If title passes to the lessee, the lessee will own the leased assets. In this case, there is no doubt that the capital lease is a purchase. If there is a bargain purchase, there is a high probability that the lessee will take advantage of the bargain. Hence, in these cases there is probable future benefit beyond the lease term indicating that the lease is like a purchase of all of the service potential of the asset. If the life criterion or fair value criterion is met, the lessee uses virtually all of the service potential asset making the lease tantamount to the purchase of the asset. In all three cases, the obligation makes the capital lease similar to a purchase. Case 13-10
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a.
The project was undertaken because many users think that operating leases give rise to assets and liabilities that should be recognized in the financial statements of lessees. Consequently, users routinely adjust current and future obligations in an attempt to recognize those assets and liabilities and reflect the effect of lease contracts in profit or loss. In 2005, the SEC estimated there are currently $1.25 trillion dollars of liabilities omitted from balance sheets because of operating lease classifications. As a result:
b.
1. The existence of two very different accounting models for leases - the capital lease model (termed the finance lease model by the IASB) and the operating lease model means that similar transactions can be accounted for very differently. This reduces comparability for users. 2. The existing standards provide opportunities to structure transactions so as to achieve a particular lease classification (financial engineering). If the lease is classified as an operating lease, the lessee obtains a source of unrecognized financing that can be difficult for users to understand. As a result, lease structuring to meet various accounting goals has developed into an entire industry. Case 13-11 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.
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.
b.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 291
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.i.
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 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 straightline 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 292
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. b.
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.
b.
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.
c.
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 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. 293
Case 14-4 a.
b.
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.
2.
Employees accumulate future defined pension benefits with years of service. Employees do not accumulate OPRBs with years of service.
3.
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 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-asyou-go basis. 294
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 employees bargain for total wages and agree to defer wages to retirement years.
d.
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.
b.
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 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 takes into consideration the benefit formula and projected salaries that will actually be used to determined 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 shuld 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 295
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. b.
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.
c.
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. 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.
c.
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.
FASB ASC 14-1 Settlement and Curtailment of a Defined Benefit Pension Plan The definitions can be found at 715-15-30-05-09 and can be accessed through the cross reference function using FAS 88. The students answers’ should be based on the following: 1. A settlement is defined as a transaction that (a) is an irrevocable action, (b) relieves the employer (or the plan) of primary responsibility for a pension benefit obligation, and (c) eliminates significant risks related to the obligation and the assets used to effect the settlement. Examples of transactions that constitute a settlement include (a) making lump-sum cash payments to plan participants in exchange for their rights to receive specified pension benefits and (b) purchasing nonparticipating annuity contracts to cover vested benefits. Examples of transactions that constitute a settlement include making lump-sum cash payments to plan participants in exchange for their rights to receive specified pension benefits and purchasing nonparticipating annuity contracts to cover vested benefits (715-30-15-6). SFAS No. 88, par. 6
296
A curtailment is an event that significantly reduces the expected years of future service of present employees or eliminates for a significant number of employees the accrual of defined benefits for some or all of their future services. Curtailments include a. Termination of employees' services earlier than expected, which may or may not involve closing a facility or discontinuing a component of an entity b. Termination or suspension of a plan so that employees do not earn additional defined benefits for future services. In the latter situation, future service may be counted toward vesting of benefits accumulated based on past service. 2. FASB ASC 715-30-35-74A A settlement and a curtailment may occur separately or together. If benefits to be accumulated in future periods are reduced (for example, because half of a work force is dismissed or a plant is closed) but the plan remains in existence and continues to pay benefits, to invest assets, and to receive contributions, a curtailment has occurred but not a settlement. If an employer purchases nonparticipating annuity contracts for vested benefits and continues to provide defined benefits for future service, either in the same plan or in a successor plan, a settlement has occurred but not a curtailment. If a plan is terminated (that is, the obligation is settled and the plan ceases to exist) and not replaced by a successor defined benefit plan, both a settlement and a curtailment have occurred (whether or not the employees continue to work for the employer). 3. FASB ASC 715-60-35-150 That maximum amount includes any gain or loss first measured at the time of settlement. The maximum amount shall be recognized in earnings if the entire projected benefit obligation is settled. If only part of the projected benefit obligation is settled, the employer shall recognize in earnings a pro rata portion of the maximum amount equal to the percentage reduction in the projected benefit obligation. 4. 715-30-05-09 The unrecognized prior service cost associated with years of service no longer expected to be rendered as the result of a curtailment is a loss. FASB ASC 14-2 EITF Interpretations for Pension Accounting Search ‘pensions.” Defined benefit plans-pensions found at 715-20. Examples of FASB ASC paragraph sections containing EITF pronouncements found under the overall topic of defined benefit-pensions are: 715-30-15-3 The guidance in this Subtopic applies to defined benefit pension plans, including but not limited to the following types of arrangements: a. [Cash balance plans [EITF 03-04, paragraph DISCUSSION, sequence 15.1] ] Cash Balance Plan [A plan with the following characteristics: [EITF 03-04, paragraph ISSUE, sequence 9] ] a. [A defined principal-crediting rate as a percentage of salary [EITF 03-04, paragraph ISSUE, sequence 10] ] b. [A defined, noncontingent interest-crediting rate that entitles participants to future interest credits at a stated, fixed rate until retirement. [EITF 03-04, paragraph ISSUE, sequence 11] ] [A cash balance plan communicates to employees a pension benefit in the form of a current account balance that is a function of current and past [EITF 03-04, paragraph ISSUE, sequence 8.1.1] ][salarybased principal credits and future interest credits thereon at a stated rate based on those principal credits. [EITF 03-04, paragraph DISCUSSION, sequence 16] ] [In a cash balance plan, individual account balances are determined by reference to a hypothetical account rather than specific assets, and the benefit is dependent on the employer's promised interestcrediting rate, not the actual return on plan assets. [EITF 03-04, paragraph DISCUSSION, sequence 19.2.1] ][ The employer's financial obligation to the plan is not satisfied by making prescribed principal and interest credit contributions—whether in cash or as a hypothetical contribution to 297
participants' accounts—for the period; rather, the employer must fund, over time, amounts that can accumulate to the actuarial present value of the benefit due at the time of distribution to each participant pursuant to the plan's terms. [EITF 03-04, paragraph DISCUSSION, sequence 18] ][ The employer's contributions to a cash balance plan trust and the earnings on the invested plan assets may be unrelated to the principal and interest credits to participants' hypothetical accounts. [EITF 03-04, paragraph DISCUSSION, sequence 20] ] [ A cash balance plan is a defined benefit plan. [EITF 03-04, paragraph DISCUSSION, sequence 15.1] ] Plan Provisions Affecting Measurement of Vested Benefits 715-30-35-40 [Under some defined benefit pension plans (typically foreign plans), the actuarial present value of benefits to which an employee is entitled if the employee terminates immediately may exceed the actuarial present value of benefits to which the employee is entitled at the expected date of separation based on service to date. For example, at one point in time, the provisions of one country's severance pay statute required that, in most cases, the benefit an employee had accrued for service to date was payable immediately upon separation. The undiscounted value of that benefit payable currently would exceed the actuarial present value of that benefit if payment was estimated to occur at the employee's expected termination date. Another example arises in another country where legislation required that deferred vested benefits of terminated employees be statutorily revalued from date of separation to normal retirement age. If the vested benefit obligation was determined assuming employee termination at the measurement date, that vested benefit obligation could exceed the accumulated benefit obligation if that obligation was measured giving consideration to a statutory revaluation only after the employee's expected date of termination. [EITF 88-01, paragraph ISSUE, sequence 7] ] 715-30-35-41 [The vested benefit obligation in the situations addressed in the preceding paragraph may be determined as either the actuarial present value of the vested benefits to which the employee is entitled if the employee separates immediately or the actuarial present value of the vested benefits to which the employee is currently entitled but based on the employee's expected date of separation or retirement. [EITF 88-01, paragraph ISSUE, sequence 8] ][ Either approach is acceptable for situations not otherwise addressed by this Subtopic in which the facts and circumstances are analogous to those in the preceding paragraph. [EITF 88-01, paragraph DISCUSSION, sequence 9.1] ] 715-30-35-90 The following circumstances identify the fact pattern to which the required accounting would apply. [An employer sponsors a defined benefit pension plan. The employer settles its pension obligation through the purchase of insurance annuity contracts from an insurance entity. The employer may or may not terminate the defined benefit pension plan. The employer appropriately applies the guidance in this Subsection. [EITF 91-07, paragraph ISSUE, sequence 8] ][ Subsequently, the insurance entity becomes insolvent and is unable to meet all of its obligations under the annuity contracts. The employer decides to make up some portion or all of any deficiency in annuity payments to the retirees. [EITF 91-07, paragraph ISSUE, sequence 9] ] 715-30-35-91 [The employer shall recognize a loss in the circumstances described in the preceding paragraph at the time the deficiency is assumed by the employer if any gain was recognized on the original settlement. [EITF 91-07, paragraph DISCUSSION, sequence 11.1] ][ The loss recognized would be the lesser of [EITF 91-07, paragraph DISCUSSION, sequence 11.2.1] ][ any gain recognized on the original settlement or [EITF 91-07, paragraph DISCUSSION, sequence 11.2.2.1] ][ the amount of the benefit obligation assumed by the employer. [EITF 91-07, paragraph DISCUSSION, sequence 11.2.2.2.1] ][The excess of the obligation assumed by the employer over the loss recognized shall be accounted for as a plan amendment or plan initiation in accordance with paragraphs 715-30-3510 through 35-17. Subsequent accounting shall be in accordance with the provisions of this Subtopic. [EITF 91-07, paragraph DISCUSSION, sequence 11.2.2.2.2] FASB ASC 14-3 EITF Interpretations for Postretirement Benefits Accounting 298
Search “pensions.” Defined benefit plans-other postretirement found at 715-60. Examples of FASB ASC paragraph sections containing EITF pronouncements found under the topic defined benefit plans-other postretirement are: Split-Dollar Life Insurance Arrangements 715-60-05-13 The Split-Dollar Life Insurance Arrangements Subsections provide guidance on accounting and reporting for split-dollar life insurance arrangements. 715-60-05-14 [Entities purchase life insurance for various reasons that may include protecting against the loss of key employees, funding deferred compensation and postretirement benefit obligations, and providing an investment return. One form of this insurance is split-dollar life insurance. The structure of split-dollar life insurance arrangements can be complex and varied. [EITF 06-04, paragraph ISSUE, sequence 12] ] 715-60-05-15 [The two most common types of arrangements are endorsement split-dollar life insurance arrangements and collateral assignment split-dollar life insurance arrangements. [EITF 06-04, paragraph ISSUE, sequence 13.1.1] ][Generally, the difference between these arrangements is dependent on the ownership and control of the life insurance policy. [EITF 06-10, paragraph 1, sequence 3.2.1] ] Split-Dollar Life Insurance Arrangements >
Overall Guidance
715-60-15-19 The Split-Dollar Life Insurance Arrangements Subsections follow the same Scope and Scope Exceptions as outlined in the General Subsection of this Subtopic, see paragraph 715-60-15-1, with specific exceptions noted below. >
Transactions
715-60-15-20 The guidance in the Split-Dollar Life Insurance Arrangements Subsections applies to the following plans and benefits: a.
[Endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to postretirement periods. [EITF 06-04, paragraph ISSUE, sequence 21.1] ]
b.
Collateral split-dollar life insurance arrangements that provide a benefit to an employee that extends to postretirement periods.
715-60-15-21 The guidance in the Split-Dollar Life Insurance Arrangements Subsections does not apply to the following plans and benefits: a. [A split-dollar life insurance arrangement that provides a specified benefit to an employee that is limited to the employee's active service period with an employer. [EITF 06-04, paragraph ISSUE, sequence 21.2] ] Split-Dollar Life Insurance Arrangements 299
715-60-35-177 [For an endorsement split-dollar life insurance arrangement within the scope of the Split-Dollar Life Insurance Arrangements Subsections, an employer shall recognize a liability for future benefits in accordance with this Subtopic (if, in substance, a postretirement benefit plan exists) or Subtopic 710-10 (if the arrangement is, in substance, an individual deferred compensation contract) based on the substantive agreement with the employee. [EITF 06-04, paragraph DISCUSSION, sequence 22.1.1] ][A liability for the benefit obligation under this Subtopic or Subtopic 710-10 has not been settled through the purchase of a typical endorsement split-dollar life insurance arrangement. [EITF 06-04, paragraph DISCUSSION, sequence 22.1.2] ] 715-60-35-178 [For example, if the employer has effectively agreed to maintain a life insurance policy during the employee's retirement, the cost of the insurance policy during postretirement periods shall be accrued in accordance with either this Subtopic or Subtopic 710-10. [EITF 06-04, paragraph DISCUSSION, sequence 22.2.1] ] 715-60-35-179 [Similarly, if the employer has effectively agreed to provide the employee with a death benefit, the employer shall accrue, over the service period, a liability for the actuarial present value of the future death benefit as of the employee's expected retirement date, in accordance with either this Subtopic or Subtopic 710-10. [EITF 06-04, paragraph DISCUSSION, sequence 22.2.2] ] 715-60-35-180 [An employer shall recognize a liability for the postretirement benefit related to a collateral assignment split-dollar life insurance arrangement in accordance with either this Subtopic (if, in substance, a postretirement benefit plan exists) or Subtopic 710-10 (if the arrangement is, in substance, an individual deferred compensation contract) if the employer has agreed to maintain a life insurance policy during the employee's retirement or provide the employee with a death benefit based on the substantive agreement with the employee. [EITF 06-10, paragraph 4, sequence 8.1] ] 715-60-35-181 [For example, if the employer has effectively agreed to maintain life insurance policy during the employee's retirement, the estimated cost of maintaining the insurance policy during the postretirement period shall be accrued in accordance with either this Subtopic or Subtopic 710-10. [EITF 06-10, paragraph 4, sequence 8.2.1] ] 715-60-35-182 [Similarly, if the employer has effectively agreed to provide the employee with a death benefit, the employer shall accrue a liability for the actuarial present value of the future death benefit as of the employee's expected retirement date, in accordance with either this Subtopic or Subtopic 710-10. [EITF 06-10, paragraph 4, sequence 8.2.2] ] 715-60-35-183 [For purposes of the Split-Dollar Life Insurance Arrangements Subsections, an employer has agreed to maintain a life insurance policy if the employer has stated or implied commitment to provide loans to an employee to fund premium payments on the underlying insurance policy during the postretirement period. Absent evidence to the contrary, it shall be presumed that an employer will provide loans to an employee to fund premium payments on the underlying insurance policy in the postretirement period if the employer has provided loans in the past or if the employer is currently promising to provide loans in the future. [EITF 06-10, paragraph 4 FN1, sequence 9] ] 715-60-35-184 [In periods following the inception of the collateral assignment split-dollar life insurance arrangement, employers shall continue to evaluate (pursuant to the guidance in the Split-Dollar Life Insurance Arrangements Subsections) whether a change in facts and circumstances (for example, an amendment to the arrangement or change from the employer's past practice) has altered the substance of 300
the collateral assignment split-dollar life insurance arrangement, which could result in a liability or an adjustment to a previously recognized liability, for a postretirement benefit. [EITF 06-10, paragraph 6, sequence 11] ] 715-60-35-185 [In addition, an employer shall recognize and measure an asset based on the nature and substance of the collateral assignment split-dollar life insurance arrangement. [EITF 06-10, paragraph 7, sequence 12.1] ] Plan Assets 715-60-55-26 [If a trust arrangement explicitly provides that segregated assets are available to satisfy claims of creditors in bankruptcy, such a provision would effectively permit those assets to be used for other purposes at the discretion of the employer. [EITF 93-03, paragraph DISCUSSION, sequence 7.2] ][It is not necessary to determine that a trust is bankruptcy-proof for the assets of the trust to qualify as plan assets under this Subtopic. Assets held in a trust that explicitly provides that such assets are available to the general creditors of the employer in the event of the employer's bankruptcy would not qualify as plan assets under this Subtopic. [EITF 93-03, paragraph DISCUSSION, sequence 8] ] 715-60-55-27 [An employer may not include in plan assets the assets of a rabbi trust. [QA 106] FASB ASC 14-4 Discount Rate on Retirement Benefits Search disclosure of assumed discount rate \FASB ASC 715-20-55 Disclosure of Assumed Discount Rates for Other Postretirement Benefit Obligations 55-1 An employer's disclosure of the weighted average of the assumed discount rates for its other postretirement benefit obligation may not necessarily be the same as that disclosed for its pension benefit obligation. Even if the assumed discount rates are the same, the weighted average of those rates that is disclosed for the other postretirement benefit obligation may not be the same as that disclosed for the pension benefit obligation because the weighted average is influenced by the timing and pattern of benefits to be provided, which can differ between a pension and a postretirement benefit plan. 55-2 For example, pension benefits are usually paid in fixed amounts throughout retirement. On the other hand, postretirement health care benefits tend to increase during retirement because retirees generally require more health care services as they age, although the net cost to employers after retirees reach age 65 is reduced by Medicare. If, as a result of the expected cost of health care, the timing or pattern of postretirement benefits differs from that for pension benefits, that difference should be reflected in the weighting of the assumed discount rates. FASB ASC 14-5 Excess Pension Plan Assets for Contractors Search Excess Pension Plan Assets for Contractors 912-715-50 Contractors' Compensation and Postretirement Employee Benefit Costs 50-1 Contractors shall consider disclosing the effect, if any, of the government's rights with respect to any excess pension plan assets in the event of a plan termination. FASB ASC 14-6 Postretirement Health Benefits for Entities in the Coal Industry 301
Search Post retirement benefits – extractive industry 05-1 This Subtopic addresses the accounting and reporting for postretirement health benefits for entities in the coal industry affected by the Coal Industry Retiree Health Benefit Act of 1992. 05-2 Current and projected operating deficits of certain benefit trusts established by the United Mine Workers of America and the Bituminous Coal Operators' Association, Inc. prompted the Coal Industry Retiree Health Benefit Act of 1992 (the Act). The Act creates a new multiemployer benefit plan called the United Mine Workers of America Combined Benefit Fund (the Combined Fund), which will provide medical and death benefits to all beneficiaries of certain earlier trusts who were actually receiving benefits as of July 20, 1992. In 1993, the Combined Fund began paying those beneficiaries their medical and death benefits. The Act provides for the assignment of beneficiaries to former employers and the allocation of any unassigned beneficiaries (referred to as orphans) to entities using a formula included in the legislation. The Act requires that responsibility for funding those payments be assigned to entities (or persons related to the entities) that had been signatories to a coal wage agreement. Under the act an entity's annual cost of benefits is based on the number of beneficiaries assigned to it plus a percentage of the cost of unassigned beneficiaries, which is a function of the number of orphans times the perbeneficiary premium. 25-1 Entities that currently have operations in the coal industry shall account for their obligation under the Act (as defined in Section 930-715-05) either as participation in a multiemployer plan or a liability imposed by the Act. Entities that currently have operations in the coal industry that decide to account for their obligation as a liability and entities that no longer have operations in the coal industry shall account for their entire obligation under the Act as a loss in accordance with Subtopic 450-20. 45-1 If an entity accounts for its obligation under the Act as a loss (see paragraph 930-715-25-1) in accordance with Subtopic 450-20, the estimated loss should be reported as an extraordinary item. 50-1 An entity shall disclose the impact of the Act, including the estimated amount of its total obligation and the method of accounting adopted. FASB ASC 14-7 Pension Cost in Regulated Industries Search other postretirement benefits Page down to extractive industries 930-715 05-1 This Subtopic addresses the accounting and reporting for postretirement health benefits for entities in the coal industry affected by the Coal Industry Retiree Health Benefit Act of 1992. 05-2 Current and projected operating deficits of certain benefit trusts established by the United Mine Workers of America and the Bituminous Coal Operators' Association, Inc. prompted the Coal Industry Retiree Health Benefit Act of 1992 (the Act). The Act creates a new multiemployer benefit plan called the United Mine Workers of America Combined Benefit Fund (the Combined Fund), which will provide medical and death benefits to all beneficiaries of certain earlier trusts who were actually receiving benefits as of July 20, 1992. In 1993, the Combined Fund began paying those beneficiaries their medical and death benefits. The Act provides for the assignment of beneficiaries to former employers and the allocation of any unassigned beneficiaries (referred to as orphans) to entities using a formula included in the legislation. The Act requires that responsibility for funding those payments be assigned to entities (or persons related to the entities) that had been signatories to a coal wage agreement. Under the act an entity's annual cost of benefits is based on the number of beneficiaries assigned to it plus a percentage of 302
the cost of unassigned beneficiaries, which is a function of the number of orphans times the perbeneficiary premium. 930-715-15 Scope and Scope Exceptions General > Overall Guidance 15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see Section 930-10-15, with specific entity qualifications noted below. > Entities 15-2 This Subtopic only applies to entities with operations in the coal industry with a multiemployer pension obligation. 930-715-25 Recognition General 25-1 Entities that currently have operations in the coal industry shall account for their obligation under the Act (as defined in Section 930-715-05) either as participation in a multiemployer plan or a liability imposed by the Act. Entities that currently have operations in the coal industry that decide to account for their obligation as a liability and entities that no longer have operations in the coal industry shall account for their entire obligation under the Act as a loss in accordance with Subtopic 450-20. 930-715-45 Other Presentation Matters General 45-1 If an entity accounts for its obligation under the Act as a loss (see paragraph 930-715-25-1) in accordance with Subtopic 450-20, the estimated loss should be reported as an extraordinary item.
930-715-50 Disclosure General 50-1 An entity shall disclose the impact of the Act, including the estimated amount of its total obligation and the method of accounting adopted.
05-1 This Subtopic provides guidance for compensation related to pension costs and other postretirement benefit costs for entities with regulated operations > Other Postretirement Benefit Cost 05-3 This Subtopic provides guidance for the difference between net periodic postretirement benefit cost as defined in Subtopic 715-60 and amounts of postretirement benefit cost considered for ratemaking purposes as an asset or a liability created by the actions of the regulator. Criteria for Recognizing Regulatory Assets for Postretirement Benefit Differences 303
25-3 For purposes of this Subtopic, other postretirement benefits refer to all forms of benefits, other than pensions, provided by an employer to retirees. 25-4 For continuing postretirement benefit plans, a regulatory asset related to Subtopic 715-60 costs shall not be recorded if the regulator continues to include other postretirement benefit costs in rates on a pay-as-you-go basis. The application of this Topic requires that a rate-regulated entity's rates be designed to recover the specific entity's costs of providing the regulated service or product. Accordingly, an entity's cost of providing a regulated service or product includes the costs provided for in Subtopic 71560. 25-5 For a continuing postretirement benefit plan a rate-regulated entity shall recognize a regulatory asset for the difference between Subtopic 715-60 costs and other postretirement benefit costs included in the entity's rates if the entity does both of the following: a. Determines that it is probable that future revenue in an amount at least equal to the deferred cost (regulatory asset) will be recovered in rates b.
Meets all of the following criteria: 1. The rate-regulated entity's regulator has issued a rate order or issued a policy statement or a generic order applicable to entities within the regulator's jurisdiction that allows both for the deferral of Subtopic 715-60 costs and for the subsequent inclusion of those deferred costs in the entity's rates. 2. The annual Subtopic 715-60 costs (including amortization of the transition obligation) will be included in rates within approximately five years from the date of adoption of that Subtopic. The change to full accrual accounting may take place in steps, but the period for deferring additional amounts shall not exceed approximately five years. 3. The combined deferral-recovery period authorized by the regulator for the regulatory asset shall not exceed approximately 20 years from the date of adoption of Subtopic 715-60. To the extent that the regulator imposes a deferral-recovery period for those costs provided for in Subtopic 715-60 greater than approximately 20 years, any proportionate amount of such costs not recoverable within approximately 20 years shall not be recognized as a regulatory asset. 4. The percentage increase in rates scheduled under the regulatory recovery plan for each future year shall be no greater than the percentage increase in rates scheduled under the plan for each immediately preceding year. This criterion is similar to that required for phase-in plans in paragraph 980-340-25-3(d). Recovery of the regulatory asset in rates on a straightline basis would meet this criterion.
25-6 This guidance applies to rate-regulated entities that elect to immediately recognize their postretirement benefit transition obligation under Subtopic 715-60 as well as those entities that elect to delay the recognition of and amortize their postretirement benefit transition obligation in accordance with that Subtopic. 25-7 For discontinued plans, a regulatory asset related to Subtopic 715-60 costs shall be recorded if it is probable that future revenue in an amount at least equal to any deferred that Subtopic costs will be recovered in rates within approximately 20 years following the adoption of that Subtopic. Rate recovery during that period may continue on a pay-as-you-go basis. For purposes of this guidance, a discontinued plan is one that results in employees not earning additional benefits for future service (that is, one that has no current service costs). 304
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, 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 again 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 305
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 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 provides 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 provides 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 decisionmaking. 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 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. 306
WWW Case 14-7 The solution to this case is dependant 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
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 employeee 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.
b.i.
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 307
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 equity. Because the options exist only to allow the holder to acquires 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.i.
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
ii.
EQUITIES
CURRENT ASSETS NONCURRENT ASSETS
$ 87,000 186,000
TOTAL ASSETS
_______ $273,000
CURRENT LIABILITIES BONDS PAYABLE PREFERRED STOCK COMMON STOCK PIC IN EXCESS OF PAR RETAINED EARNINGS TOTAL EQUITIES
Proprietary theory income statement: REVENUES COST OF GOODS SOLD GROSS PROFIT OPERATING EXPENSES OPERATING INCOME INTEREST EXPENSE NET INCOME
$450,000 220,000 $230,000 64,000 166,000 10,000 $156,000
308
$ 19,000 100,000 20,000 50,000 48,000 36,000 $273,000
Proprietary theory balance sheet: ASSETS CURRENT ASSETS NONCURRENT ASSETS
LIABILITIES $ 87,000 186,000
CURRENT LIABILITIES BONDS PAYABLE TOTAL LIABILITIES
$ 19,000 100,000 $119,000
STOCKHOLDERS' EQUITY
TOTAL ASSETS
$273,000
iii. Residual Equity theory income statement: REVENUES COST OF GOODS SOLD GROSS PROFIT OPERATING EXPENSES OPERATING INCOME INTEREST EXPENSE PREFERRED DIVIDENDS NET INCOME
PREFERRED STOCK COMMON STOCK PIC IN EXCESS OF PAR RETAINED EARNINGS TOTAL SE
$ 20,000 50,000 48,000 36,000 $154,000
TOTAL LIAB. & SE
$273,000
$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
CURRENT LIABILITIES BONDS PAYABLE TOTAL LIABILITIES PREFERRED STOCK
$ 19,000 100,000 $119,000 $ 20,000
RESIDUAL EQUITY
TOTAL ASSETS b.
_______ $273,000
COMMON STOCK PIC IN EXCESS OF PAR RETAINED EARNINGS TOTAL SE TOTAL LIAB. & SE
50,000 48,000 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 = 0.77 309
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.
b.
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.
c.
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.
d.
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. 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. 3. The zero retained earnings balance is dated and this date is retained until it loses its significance (typically 5 to 10 years). Carrol, Inc. should prepare the following journal entries to accomplish the quasi-reorganization. Additional paid-in capital $ 100,000 Retained Earnings 1,100,000 310
Common Stock
Equipment
$1,200,000
2,000,000 Retained Earnings
2,000,000
Carrot, Inc. should also date the retained earnings balance December 31, 2011 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. v. The date of exercise, adjusted for the income tax effect to the corporation.
b.
The conceptual merits of the methods are: a.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. 311
Case 15-6 a.l.
Under FASB ASC 718-10-50, the required financial statement disclosure at December 31, 2010 includes sufficient information that enables users of the financial statements to understand all of the following: a. The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders b. The effect of compensation cost arising from share-based payment arrangements on the income statement c. 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 d. 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. c. 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 312
02. Exercised or converted 03. Forfeited 04. Expired. 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 30-22) 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. e. 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 weighted-average remaining contractual term of options (or share units) outstanding 2. The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value (except for nonpublic entities), and weighted-average remaining contractual term of options (or share units) currently exercisable (or convertible). 3.
b.i.
At December 31, 2011, 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.
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. 313
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.
b.
The applications of any one of these theories to specific situations depends 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 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 314
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.i.
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. a. Legal or stated capital is the amount of par or stated capital applicable to the shares of stock that have been issued and not retired by appropriate legal action. b.
Amount in excess of legal or stated capital is any amount paid in, contributed or designated as permanent capital by the Board of Directors in excess of the par or stated value of issued shares.
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. 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 315
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. c.
d.
Four sources of capital in excess of par or stated value of shares: 1.
Issuance of shares for a consideration in excess of par or stated value per share.
2.
Issuance of shares as a stock dividend, where the amount to be capitalized per share exceeds its par or stated value.
3.
Re-issuance of treasury shares for an amount in excess of the cost incurred in reacquiring 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 a.
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. 2.
b.
From the accounting standpoint the distinction between a stock dividend and a stock splitup 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 pro rated 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. 316
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. c.
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 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.
b.
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. 317
c.
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 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.
b.
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. As a result, 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. Since nothing is reported in the financial statements, the granting of these options has no impact on the financial ratios either. 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. As a result, 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. Since nothing is reported in the financial statements, the granting of these options has no impact on the financial ratios either. One could argue that the fair value should be reported as an expense. Since it is not, net income is overstated, retained earnings is overstated, and paid-in capital is understated. Thus, any financial ratios that use net income in the numerator would be overstated. 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. 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. Moreover, 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. 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.
c.
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.
d.
Fair value accounting for employee stock options is consistent with the conceptual framework’s definition of expense because we are giving the employee something of value – the fair value of 318
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. Because fair value accounting for employee stock options properly recognizes an expense equal to the fair value of the options granted to the employees, we always recognize an expense which is consistent with the qualitative characteristic of representational faithfulness. 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 should be considered ethical. 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 factors of production remain 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.
b.
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-toequity 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.
FASB ASC 15-1 Cost to Issue Equity Securities to Effect a Business Combination The costs of issuing equity Securities to Effect a Business Combination is an acquisition related cost and is recorded as an expense under FASB ASC 805-10-25-23. Found by searching business combination and acquisition costs. >
Acquisition-Related Costs
805-10-25-23 319
Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder’s fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisitionrelated costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities shall be recognized in accordance with other applicable GAAP. FASB ASC 15-2 Treasury Stock Under FASB ASC 505-30-45, treasury stock may not be reported as an asset. Found by searching treasury stock. The standard does allow some exceptions for state laws (505-30-50-2) but at the present time no state allows treasury stock to be disclosed as an asset. 505 Equity 30 Treasury Stock 45 Other Presentation Matters General 505-30-45-1 If a corporation's stock is acquired for purposes other than retirement (formal or constructive), or if ultimate disposition has not yet been decided, the cost of acquired stock may be shown separately as a deduction from the total of capital stock, additional paid-in capital, and retained earnings, or may be accorded the accounting treatment appropriate for retired stock specified in paragraphs 505-30-30-7 through 30-10. Disclosures Relating to State Laws 505-30-50-2 State laws may effect an entity's repurchase of its own outstanding common stock. If state laws relating to an entity's repurchase of its own outstanding common stock restrict the availability of retained earnings for payment of dividends or have other effects of a significant nature, those facts shall be disclosed. FASB ASC 15-3 Quasi-reorganizations Found by searching quasi-reorganizations 852-20 The students’ answers should be based on the following 852-20-05 Overview and Background General 05-1 This Subtopic addresses the accounting applicable to a corporate readjustment procedure in which, without the creation of a new corporate entity and without the intervention of formal court proceedings, an entity restates its balance sheet to fair value. This corporate readjustment procedure may eliminate an accumulated deficit and/or prevent future charges to its income statement that otherwise 320
would be made. The accounting permitted through such a procedure is an exception to the general rule discussed in paragraph 852-20-25-2. 05-2 Readjustments of this kind fall in the category of what are called quasi-reorganizations. This Subtopic does not deal with the general question of quasi-reorganizations, but only with cases in which the exception permitted in paragraph 852-20-25-2 is availed of by a corporation. Such cases are referred to as readjustments. The accounting and reporting issues that arise and are addressed in this Subtopic consist of what is permitted in a readjustment and what is permitted thereafter. 05-3 This Subtopic does not address quasi-reorganizations involving only deficit reclassifications. 852-20-15 Scope and Scope Exceptions General > Entities 15-1 The guidance in this Subtopic applies to all public and nonpublic entities that are corporations. > Transactions 15-2 The guidance in this Subtopic applies only to readjustments in which the current income, or retained earnings or accumulated deficit account, or the income account of future years is relieved of charges that would otherwise be made against it, and is therefore limited to readjustments of the type specified in paragraph 852-20-25-2. 15-3 The guidance in this Subtopic does not apply to the following transactions and activities: a. Quasi-reorganizations involving only deficit reclassifications b. Charges against additional paid-in capital in other types of readjustments such as readjustments for the purpose of correcting erroneous credits made to additional paid-in capital in the past c. Financial reporting for entities that enter and intend to emerge from Chapter 11 reorganization, at the time of such reorganization. 852-20-20 Glossary Bankruptcy Code A federal statute, enacted October 1, 1979, as title 11 of the United States Code by the Bankruptcy Reform Act of 1978, that applies to all cases filed on or after its enactment and that provides the basis for the current federal bankruptcy system. Chapter 11 A reorganization action, either voluntarily or involuntarily initiated under the provisions of the Bankruptcy Code, that provides for a reorganization of the debt and equity structure of the business and allows the business to continue operations. A debtor may also file a plan of liquidation under Chapter 11. 852-20-25 Recognition General 25-1 This Section addresses the conditions under which a corporation may recognize a readjustment of its retained earnings or accumulated deficit balance. 25-2 The general requirement is that additional paid-in capital, however created, shall not be used to relieve the income account of the current or future years of charges that would otherwise be made to the income account. As an exception to this requirement, if a reorganized entity would be relieved of 321
charges that would be required to be made against income if the existing corporation were continued, it may be permissible to accomplish the same result without reorganization provided the facts were as fully revealed to and the action as formally approved by the shareholders as in reorganization. 25-3 If a corporation elects to restate its assets, capital stock, additional paid-in capital, and retained earnings or accumulated deficit through a readjustment and therefore avail itself of permission to relieve its future income account or retained earnings account of charges that would otherwise be made against it, it shall make a clear report to its shareholders of the restatements proposed to be made, and obtain their formal consent. It shall present a fair balance sheet as at the date of the readjustment, in which the adjustment of carrying amounts is reasonably complete, in order that there may be no continuation of the circumstances that justify charges to additional paid-in capital. 25-4 When the amounts to be written off in a readjustment have been determined, they shall be charged first against retained earnings to the full extent of such retained earnings; any balance may then be charged against additional paid-in capital. An entity that has subsidiaries shall apply this rule in such a way that no consolidated retained earnings survive a readjustment in which any part of losses has been charged to additional paid-in capital. If the retained earnings of any subsidiaries cannot be applied against the losses before application against additional paid-in capital, the parent entity's interest in such retained earnings shall be regarded as capitalized by the readjustment just as retained earnings at the date of acquisition is capitalized, so far as the parent is concerned. 25-5 The effective date of the readjustment, from which the income of the entity is subsequently determined, shall be as near as practicable to the date on which formal consent of the stockholders is given, and shall ordinarily not be before the close of the last completed fiscal year. When the readjustment has been completed, the entity's accounting shall be substantially similar to that appropriate for a new entity. 25-6 Additional paid-in capital originating in such a readjustment is restricted in the same manner as that of a new corporation; charges against it shall be only those which may properly be made against the additional paid-in capital of a new corporation. 25-7 The accounting for tax benefits arising from deductible temporary differences and carryforwards related to a readjustment is addressed in Subtopic 852-740. 852-20-30 Initial Measurement General 30-1 This Section provides guidance on the adjustment of accounts required by paragraph 852-20-253 as of the readjustment date in connection with the readjustments addressed by this Subtopic. 30-2 A write-down of assets below amounts that are likely to be subsequently realized, though it may result in conservatism in the balance sheet at the readjustment date, may also result in overstatement of earnings or of retained earnings when the assets are subsequently realized. Therefore, in general, assets shall be carried forward as of the date of readjustment at fair and not unduly conservative amounts, determined with due regard for the accounting to be subsequently employed by the entity. 30-3 If the fair value of any asset is not readily determinable a conservative estimate may be made, but in that case the amount shall be described as an estimate. Paragraph 852-20-35-2 describes the subsequent accounting for any material difference arising through realization or otherwise and not attributable to events occurring or circumstances arising after that date. 30-4 Similarly, if potential losses or charges are known to have arisen before the date of readjustment but such amounts are then indeterminate, provision may properly be made to cover the maximum probable losses or charges. 852-20-35 Subsequent Measurement General 322
35-1 Section 852-20-30 addresses the adjustments required to be made at the date of a readjustment addressed by this Subtopic. This Section addresses the subsequent accounting if the amounts determined as of the date of readjustment are found to have been excessive or insufficient. 35-2 If the fair value of any asset was not readily determinable and a conservative estimate was made at the date of the readjustment, any material difference arising through realization or otherwise and not attributable to events occurring or circumstances arising after that date shall not be carried to income or retained earnings. Similarly, if provisions for losses or charges established at the date of readjustment are subsequently found to have been excessive or insufficient, the difference shall not be carried to retained earnings nor used to offset losses or gains originating after the readjustment, but shall be recorded as additional paid-in capital. 852-20-50 Disclosure General 50-1 This Section addresses an entity's disclosure requirements for periods following a readjustment within the scope of this Subtopic. 50-2 After such a readjustment, retained earnings previously accumulated cannot properly be carried forward under that title. A new retained earnings account shall be established, dated to show that it runs from the effective date of the readjustment, and this dating shall be disclosed in financial statements until such time as the effective date is no longer deemed to possess any special significance. The dating of retained earnings following a quasi-reorganization would rarely, if ever, be of significance after a period of 10 years. There may be exceptional circumstances in which the discontinuance of the dating of retained earnings could be justified at the conclusion of a period less than 10 years. FASB ASC 15-4 Dividends in Arrears Search cumulative preferred dividends 440-10-50 50-1 Notwithstanding more explicit disclosures required elsewhere in this Codification, all of the following situations shall be disclosed in financial statements: a. Unused letters of credit b. Long-term leases (see Sections 840-10-50, 840-20-50, and 840-30-50) c. Assets pledged as security for loans d. Pension plans (see Section 715-20-50) e. The existence of cumulative preferred stock dividends in arrears f. Commitments, including: 1. A commitment for plant acquisition 2. An obligation to reduce debts 3. An obligation to maintain working capital 4. An obligation to restrict dividends. FASB ASC 15-5 Stock Dividends and Splits Search stock dividends and splits 505-20 The students’ answers should be based on the following: 323
505-20-05 Overview and Background General 05-1 This Subtopic addresses the accounting for stock dividends and stock splits. It includes guidance for the recipient as well as for the issuer. 05-2 Many recipients of stock dividends look upon them as distributions of corporate earnings, and usually in an amount equivalent to the fair value of the additional shares received. If the issuances of stock dividends are so small in comparison with the shares previously outstanding, such issuances generally do not have any apparent effect on the share market price and, consequently, the market value of the shares previously held remains substantially unchanged. 05-3 However, a stock dividend really takes nothing from the property of the corporation and adds nothing to the interests of the stockholders; that is, the corporation's property is not diminished and the interests of the stockholders are not increased. The proportional interest of each shareholder remains the same. The only change is in the evidence that represents that interest; the new shares and the original shares together representing the same proportional interests that the original shares represented before the issue of the new ones. Pending Content: Transition Date: December 15, 2009 Transition Guidance: 505-20-65-1 [Paragraph superseded by Accounting Standards Update No. 2010-01] 05-4 If there is an increase in the market value of a recipient's holdings, such unrealized appreciation is not income. In the case of a stock dividend or stock split, there is no distribution, division, or severance of corporate assets. Moreover, there is nothing resulting there from that the shareholder can realize without parting with some of his or her proportionate interest in the corporation. Pending Content: Transition Date: December 15, 2009 Transition Guidance: 505-20-65-1 If there is an increase in the market value of a recipient's holdings, such unrealized appreciation is not income. In the case of a stock dividend or stock split, there is no distribution, division, or severance of corporate assets. Moreover, there is nothing resulting there from that the shareholder can realize without parting with some of his or her proportionate interest in the corporation. 05-5 See paragraph 260-10-55-12 for earnings per share (EPS) guidance if the number of common shares outstanding increases as a result of a stock dividend or stock split. 505-20-15 Scope and Scope Exceptions General > Entities 15-1 The guidance in this Subtopic applies to all public and nonpublic entities that are corporations. > Transactions 15-2 The guidance in this Subtopic applies to all stock dividends and stock splits, with specific exceptions noted below. Pending Content: Transition Date: December 15, 2009 Transition Guidance: 505-20-65-1 The guidance in this Subtopic applies to all stock dividends and stock splits, with specific exceptions noted in paragraphs 505-20-15-3 through 15-3A. 15-3 The guidance in this Subtopic does not apply to the accounting for a distribution or issuance to shareholders of any of the following: a. Shares of another corporation held as an investment b. Shares of a different class 324
c. Rights to subscribe for additional shares d. Shares of the same class in cases in which each shareholder is given an election to receive cash or shares. 15-3A Pending Content: Transition Date: December 15, 2009 Transition Guidance: 505-20-65-1 Item (d) in the preceding paragraph includes, but is not limited to, a distribution having both of the following characteristics: a. The shareholder has the ability to elect to receive the shareholder’s entire distribution in cash or shares of equivalent value. b. There is a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate. For guidance on recognition of an entity’s commitment to make a distribution described in the preceding paragraph, see paragraph 480-10-25-14. For guidance on computation of diluted EPS of an entity’s commitment to make such a distribution, see the guidance in paragraphs 260-10-45-45 through 45-47.
505-20-20 Glossary Stock Dividend An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to give the recipient shareholders some ostensibly separate evidence of a part of their respective interests in accumulated corporate earnings without distribution of cash or other property that the board of directors deems necessary or desirable to retain in the business. Note: The following definition is Pending Content; see Transition Guidance in 505-20-65-1. An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to give the recipient shareholders some ostensibly separate evidence of a part of their respective interests in accumulated corporate earnings without distribution of cash or other property that the board of directors deems necessary or desirable to retain in the business. A stock dividend takes nothing from the property of the corporation and adds nothing to the interests of the stockholders; that is, the corporation’s property is not diminished and the interests of the stockholders are not increased. The proportional interest of each shareholder remains the same. Stock Split An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price and, thereby, of obtaining wider distribution and improved marketability of the shares. Sometimes called a stock split-up. 505-20-25 Recognition General > Criteria for Treatment as Stock Dividend or Stock Split
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25-1 This Section provides guidance on determining whether stock dividends and stock splits are to be accounted for in accordance with their actual form or whether their substance requires different accounting. > Stock Dividend in Form 25-2 The number of additional shares issued as a stock dividend may be so great that it has, or may reasonably be expected to have, the effect of materially reducing the share market value. In such a situation, because the implications and possible shareholder belief discussed in paragraph 505-20-30-3 are not likely to exist, the substance of the transaction is clearly that of a stock split. 25-3 The point at which the relative size of the additional shares issued becomes large enough to materially influence the unit market price of the stock will vary with individual entities and under differing market conditions and, therefore, no single percentage can be established as a standard for determining when capitalization of retained earnings in excess of legal requirements is called for and when it is not. Except for a few instances, the issuance of additional shares of less than 20 or 25 percent of the number of previously outstanding shares would call for treatment as a stock dividend as described in paragraph 505-20-30-3. > Stock Split in Form 25-4 A stock split is confined to transactions involving the issuance of shares, without consideration to the corporation, for the purpose of effecting a reduction in the unit market price of shares of the class issued and, therefore, of obtaining wider distribution and improved marketability of the shares. 25-5 Few cases will arise in which the aforementioned purpose can be accomplished through an issuance of shares that is less than 20 or 25 percent of the previously outstanding shares. 25-6 The corporation's representations to its shareholders as to the nature of the issuance is one of the principal considerations in determining whether it shall be recorded as a stock dividend or a stock split. Nevertheless, the issuance of new shares in ratios of less than 20 or 25 percent of the previously outstanding shares, or the frequent recurrence of issuances of shares, would destroy the presumption that transactions represented to be stock splits shall be recorded as stock splits. 505-20-30 Initial Measurement General 30-1 This Section provides guidance for the issuer and recipient of either a stock dividend or a stock split. > Issuer's Accounting for a Stock Dividend or Stock Split 30-2 Section 505-20-25 provides guidance on determining whether a stock dividend or a stock split shall be accounted for according to its form or whether it shall be accounted for differently. The following guidance addresses the accounting for the substantive nature of the transaction as either a stock dividend or a stock split. > > Stock Dividend 30-3 In accounting for a stock dividend, the corporation shall transfer from retained earnings to the category of capital stock and additional paid-in capital an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings that the shareholder may believe to have been distributed to him or her will be left, except to the extent otherwise dictated by legal requirements, in retained earnings subject to possible further similar stock issuances or cash distributions. 30-4 The accounting required in the preceding paragraph will likely result in the capitalization of retained earnings in an amount in excess of that called for by the laws of the state of incorporation; such laws generally require the capitalization only of the par value of the shares issued, or, in the case of 326
shares without par value, an amount usually within the discretion of the board of directors. However, these legal requirements are, in effect, minimum requirements and do not prevent the capitalization of a larger amount per share. > > > Alternative Treatment Permitted for Closely Held Entity 30-5 In cases of closely held entities, it is presumed that the intimate knowledge of the corporations' affairs possessed by their shareholders would preclude any implications and possible shareholder belief as are referred to in paragraph 505-20-30-3. In such cases, there is no need to capitalize retained earnings other than to meet legal requirements. > > Stock Split 30-6 In the case of a stock split, there is no need to capitalize retained earnings, other than to the extent occasioned by legal requirements. > Recipient's Accounting for a Stock Dividend or Stock Split 30-7 A shareholder's interest in the corporation remains unchanged by a stock dividend or stock split except as to the number of share units constituting such interest. Therefore, the cost of the shares previously held shall be allocated equitably to the total shares held after receipt of the stock dividend or stock split. When any shares are later disposed of, a gain or loss shall be determined on the basis of the adjusted cost per share. 505-20-50 Disclosure General 50-1 Paragraph 505-20-25-2 identifies a situation in which a stock dividend in form is a stock split in substance. In such instances every effort shall be made to avoid the use of the word dividend in related corporate resolutions, notices, and announcements and that, in those cases in which because of legal requirements this cannot be done, the transaction be described, for example, as a stock split effected in the form of a dividend. FASB ASC 15-6 Treasury Stock Search treasury stock 505-30 The students’ answers should be based on the following: 505-30-05 Overview and Background General 05-1 This Subtopic addresses the accounting and reporting for an entity’s repurchase of its own outstanding common stock as well as the subsequent constructive or actual retirement of those shares. 05-2 Entities may repurchase their own outstanding common stock for a variety of different purposes. Repurchased common stock is often referred to as treasury stock or treasury shares. 05-3 When entities repurchase their own common stock, laws applicable to those entities may affect the treatment and accounting for repurchased shares of stock. Entities sometimes pay more or less for the repurchased shares than either their fair value or their original issue price. 327
505-30-15 Scope and Scope Exceptions General > Entities 15-1 The guidance in this Subtopic applies to all public and nonpublic entities, unless more specific guidance for those entities is provided in other Topics. > Transactions 15-2 The guidance in this Subtopic applies to all transactions involving the repurchase of an entity's own outstanding common stock as well as the subsequent constructive or actual retirement of those shares, unless more specific guidance for those transactions is provided in other Topics. 505-30-25 Recognition General 25-1 This Section addresses the accounting requirements for the differences in amounts that result in either of the following situations: a. An entity repurchases its own outstanding common stock for an amount that differs from the price obtainable in open market transactions. b. An entity subsequently resells previously repurchased common stock for an amount that differs from the repurchase amount paid. This Section also identifies a program to acquire treasury shares, often described as an accelerated share repurchase program, as two separate transactions. 25-2 Laws of some states govern the circumstances under which an entity may acquire its own stock and prescribe the accounting treatment therefor. If such requirements are at variance with the requirements of paragraphs 505-30-25-7 and 505-30-30-6 through 30-10, the accounting shall conform to the applicable law. > Requirement to Allocate Repurchase Amount 25-3 The facts and circumstances associated with a share repurchase may suggest that the total payment relates to other than the shares repurchased. An entity offering to repurchase shares only from a specific shareholder (or group of shareholders) suggests that the repurchase may involve more than the purchase of treasury shares. Also, if an entity repurchases shares at a price that is different from the price obtainable in transactions in the open market or transactions in which the identity of the selling shareholder is not important, some portion of the amount being paid presumably represents a payment for stated or unstated rights or privileges that shall be given separate accounting recognition. See paragraph 505-30-30-3 for the measurement requirements associated with the different elements identified within such a transaction. 25-4 Payments by an entity to a shareholder or former shareholder attributed, for example, to a standstill agreement, or any agreement in which a shareholder or former shareholder agrees not to purchase additional shares, shall be expensed as incurred. Such payments do not give rise to assets of the entity. > Accelerated Share Repurchase Programs 25-5 An accelerated share repurchase program is a combination of transactions that permits an entity to repurchase a targeted number of shares immediately with the final repurchase price of those shares determined by an average market price over a fixed period of time. An accelerated share repurchase 328
program is intended to combine the immediate share retirement benefits of a tender offer with the market impact and pricing benefits of a disciplined daily open market stock repurchase program. 25-6 An entity shall account for such an accelerated share repurchase program as the following two separate transactions: a. As shares of common stock acquired in a treasury stock transaction recorded on the acquisition date b. As a forward contract indexed to its own common stock. Subtopic 815-40 provides guidance on the accounting for contracts that are indexed to an entity’s own common stock. Example 1 (see paragraph 505-30-55-1) provides an illustration of an accelerated share repurchase program that is addressed by this guidance. > Subsequent Resale of Shares Repurchased 25-7 After an entity's repurchase of its own outstanding common stock, sometimes it may either retire the repurchased shares and issue additional common shares, or, as an alternative, resell the repurchased shares. In either case, the price received may differ from the amount paid to repurchase the shares. While the net asset value of the shares of common stock outstanding in the hands of the public may be increased or decreased by such repurchase and retirement, such transactions relate to the capital of the corporation and do not give rise to corporate profits or losses. There is no essential difference between the following: a. The repurchase and retirement of a corporation's own common stock and the subsequent issue of common shares b. The repurchase and resale of its own common stock. 25-8 Even though there may be cases where the transactions involved are so inconsequential as to be immaterial, as a broad general principle, such transactions shall not be reflected in retained earnings (either directly or through inclusion in the income statement). The qualification shall not be applied to any transaction that, although in itself inconsiderable in amount, is a part of a series of transactions that in the aggregate are of substantial importance. 25-9 The difference between the repurchase and resale prices of a corporation's own common stock shall be reflected as part of the capital of a corporation and allocated to the different components within stockholder equity as required by paragraphs 505-30-30-5 through 30-10. 505-30-30 Initial Measurement General 30-1 This Section provides guidance on measuring amounts that arise from repurchases of an entity's own outstanding common stock. The measurement issues addressed include both of the following: a. Determining the allocation of amounts paid to the repurchased shares and other elements of the repurchase transaction b. Further allocation of amounts allocated to repurchased shares to various components of stockholder equity upon formal or constructive retirement. > Allocating Repurchase Price to Other Elements of the Repurchase Transaction 30-2 An allocation of repurchase price to other elements of the repurchase transaction may be required if an entity purchases treasury shares at a stated price significantly in excess of the current market price 329
of the shares. An agreement to repurchase shares from a shareholder may also involve the receipt or payment of consideration in exchange for stated or unstated rights or privileges that shall be identified to properly allocate the repurchase price. 30-3 For example, the selling shareholder may agree to abandon certain acquisition plans, forego other planned transactions, settle litigation, settle employment contracts, or restrict voluntarily the ability to purchase shares of the entity or its affiliates within a stated time period. If the purchase of treasury shares includes the receipt of stated or unstated rights, privileges, or agreements in addition to the capital stock, only the amount representing the fair value of the treasury shares at the date the major terms of the agreement to purchase the shares are reached shall be accounted for as the cost of the shares acquired. The price paid in excess of the amount accounted for as the cost of treasury shares shall be attributed to the other elements of the transaction and accounted for according to their substance. If the fair value of those other elements of the transaction is more clearly evident, for example, because an entity's shares are not publicly traded, that amount shall be assigned to those elements and the difference recorded as the cost of treasury shares. If no stated or unstated consideration in addition to the capital stock can be identified, the entire purchase price shall be accounted for as the cost of treasury shares. 30-4 Transactions do arise, however, in which a reacquisition of an entity's stock may take place at prices different from routine transactions in the open market. For example, to obtain the desired number of shares in a tender offer to all or most shareholders, the offer may need to be at a price in excess of the current market price. In addition, a block of shares representing a controlling interest will generally trade at a price in excess of market, and a large block of shares may trade at a price above or below the current market price depending on whether the buyer or seller initiates the transaction. An entity's reacquisition of its shares in those circumstances is solely a treasury stock transaction properly accounted for at the purchase price of the treasury shares. Therefore, in the absence of the receipt of stated or unstated consideration in addition to the capital stock, the entire purchase price shall be accounted for as the cost of treasury shares. > Allocating the Cost of Treasury Shares to Components of Shareholder Equity Upon Formal or Constructive Retirement 30-5 An entity that repurchases its own outstanding common stock may be required under paragraph 505-30-30-3 to allocate a portion of the repurchase price to other elements of the transaction. 30-6 Once the cost of the treasury shares is determined under the requirements of this Section, and if a corporation's stock is acquired for purposes other than retirement (formal or constructive), or if ultimate disposition has not yet been decided, paragraph 505-30-45-1 permits the cost of acquired stock to either be shown separately as a deduction from the total of capital stock, additional paid-in capital, and retained earnings, or be accorded the following accounting treatment appropriate for retired stock. 30-7 The difference between the cost of the treasury shares and the stated value of a corporation's common stock repurchased and retired, or repurchased for constructive retirement, shall be reflected in capital. 30-8 When a corporation's stock is retired, or repurchased for constructive retirement (with or without an intention to retire the stock formally in accordance with applicable laws), an excess of repurchase price over par or stated value may be allocated between additional paid-in capital and retained earnings. Alternatively, the excess may be charged entirely to retained earnings in recognition of the fact that a corporation can always capitalize or allocate retained earnings for such purposes. If a portion of the excess is allocated to additional paid-in capital, it shall be limited to the sum of both of the following: a. ` All additional paid-in capital arising from previous retirements and net gains on sales of treasury stock of the same issue b. `The pro rata portion of additional paid-in capital, voluntary transfers of retained earnings, capitalization of stock dividends, and so forth, on the same issue. For this purpose, any remaining additional paid-in capital applicable to issues fully retired (formal or constructive) is deemed to be applicable pro rata to shares of common stock. 330
30-9 When a corporation's stock is retired, or repurchased for constructive retirement (with or without an intention to retire the stock formally in accordance with applicable laws), an excess of par or stated value over the cost of treasury shares shall be credited to additional paid-in capital. 30-10 Gains on sales of treasury stock not previously accounted for as constructively retired shall be credited to additional paid-in capital; losses may be charged to additional paid-in capital to the extent that previous net gains from sales or retirements of the same class of stock are included therein, otherwise to retained earnings. 505-30-45 Other Presentation Matters General 45-1 If a corporation's stock is acquired for purposes other than retirement (formal or constructive), or if ultimate disposition has not yet been decided, the cost of acquired stock may be shown separately as a deduction from the total of capital stock, additional paid-in capital, and retained earnings, or may be accorded the accounting treatment appropriate for retired stock specified in paragraphs 505-30-30-7 through 30-10. 505-30-50 Disclosure General 50-1 This Section establishes incremental disclosure requirements that apply to specific circumstances in which an entity repurchases its own outstanding common stock. > Disclosures Relating to State Laws 50-2 State laws may effect an entity's repurchase of its own outstanding common stock. If state laws relating to an entity's repurchase of its own outstanding common stock restrict the availability of retained earnings for payment of dividends or have other effects of a significant nature, those facts shall be disclosed.
> Disclosures Relating to Allocation of Repurchase Price 50-3 A repurchase of shares at a price significantly in excess of the current market price creates a presumption that the repurchase price includes amounts attributable to items other than the shares repurchased. A repurchase of shares at a price significantly in excess of the current market price may require an entity to allocate amounts to other elements of the transaction under the requirements of paragraph 505-30-30-2. 50-4 The allocation of amounts paid to the treasury shares and other elements of the transaction requires significant judgment and consideration of many factors that can significantly affect amounts recognized in the financial statements. Disclosure of the allocation of amounts and the accounting treatment for such amounts is necessary to enable the user of the financial statements to understand the nature of significant transactions that may affect, in part, the capital of the entity. The allocation of amounts paid and the accounting treatment for such amounts shall be disclosed. Room for Debate Debate 15-1
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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 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 332
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 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 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.
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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 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 334
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. 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 335
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. 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 parts and report each part in accordance with the financial statement element it meets the definition of.
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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 15-13 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.
CHAPTER 16 Case 16-1
a.
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.
b.i.
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 337
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 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.i.
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 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. 338
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.
b.
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.
Under FASB ASC 280,t here 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. 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 states 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 339
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 c.
Under FASB ASC 280-10-50, the following segmental information is required to be disclosed:
a. 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 b. c. c. d. e. f. g. h. i. j.
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 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 Extraordinary items Significant noncash items other than depreciation, depletion, and amortization expense.
Case 16-4 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. 340
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. Case 16-5 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 longterm 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. b.
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.
c. Inventory valued at cost and deferred income each represent accounts measured in past exchanges and must be translated at historical rates. d. Long-term debt is translated at the current rate. 341
Case 16-6 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.
b.
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 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 foreigncurrency-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-currencydenominated 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 16-7 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. 342
4. Exchange gains and losses are accumulated and reported as a separate component of stockholders' equity in the unrealized capital section. 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 were 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 str 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. 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. 343
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 earlier 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 16-8 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. b. 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. 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. 344
d. 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 16-9 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. 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. c. 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. 345
d. 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. 16-10 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 730-5-2&3 consequently the patent should be recorded as an expense and should not be recorded as an asset. The students’ answers should include the following: 05-2 At the time most research and development costs are incurred, the future benefits are at best uncertain. In other words, there is no indication that an economic resource has been created. Moreover, even if at some point in the progress of an individual research and development project the expectation of future benefits becomes sufficiently high to indicate that an economic resource has been created, the question remains whether that resource should be recognized as 346
an asset for financial accounting purposes. Although future benefits from a particular research and development project may be foreseen, they generally cannot be measured with a reasonable degree of certainty. There is normally little, if any, direct relationship between the amount of current research and development expenditures and the amount of resultant future benefits to the entity. Research and development costs therefore fail to satisfy the suggested measurability test for accounting recognition as an asset. 05-3 Also, there is often a high degree of uncertainty about whether research and development expenditures will provide any future benefits. Thus, even an indirect cause and effect relationship can seldom be demonstrated. Because there is generally no direct or even indirect basis for relating costs to revenues, the principles of associating cause and effect and systematic and rational allocation cannot be applied to recognize research and development costs as expenses. That is, the notion of matching, when used to refer to the process of recognizing costs as expenses on any sort of cause and effect basis, cannot be applied to research and development costs. The general lack of discernible future benefits at the time the costs are incurred indicates that the immediate recognition principle of expense recognition should apply. > Accounting for Research and Development Costs 25-1 All research and development costs encompassed by this Subtopic shall be charged to expense when incurred. b.
In a business combination all identifiable assets are recorded at their fair market values under the provisions of FASB 805-20-30.
Measurement Principle 30-1 The acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values. Yes, the asset’s value on the acquired company’s books is irrelevant under FASB ASC 805-2030-1
2
FASB ASC 16-2 Consolidations and the EITF Search “new basis.” Found at 805-50. Then select the Print withSources function The FASB ASC paragraphs containing information on new basis of accounting originally issued by the EITF include: The guidance in the New Basis of Accounting (Pushdown) Subsections also addresses whether pushdown accounting is required in the separate financial statements of the acquiree. [EITF 86-09, paragraph ISSUE, sequence 12.2.2.2.2] ] The guidance in the New Basis of Accounting (Pushdown) Subsections applies to the following transactions: a.
[A publicly traded master limited partnership formed from assets of existing businesses. Paragraph 805-50-05-7 explains that typically, the general partner of the master limited partnership is affiliated with the existing business. [EITF 87-21, paragraph ISSUE, sequence 15.1] ]
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b.
[An acquisition in which all of the following conditions are met: [EITF 86-09, paragraph ISSUE, sequence 12.1] ] 1. [The acquiree is not a party to the transaction effecting change in ownership and is not a Securities and Exchange Commission (SEC) registrant. [EITF 86-09, paragraph ISSUE, sequence 12.2.1] ] 2. [A step-up in tax basis is elected. [EITF 86-09, paragraph ISSUE, sequence 12.2.2.1] ] 3. [There are no compelling reasons for retaining the old basis. [EITF 86-09, paragraph ISSUE, sequence 12.2.2.2.1] ]
805-50-15-9 Pending Content: Transition Date: December 15, 2008Transition Guidance: 805-10-65-1 [For a transaction meeting the conditions in (b) in the preceding paragraph, guidance is provided solely on whether pushdown accounting is required in the preparation of the acquired entity's financial statements. [EITF 86-09, paragraph ISSUE, sequence 12.2.2.2.2] ] Pushdown accounting is not required for entities that are not Securities and Exchange Commission (SEC) registrants. [EITF 86-09, paragraph DISCUSSION, sequence 17.1] ] New Basis of Accounting (Pushdown) 805-50-30-7 Pending Content: Transition Date: December 15, 2008Transition Guidance: 805-10-65-1 [Because of such factors as the consideration of common ownership and changes in control, [EITF 8721, paragraph DISCUSSION, sequence 24.2.2.2.2.2.1.1] ][ a new basis of accounting is not appropriate for any of the following transactions that create a master limited partnership: [EITF 87-21, paragraph DISCUSSION, sequence 24.1] ] a. [A rollup in which the general partner of the new master limited partnership was also the general partner in some or all of the predecessor limited partnerships and no cash is involved in the transaction. [EITF 87-21, paragraph DISCUSSION, sequence 24.2.1] ][ Transaction costs in a rollup shall be charged to expense. [EITF 87-21, paragraph DISCUSSION, sequence 25.1] ] b. [A dropdown in which the sponsor receives 1 percent of the units in the master limited partnership as the general partner and 24 percent of the units as a limited partner, the remaining 75 percent of the units are sold to the public, and a two-thirds vote of the limited partners is required to replace the general partner. [EITF 87-21, paragraph DISCUSSION, sequence 24.2.2.1] ] c. [A rollout. [EITF 87-21, paragraph DISCUSSION, sequence 24.2.2.2.1] ] d. [A reorganization. [EITF 87-21, paragraph DISCUSSION, sequence 24.2.2.2.2.1] ] 348
SEC Staff Announcement: Push-Down Accounting 805-50-S99-2 The following is the text of SEC Staff Announcement: Push Down Accounting. [Date Discussed: April 18-19, 2001 [EITF D-097, paragraph , sequence 1] ] [The SEC staff has received a number of inquiries regarding the facts and circumstances under which push-down accounting is required to be applied by SEC registrants. In Staff Accounting Bulletin No. 54, Application of "Pushdown" Basis of Accounting in Financial Statements of Subsidiaries Acquired by Purchase, the SEC staff indicated that it believes push-down accounting is required in "purchase transactions that result in an entity becoming substantially wholly owned." [EITF D-097, paragraph , sequence 2] ] [The SEC staff believes that the views in SAB 54 also should be followed in the context of a company that becomes substantially wholly owned as a result of a series of related and anticipated transactions. In determining whether a company has become substantially wholly owned, the SEC staff has stated that push-down accounting would be required if 95 percent or more of the company has been acquired (unless the company has outstanding public debt or preferred stock that may impact the acquirer's ability to control the form of ownership of the company), permitted if 80 percent to 95 percent has been acquired, and prohibited if less than 80 percent of the company is acquired. [EITF D-097, paragraph , sequence 3] ] [For example, if a parent company purchases all the outstanding minority interest of a majorityowned subsidiary (which has no public debt outstanding) in a single transaction or a series of related and anticipated transactions which includes the subsequent issuance of subsidiary shares to new investors, the SEC staff believes that push-down accounting would be required to be applied in the subsidiary's financial statements, regardless of the size of the minority interest sold to new investors. The SEC staff believes that push-down accounting would be required even though the subsidiary became wholly owned for only a short time and there was a plan for the subsidiary to issue shares subsequent to becoming wholly owned. [EITF D-097, paragraph , sequence 4] ] [In applying SAB 54 to specific facts and circumstances, a registrant must distinguish between transactions resulting in only a significant change in (recapitalization of) a company's ownership (for example, as the result of an initial public offering for which push-down accounting is not required) and purchase transactions in which the company becomes substantially wholly owned and for which push-down accounting is required. [EITF D-097, paragraph , sequence 5] ] [For purposes of determining whether a company has become "substantially wholly owned" as the result of a single transaction or a series of related and anticipated transactions in which investors acquire ownership interests, the SEC staff believes that it is appropriate to aggregate the holdings of those investors who both "mutually promote" the acquisition and "collaborate" on the subsequent control of the investee company (the collaborative group). FN1 That is, the SEC staff believes that push-down accounting is required if a company becomes substantially wholly owned by a group of investors who act together as effectively one investor and are able to control the form of ownership of the investee. [EITF D-097, paragraph , sequence 6] ] [FN1 Topic No. D-97 Footnote 1—A collaborative group is not necessarily the same as a control group as defined in SEC Staff Announcement: Issue No. 88-16, "Basis in Leveraged Buyout Transactions." [EITF D-097, paragraph , sequence 7] ]
349
[The SEC staff believes that under a "mutual promotion and subsequent collaboration" model, a member of a collaborative group would be any investor FN2 that helps to consummate the acquisition and works or cooperates with the subsequent control of the acquired company. For purposes of assessing whether an investor is part of a collaborative group, the SEC staff believes that a rebuttable presumption exists that any investor investing at the same time as or in reasonable proximity to the time others invest in the investee is part of the collaborative group with the other investor(s). Determination of whether such a presumption is rebutted necessarily will involve the consideration of all pertinent facts and circumstances. Among the factors considered by the SEC staff FN3 that would be indicative of an investor not being part of a collaborative group include: [EITF D-097, paragraph , sequence 8] ] contingent upon any other investor making investments in the investee. [EITF D-097, paragraph , sequence 14] ] [The investor does not have other relationships with any other investor that are material to either investor. [EITF D-097, paragraph , sequence 15] ] [II. Risk of Ownership [EITF D-097, paragraph , sequence 16] ] [The investor is investing at fair value. [EITF D-097, paragraph , sequence 17] ] [The investor invests funds from its own resources. [EITF D-097, paragraph , sequence 18] ] [The investor fully shares with all other investors in the risks and rewards of ownership in the investee in proportion to its class and amount of investment. That is, the investor's downside risk or upside reward are not limited, and the investor does not receive any other direct or indirect benefits from any other investor as a result of investing in the investee. FN4 [EITF D-097, paragraph , sequence 19] ] [FN4 Topic No. D-97 Footnote 4—Put options, call options, tag-along rights, and dragalong rights should be carefully evaluated. They may act to limit an investor's risk and rewards of ownership, effective voting rights, or ability to sell its investee shares. A tagalong right grants a shareholder the option to participate in a sale of shares by the controlling shareholder or collaborative group, generally under the same terms and in the same proportion. A drag-along right grants the controlling shareholder or collaborative group the option to compel shareholders subject to the drag-along provision to sell their shares in a transaction in which the controlling shareholder or collaborative group transfers control of the company, generally under the same terms and in the same proportion. [EITF D-097, paragraph , sequence 20] ] [The funds invested by the investor are not directly or indirectly provided or guaranteed by any other investor. [EITF D-097, paragraph , sequence 21] ] [The investor is at risk only for its own investment in the investee and not another's investment in the investee. That is, the investor is not providing or guaranteeing any part of another investor's investment in the investee. FN5 [EITF D-097, paragraph , sequence 22] ] [FN5 Topic No. D-97 Footnote 5—See footnote 4. [EITF D-097, paragraph , sequence 23] ] [III. Promotion [EITF D-097, paragraph , sequence 24] ] 350
[The investor did not solicit other parties to invest in the investee. [EITF D-097, paragraph , sequence 25] ] [IV. Subsequent Collaboration [EITF D-097, paragraph , sequence 26] ] [The investor is free to exercise its voting rights in any and all shareholder votes. [EITF D-097, paragraph , sequence 27] ] [The investor does not have disproportionate or special rights that other investors do not have, such as a guaranteed seat(s) on the investee's board, required supermajority voting rights for major or significant corporate decisions, guaranteed consent rights over corporate actions, guaranteed or specified returns, and so forth. [EITF D-097, paragraph , sequence 28] ] [The investor's ability to sell its investee shares is not restricted, except as provided by the securities laws or by what is reasonable and customary in individually negotiated investment transactions for closely held companies (for example, a right of first refusal held by the investee on the investor's shares in the event of a bona fide offer from a third party). [EITF D-097, paragraph , sequence 29] ] [The SEC staff has considered the applicability of push-down accounting in transactions in which financial investors, acting together effectively as one investor (that is, as a collaborative group), acquire ownership interests in a company. The investee company experiences a significant change in ownership, but no single financial investor obtains substantially all of the ownership interest in the company. Consider the following example: [EITF D-097, paragraph , sequence 30] ] [Investor C formulates a plan to acquire and consolidate companies in a highly fragmented industry in order to achieve economies of scale. Investor C approaches Investors A and B with the plan, and they agree to invest with Investor C in the acquisition and consolidation plan. Investors A, B, and C (the Investors) are each substantive entities, with no overlap of employees but with a number of prior joint investments and other business relationships that are individually material to the Investors. Furthermore, upon completion of the current plan, the resulting entity is expected to be material to each individual investor. [EITF D-097, paragraph , sequence 31] ] [Shortly thereafter, Company D is identified as an acquisition candidate in the industry. The Investors negotiate a legally binding agreement with Company D to acquire 100 percent of the outstanding common stock of Company D (to be held 40 percent, 40 percent, and 20 percent by Investors A, B, and C, respectively) for cash. In connection with the change in ownership, Company D's bylaws are amended to provide that the Investors each have the right to elect an equal number of members of Company D's board of directors. Company D's board of directors also is to include Company D's chief executive officer and two independent directors. In addition, the bylaws are amended to provide that no action requiring board of directors' approval may be approved without consent of a majority of the board as well as a majority of the Investor A directors, the Investor B directors, and the Investor C directors, each voting as a separate class. Effectively, any significant corporate action by Company D would require the approval of each investor. [EITF D-097, paragraph , sequence 32] ] [Stock held by the Investors is to be restricted as to transfer for five years, after which each of the Investors has a right of first refusal and tag-along rights if some part of the group of Investors decides to sell its interests. [EITF D-097, paragraph , sequence 33] ] 351
[The funds invested by each investor come from the respective investor's resources; however, Investors A and B provide Investor C certain limited first-loss guarantees of its investment. [EITF D-097, paragraph , sequence 34] ] [In the context of this example, the SEC staff concluded that Investors A, B, and C did not overcome the presumption that they were members of a collaborative group of investors. Furthermore, since the collaborative group of Investors acquired 100 percent of the outstanding common stock of Company D, the SEC staff concluded that push-down accounting was required to be applied in Company D's financial statements. The factors the SEC staff considered in reaching its conclusion that the presumption was not rebutted included, among others, the following: [EITF D-097, paragraph , sequence 35] ] [Investors A, B, and C acted in concert to negotiate their concurrent investments in Company D, which were made pursuant to the same contract. [EITF D-097, paragraph , sequence 36] ] [The investments by Investors A, B, and C were being made in connection with a broader strategic initiative the three investors were pursuing together. [EITF D-097, paragraph , sequence 37] ] [There were a number of prior business relationships between the Investors that were material to the Investors. [EITF D-097, paragraph , sequence 38] ] [Investor C does not share fully in the risks and rewards of ownership due to the limited first-loss guarantees provided by Investors A and B. [EITF D-097, paragraph , sequence 39] ] [No single Investor controlled the board of directors, and due to the amendments to the bylaws regarding board representation and voting, any of the three Investors could unilaterally block any board action. In other words, Investors A, B, and C were compelled to collaborate on the subsequent control of Company D. [EITF D-097, paragraph , sequence 40] ] [There are restrictions on each Investor's ability to transfer its shares. [EITF D-097, paragraph , sequence 41] ] [The guidance in this announcement should be applied prospectively to transactions initiated after April 19, 2001. [EITF D-097, paragraph , sequence 42] [FN2 Topic No. D-97 Footnote 2—Preexisting, or rollover, investors should be evaluated for inclusion in the collaborative group on the same basis as new investors. [EITF D-097, paragraph , sequence 9] ] [FN3 Topic No. D-97 Footnote 3—In an assessment of whether the presumption is overcome, any single factor should not be considered in isolation. [EITF D-097, paragraph , sequence 10] ] [I. Independence [EITF D-097, paragraph , sequence 11] ] [The investor is substantive. For example, the investor is an entity with substantial capital (that is, comparable to that expected for a substantive business with similar risks and rewards) and other operations. In contrast, an investor that is a special-purpose entity whose only substantive assets or operations are its investment in the investee generally would not be considered substantive. [EITF D-097, paragraph , sequence 12] ] 352
FASB ASC 16-3 Definition of Business Search business combinations and definition of a business 805-10-55-4 A business consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business. The three elements of a business are defined as follows: a. Input. Any economic resource that creates, or has the ability to create, outputs when one or more processes are applied to it. Examples include long-lived assets (including intangible assets or rights to use long-lived assets), intellectual property, the ability to obtain access to necessary materials or rights, and employees. b.
Process. Any system, standard, protocol, convention, or rule that when applied to an input or inputs, creates or has the ability to create outputs. Examples include strategic management processes, operational processes, and resource management processes. These processes typically are documented, but an organized workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs. Accounting, billing, payroll, and other administrative systems typically are not processes used to create outputs.
c. Output. The result of inputs and processes applied to those inputs that provide or have the ability to provide a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. FASB ASC 16-4 Noncontrolling Interests Cross reference FAS 160 810-10-65 Transition Related to FASB Statements No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51, and No. 164, Not-for-Profit Entities: Mergers and Acquisitions 65-1 The following represents the transition and effective date information related to FASB Statements No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51, and No. 164, Not-for-Profit Entities: Mergers and Acquisitions: a. Except as noted in item (d), the pending content that links to this paragraph is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. b. The pending content that links to this paragraph shall be applied prospectively as of the beginning of the fiscal year in which that content is initially adopted, except for the presentation and disclosure requirements. The presentation and disclosure requirements shall be applied retrospectively for all periods presented, as follows: 1. The noncontrolling interest shall be reclassified to equity in accordance with paragraph 81010-45-16. 2. Consolidated net income shall be adjusted to include the net income attributed to the noncontrolling interest. 353
3. Consolidated comprehensive income shall be adjusted to include the comprehensive income attributed to the noncontrolling interest. 4. The disclosures in paragraphs 810-10-50-1A through 50-1B shall be provided. c. Paragraph 810-10-45-21 requires that the noncontrolling interest continue to be attributed its share of losses even if that attribution results in a deficit noncontrolling interest balance. If, in the year of adoption, an entity’s consolidated net income attributable to the parent would have been significantly different had the prior requirement in paragraph 810-10-45-7 been applied, the entity shall disclose pro forma consolidated net income attributable to the parent and pro forma earnings per share as if the previous prior requirement in paragraph 810-10-45-7 had been applied in the year of adoption. d. Not-for-profit entities (NFPs) shall apply the pending text that links to this paragraph prospectively in the first set of initial or annual financial statements for a reporting period beginning on or after December 15, 2009. e. The pending content linked to this paragraph may amend or supersede either nonpending content or other pending content with different or the same effective dates. If a paragraph contains multiple pending content versions of that paragraph, it may be necessary to refer to the transition paragraphs of all such pending content to determine the paragraph that is applicable to a particular fact pattern. FASB ASC 16-5 Proportionate Consolidation Search proportionate consolidation 932-810-45 Proportionate Consolidation 45-1 Paragraph 810-10-45-14 explains that a proportionate gross financial statement presentation is not appropriate for an investment in an unincorporated legal entity accounted for by the equity method of accounting unless the investee is in either the construction industry or an extractive industry (as discussed in this Topic and paragraph 930-810-45-1 ). As indicated in that paragraph, an entity is in an extractive industry only if its activities are limited to the extraction of mineral resources (such as oil and gas exploration and production) and not if its activities involve related activities such as refining, marketing, or transporting extracted mineral resources. FASB ASC 16-6 Value beyond Proven and Probable Reserves Search value beyond proven and probable reserves 930-805-30 Value Beyond Proven and Probable Reserves 30-1 An entity shall include value beyond proven and probable reserves in the value allocated to mining assets in a purchase price allocation to the extent that a market participant would include value beyond proven and probable reserves in determining the fair value of the asset. > Anticipated Future Price Fluctuations 30-2 An entity shall include the effects of anticipated fluctuations in the future market price of minerals in determining the fair value of mining assets in a purchase price allocation in a manner that is consistent with the expectations of marketplace participants. Generally, an entity should consider all 354
available information including current prices, historical averages, and forward pricing curves. Those marketplace assumptions typically should be consistent with the acquiring entity's operating plans with respect to developing and producing minerals. It generally would be inappropriate for an entity to use a single factor, such as the current price or a historical average, as a surrogate for estimating future prices without considering other information that a market participant would consider. FASB ASC 16-7 Demutualization of Life Insurance Companies Search Demutualization 944-895-05 > The Demutualization Process 05-5Mutual insurance entities differ from stock insurance entities in that they do not have stockholders. A mutual insurance entity is considered to be owned by policyholders whose insurance contracts embody their rights as insureds and as members of the mutual insurance entity. 05-6The process of demutualization or formation of a mutual insurance holding entity is subject to scrutiny and approval by state insurance regulatory authorities. Most states have some form of demutualization statute. A range of demutualization statutes and regulations exist for insurance entities. Typically, those laws contemplate a direct and full reorganization of the mutual insurer to a stock form. In accordance with some demutualization statutes, eligible policyholders receive stock, policy credits, policyholder benefits, cash, or subscription rights as consideration for their membership interest. 05-7The process for allocating the aggregate consideration among eligible policyholders varies based on individual entity circumstances and applicable regulatory statutes. The allocation process generally consists of a fixed and a variable component. 05-8The fixed component represents consideration for eligible policyholders’ membership interest in the mutual insurer and consists of a given number of shares per policyholder (or sometimes, per policy). 05-9The variable component represents consideration for eligible policyholders’ contribution to the value of the insurer. The variable component of the aggregate compensation is allocated to policyholders in proportion to the actuarial contributions of their eligible policies, if positive. A policy’s actuarial contribution consists of its historical equity share (the policy’s past contribution to entity equity) and, in most cases, the prospective equity share; that is, the present value of the policy’s expected future contributions to entity equity. FASB ASC 16-8 Affiliated Sales in the Consolidation of Regulated Industries Consolidation and regulated operations and affiliated sales 980-810-45 Affiliated Sales 45-1 Profit on sales to regulated affiliates shall not be eliminated in general-purpose financial statements if both of the following criteria are met: a. The sales price is reasonable. b. It is probable that, through the rate-making process, future revenue approximately equal to the sales price will result from the regulated affiliate's use of the products. 45-2 The sales price usually shall be considered reasonable if the price is accepted or not challenged by the regulator that governs the regulated affiliate. Otherwise, reasonableness shall be considered in light of the circumstances. For example, reasonableness might be judged by the return on investment 355
earned by the manufacturing or construction operations or by a comparison of the transfer prices with prices available from other sources. Room for Debate Debate 16-1 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 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.
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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. 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.
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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 is 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 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 358
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 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 16-8 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
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.
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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 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 is 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 amount of hours necessary to complete the Lakes Brothers audit in compared to the current year.
b.
1. Obtain the relevant facts. - Barbara Montgomery is being pressured to work hours on the Lakes Brothers audit "off-the-clock." 2. 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 amount of hours necessary to complete the Lakes Brothers audit is compared to the current year. 3. 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 mislead about the hours necessary to actually complete the job. The firm and the client will also be mislead 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 360
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 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.
b.
No comment or opinion qualification 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.
b.
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 qualified.
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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 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, 2011 be adjusted for the ascertainable economic effects of this development.)
b.
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 Subject to" opinion or disclaimer of opinion (neither of which is proper under the given assumption) might be justified if the development were 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 362
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 2008 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 2008. 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
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 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 363
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. c.
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 17-6 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.
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 insure 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. 364
b.i.
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. 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.
iv.
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 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 365
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 were initially required to comply with SOX’s provisions for fiscal periods ending on or after July 15, 2006. Case 17-7 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.
b.
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 17-8 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.
b.
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 formation of corporations have not yet been successful. The legal liability issue will continue to be an important topic in the near future.
Case 17-9 366
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 representionally 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.
e.
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. .
Case 17-10 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. 367
b.
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 following discussion indicates that the potential loss should be disclosed; however, since no amount is given, the amount of the loss cannot be accrued. The answer to Part b is contained at the end of this question. 05-1 This Subtopic provides guidance for the recognition and disclosure of a loss contingency. 05-2 This Subtopic, in combination with Subtopics 450-10 and 450-30, provides general guidance regarding gain and loss contingencies. Other Topics include gain or loss contingencies related to those specific Topics. Therefore, the Contingencies Topic does not include all standards related to contingencies. While not intended to be all-inclusive, the following Relationships Sections within the Contingency Subtopics provide links to many Topic-specific contingencies: a. See Section 450-10-60 for references to other standards related to uncertainties that could result in either a gain or a loss. b. See Section 450-20-60 for references to other standards related to uncertainties that could result in a future loss. c. See Section 450-30-60 for references to other standards related to uncertainties that could result in a future gain. 05-3 The following are examples of loss contingencies for which links are provided in Section 450-20-60: a. Collectibility of receivables b. Obligations related to product warranties and product defects c. Risk of loss from catastrophes assumed by property and casualty insurance entities including reinsurance entities d. Guarantees of indebtedness of others e. Obligations of commercial banks under standby letters of credit f. Agreements to repurchase receivables (or to repurchase the related property) that have been sold. > Dealing with Uncertainty when Accounting for Losses 05-4 Accounting standards use two primary approaches to dealing with uncertainty in loss circumstances: a. Recognition using a probability threshold b. Measurement using a fair value objective. 05-5 This Subtopic deals with uncertainty by requiring a probability threshold for recognition of a loss contingency and that the amount of the loss be reasonably estimable. As noted in paragraph 450-20-30-1, when both of those recognition criteria are met, and the reasonably estimable loss is a range, it requires accrual of the amount that appears to be a better estimate than any other estimate within the range, or accrual of the minimum amount in the range if no amount within the range is a better estimate than any other amount. 368
05-6 In contrast, fair value is not an estimate of the ultimate settlement amount or the present value of an estimate of the ultimate settlement amount. Uncertainty in the amount and timing of the future cash flows necessary to settle a liability and the likelihood of possible outcomes are incorporated into the measurement of the fair value of the liability. For example, a third party would charge a price to assume an uncertain liability even though the likelihood of a future sacrifice is less than probable. Similarly, when the likelihood of a future sacrifice is probable, the price a third party would charge to assume an obligation incorporates expectations about some future events that are less than probable. Recognizing the fair value of an obligation results in recognition of some obligations for which the likelihood of future settlement, although more than zero, is less than probable from a loss contingencies perspective. 05-7 Because this Subtopic deals with uncertainty differently, the recognition guidance in Section 450-20-25 is inconsistent with standards in other Topics that have an objective of measuring fair value. > Accruals of Loss Contingencies Do Not Provide Financial Protection 05-8 Accrual of a loss related to a contingency does not create or set aside funds to lessen the possible financial impact of a loss. Confusion exists between accounting accruals (sometimes referred to as accounting reserves) and the reserving or setting aside of specific assets to be used for a particular purpose or contingency. Accounting accruals are simply a method of allocating costs among accounting periods and have no effect on an entity's cash flow. Those accruals in no way protect the assets available to replace or repair uninsured property that may be lost or damaged, or to satisfy claims that are not covered by insurance, or, in the case of insurance entities, to satisfy the claims of insured parties. Accrual, in and of itself, provides no financial protection that is not available in the absence of accrual. 05-9 An entity may choose to maintain or have access to sufficient liquid assets to replace or repair lost or damaged property or to pay claims in case a loss occurs. Alternatively, it may transfer the risk to others by purchasing insurance. The accounting standards set forth in this Subtopic do not affect the fundamental business economics of that decision. That is a financial decision, and if an entity's management decides to do neither, the presence or absence of an accrued credit balance on the balance sheet will have no effect on the consequences of that decision. Insurance or reinsurance reduces or eliminates risks and the inherent earnings fluctuations that accompany risks. Unlike insurance and reinsurance, the use of accounting reserves does not reduce or eliminate risk. The use of accounting reserves is not an alternative to insurance and reinsurance in protecting against risk. Earnings fluctuations are inherent in risk retention, and they are reported as they occur. > Types of Loss Contingencies 05-10 The following are examples of loss contingencies that are discussed in this Subtopic: a. Injury or damage caused by products sold b. Risk of loss or damage of property by fire, explosion, or other hazards c. Actual or possible claims and assessments d. Threat of expropriation of assets e. Pending or threatened litigation. 450-20-15 Scope and Scope Exceptions General > Overall Guidance 369
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see Section 450-10-15, with specific transaction exceptions noted below. > Transactions 15-2 The following transactions are excluded from the scope of this Subtopic because they are addressed elsewhere in the FASB ASC: a. Stock issued to employees, which is discussed in Topic 718. b. Employment-related costs, including deferred compensation contracts, which are discussed in Topics 710, 712, and 715. However, certain postemployment benefits are included in the scope of this Subtopic through application of paragraphs 712-10-25-4 through 25-5. c. Uncertainty in income taxes, which is discussed in Section 740-10-25. d. Accounting and reporting by insurance entities, which is discussed in Topic 944. 450-20-20 Glossary Contingency An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur. Gain Contingency An existing condition, situation, or set of circumstances involving uncertainty as to possible gain to an entity that will ultimately be resolved when one or more future events occur or fail to occur. Loss Contingency An existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur. The term loss is used for convenience to include many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses. Probable The future event or events are likely to occur. Reasonably Possible The chance of the future event or events occurring is more than remote but less than likely. Remote The chance of the future event or events occurring is slight. 450-20-25 Recognition General Rule 25-1 When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. As indicated in the definition of contingency, the term loss is used for convenience to include many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses. The Contingencies Topic uses the terms probable, reasonably possible, and remote to identify three areas within that range. 25-2 An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met: a. Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which 370
financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss. b. The amount of loss can be reasonably estimated. The purpose of those conditions is to require accrual of losses when they are reasonably estimable and relate to the current or a prior period. Paragraphs 450-20-55-1 through 55-17 and Examples 1–2 (see paragraphs 450-20-55-18 through 55-35) illustrate the application of the conditions. As discussed in paragraph 450-20-50-5, disclosure is preferable to accrual when a reasonable estimate of loss cannot be made. Further, even losses that are reasonably estimable shall not be accrued if it is not probable that an asset has been impaired or a liability has been incurred at the date of an entity's financial statements because those losses relate to a future period rather than the current or a prior period. Attribution of a loss to events or activities of the current or prior periods is an element of asset impairment or liability incurrence. > Assessing Probability of Incurrence of a Loss 25-3 The conditions in the preceding paragraph are not intended to be so rigid that they require virtual certainty before a loss is accrued. Instead, the condition in (a) in the preceding paragraph is intended to proscribe accrual of losses that relate to future periods. > Assessing Whether a Loss Is Reasonably Estimable 25-4 The condition in paragraph 450-20-25-2(b) is intended to prevent accrual in the financial statements of amounts so uncertain as to impair the integrity of those statements. 25-5 That requirement shall not delay accrual of a loss until only a single amount can be reasonably estimated. To the contrary, when the condition in paragraph 450-20-25-2(a) is met and information available indicates that the estimated amount of loss is within a range of amounts, it follows that some amount of loss has occurred and can be reasonably estimated. Thus, when the condition in paragraph 450-20-25-2(a) is met with respect to a particular loss contingency and the reasonable estimate of the loss is a range, the condition in paragraph 450-20-25-2(b) is met and an amount shall be accrued for the loss. The issue of subsequent events is discussed in 450-20-30 450-20-30 Initial Measurement General 30-1 If some amount within a range of loss appears at the time to be a better estimate than any other amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range shall be accrued. Even though the minimum amount in the range is not necessarily the amount of loss that will be ultimately determined, it is not likely that the ultimate loss will be less than the minimum amount. Examples 1–2 (see paragraphs 450-20-55-18 through 55-35) illustrate the application of these initial measurement standards. 450-20-50 Disclosure General Accruals for Loss Contingencies 50-1 Disclosure of the nature of an accrual made pursuant to the provisions of paragraph 45020-25-2, and in some circumstances the amount accrued, may be necessary for the financial statements not to be misleading. Terminology used shall be descriptive of the nature of the accrual, such as estimated liability or liability of an estimated amount. The term reserve shall not be used for an accrual made pursuant to paragraph 450-20-25-2; that term is limited to an amount of unidentified or unsegregated assets held or retained for a specific purpose. Examples 1 (see 371
paragraph 450-20-55-18) and 2, Cases A, B, and D (see paragraphs 450-20-55-23, 450-20-55-27, and 450-20-55-32) illustrate the application of these disclosure standards. 50-2 If the criteria in paragraph 275-10-50-8 are met, paragraph 275-10-50-9 requires disclosure of an indication that it is at least reasonably possible that a change in an entity's estimate of its probable liability could occur in the near term. Example 3 (see paragraph 450-2055-36) illustrates this disclosure for an entity involved in litigation. Unrecognized Contingencies 50-3 Disclosure of the contingency shall be made if there is at least a reasonable possibility that a loss or an additional loss may have been incurred and either of the following conditions exists: a. An accrual is not made for a loss contingency because any of the conditions in paragraph 450-20-25-2 are not met. b. An exposure to loss exists in excess of the amount accrued pursuant to the provisions of paragraph 450-20-30-1. Examples 1–3 (see paragraphs 450-20-55-18 through 55-37) illustrate the application of these disclosure standards. 50-4 The disclosure in the preceding paragraph shall include both of the following: a. The nature of the contingency b. An estimate of the possible loss or range of loss or a statement that such an estimate cannot be made. 50-5 Disclosure is preferable to accrual when a reasonable estimate of loss cannot be made. For example, disclosure shall be made of any loss contingency that meets the condition in paragraph 450-20-25-2(a) but that is not accrued because the amount of loss cannot be reasonably estimated (the condition in paragraph 450-20-25-2[b]). Disclosure also shall be made of some loss contingencies that do not meet the condition in paragraph 450-20-25-2(a)—namely, those contingencies for which there is a reasonable possibility that a loss may have been incurred even though information may not indicate that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. 50-6 Disclosure is not required of a loss contingency involving an unasserted claim or assessment if there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment unless both of the following conditions are met: a. It is considered probable that a claim will be asserted. b. There is a reasonable possibility that the outcome will be unfavorable. 50-7 Disclosure of noninsured or underinsured risks is not required by this Subtopic. However, disclosure in appropriate circumstances is not discouraged. 50-8 No disclosure about general or unspecified business risks is required by this Subtopic, however, Topic 275 requires disclosure of certain business risks. Part a. Since the accident occurred before the end of the year, as long as the expected loss can be reasonably estimated it should be accrued and reported in the December 31 financial statements. Contingencies and subsequent events are discussed in FASB ASC 450-20-50-9 as follows: Losses Arising After the Date of the Financial Statements 50-9 Disclosure of a loss, or a loss contingency, arising after the date of an entity's financial statements but before those financial statements are issued, as described in paragraphs 450-20-256 through 25-7, may be necessary to keep the financial statements from being misleading if an accrual is not required. If disclosure is deemed necessary, the financial statements shall include both of the following: a. The nature of the loss or loss contingency b. An estimate of the amount or range of loss or possible loss or a statement that such an estimate cannot be made. 372
50-10 Occasionally, in the case of a loss arising after the date of the financial statements if the amount of asset impairment or liability incurrence can be reasonably estimated, disclosure may best be made by supplementing the historical financial statements with pro forma financial data giving effect to the loss as if it had occurred at the date of the financial statements. It may be desirable to present pro forma statements, usually a balance sheet only, in columnar form on the face of the historical financial statements. Part b Given the above 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 a. 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. Following is that discussion: 235-10-05 Overview and Background 05-1The Notes to Financial Statements Topic addresses the content and usefulness of disclosure by an entity of the accounting policies judged by management to be most appropriate to fairly present the entity's financial statements. 05-2Disclosure of accounting policies related to specific financial statement line items are addressed in the related Topics. > Importance of Accounting Policies Disclosure 05-3The accounting policies of an entity are the specific accounting principles and the methods of applying those principles that are judged by the management of the entity to be the most appropriate in the circumstances to present fairly financial position, cash flows, and results of operations in accordance with generally accepted accounting principles (GAAP) and that, accordingly, have been adopted for preparing the financial statements. 05-4The accounting policies adopted by an entity can affect significantly the presentation of its financial position, cash flows, and results of operations. Accordingly, the usefulness of financial statements for purposes of making economic decisions about the entity depends significantly upon the user's understanding of the accounting policies followed by the entity. 235-10-15 Scope and Scope Exceptions > Overall Guidance 15-1The Scope Section of the Overall Subtopic establishes the pervasive scope for the Notes to Financial Statements Topic. > Entities 15-2The guidance in the Notes to Financial Statements Topic applies to all entities. 235-10-50 Disclosure > Accounting Policies Disclosure 50-1Information about the accounting policies adopted by an entity is essential for financial statement users. When financial statements that are issued or are available to be issued (as discussed in Section 855-10-25) purport to present fairly financial position, cash flows, and results of operations in accordance with generally accepted accounting principles (GAAP), a 373
description of all significant accounting policies of the entity shall be included as an integral part of the financial statements. In circumstances where it may be appropriate to issue one or more of the basic financial statements without the others, purporting to present fairly the information given in accordance with GAAP, statements so presented also shall include disclosure of the pertinent accounting policies. > Accounting Policies Disclosure in Interim Periods 50-2The provisions of the preceding paragraph are not intended to apply to unaudited financial statements issued as of a date between annual reporting dates (for example, each quarter) if the reporting entity has not changed its accounting policies since the end of its preceding fiscal year. > What to Disclose 50-3Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure shall encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it shall encompass those accounting principles and methods that involve any of the following: a. A selection from existing acceptable alternatives b. Principles and methods peculiar to the industry in which the entity operates, even if such principles and methods are predominantly followed in that industry c. Unusual or innovative applications of GAAP. > Examples of Disclosures 50-4Examples of disclosures by an entity commonly required with respect to accounting policies would include, among others, those relating to the following: a. Basis of consolidation b. Depreciation methods c. Amortization of intangibles d. Inventory pricing e. Accounting for recognition of profit on long-term construction-type contracts f. Recognition of revenue from franchising and leasing operations. > Avoid Duplicate Details of Disclosures 50-5Financial statement disclosure of accounting policies shall not duplicate details (for example, composition of inventories or of plant assets) presented elsewhere as part of the financial statements. In some cases, the disclosure of accounting policies shall refer to related details presented elsewhere as part of the financial statements; for example, changes in accounting policies during the period shall be described with cross-reference to the disclosure required by Topic 250 > Format 50-6This Subtopic recognizes the need for flexibility in matters of format (including the location) of disclosure of accounting policies provided that the entity identifies and describes its significant accounting policies as an integral part of its financial statements in accordance with the provisions of this Subtopic. Disclosure is preferred in a separate summary of significant accounting policies preceding the notes to financial statements, or as the initial note, under the same or a similar title. FASB ASC 17-3 Accounting for Changing Prices Search Changing Prices 255-10-50 374
General > Introduction 50-1 A business entity that prepares its financial statements in U.S. dollars and in accordance with U.S. generally accepted accounting principles (GAAP) is encouraged, but not required, to disclose supplementary information on the effects of changing prices. Entities are not discouraged from experimenting with other forms of disclosure. > Presentation 50-2 This Subtopic provides guidance on those encouraged disclosures. For that reason, the guidance that describes how to present the disclosures is included in this Section rather than Section 250–10–45. > > Five-Year Summary of Selected Financial Data 50-3 An entity shall disclose all of the following information for each of the five most recent years: a. Net sales and other operating revenues b. Income from continuing operations on a current cost basis c. on net monetary items d. Increase or decrease in the current cost or lower recoverable amount of inventory and property, plant, and equipment, net of inflation e. The aggregate foreign currency translation adjustment on a current cost basis, if applicable f. Net assets at year-end on a current cost basis g. Income per common share from continuing operations on a current cost basis h. Cash dividends declared per common share i. Market price per common share at year-end. 50-4 For the purposes of this Subtopic, except where otherwise provided, inventory and property, plant, and equipment shall include land and other natural resources and capitalized leasehold interests but not goodwill or other intangible assets. 50-5 An entity that presents consolidated financial statements shall present the information required by this Subtopic on the same consolidated basis. The information required by this Subtopic need not be presented for a parent company, an investee company, or other entity in a financial report that includes the results for that entity in consolidated financial statements. 50-6 The information required by this Subtopic shall be presented as supplementary information in any published annual report that contains the primary financial statements of the entity except that the information need not be presented in an interim financial report. The information required by this Subtopic need not be presented for segments of a business entity although such presentations are encouraged. 50-7 The information presented in the five-year summary shall be stated as either of the following: a. In average-for-the-year or end-of-year units of constant purchasing power b. In dollars having a purchasing power equal to that of dollars of the base period used by the Bureau of Labor Statistics in calculating the Consumer Price Index for All Urban Consumers. As a practical matter, this option is not available to entities that measure a significant part of their operations in one or more functional currencies other than the U.S. dollar and that elect to use the restate-translate method for measuring inflationadjusted current cost information. 375
50-8 An entity shall disclose the level of the Consumer Price Index for All Urban Consumers used for each of the five most recent years. If the level of the Consumer Price Index at the end of the year and the data required to compute the average level of the index over the year have not been published in time for preparation of the annual report, they may be estimated by referring to published forecasts based on economic statistics or by extrapolation based on recently reported changes in the index. 50-9 If the entity has a significant foreign operation measured in a functional currency other than the U.S. dollar, it shall disclose whether adjustments to the current cost information to reflect the effects of general inflation are based on the Consumer Price Index for All Urban Consumers (the translate-restate method) or on a functional currency general price level index (the restatetranslate method). 50-10 The entity shall provide an explanation of the disclosures required by this Subtopic and a discussion of their significance in the circumstances of the entity. Disclosure and discussion of additional information to help users of the financial report understand the effects of changing prices on the activities of the entity are encouraged. > > Additional Disclosures for the Current Year 50-11 In addition to the information required by paragraphs 255-10-50-3 through 50-10, an entity shall provide the information specified in paragraphs 255-10-50-12 through 50-16 if income from continuing operations on a current cost-constant purchasing power basis would differ significantly from income from continuing operations in the primary financial statements. 50-12 An entity shall disclose certain components of income from continuing operations for the current year on a current cost basis (see paragraphs 255-10-50-39 through 50-41), applying the same constant purchasing power option used for presentation of the five-year summary. The information may be presented in any of the following formats: a. In a statement format (disclosing revenues, expenses, gains, and losses) b. In a reconciliation format (disclosing adjustments to the income from continuing operations that is shown in the primary income statement) c. In notes to the five-year summary required by paragraph 255-10-50-3. 50-13 Formats for presenting the supplementary information are illustrated in Example 1 (see paragraphs 255-10-55-14 through 55-21). Whichever format is used, the presentation shall disclose (for example, in a reconciliation format) or allow the reader to determine (for example, in a statement format) the difference between the amount in the primary statements and the current cost amount of all of the following items: a. Cost of goods sold and depreciation b. Depletion c. Amortization expense. FASB ASC 17-4 Interim Financial Reports in the Oil and Gas Industry Search oil and gas and interim reporting 932-270-50 50-1 The disclosures set forth in Subtopic 932-235 are not required in interim financial reports. However, interim financial reports shall include information about a major discovery or other favorable or adverse event that causes a significant change from the information presented in the most recent annual financial report concerning oil and gas reserve quantities. 376
FASB ASC 17-5 Interim Financial Reports in the Construction Industry Search contractors and accounting policies Accounting Policies 50-1 Construction contractors shall follow the general disclosure requirements of Subtopic 235-10. Significant accounting policy disclosures relating to construction contractors include both of the following: a. Information relating to the method of reporting by affiliated entities shall be disclosed. b. If the operating cycle exceeds one year, the range of contract durations shall be disclosed. > Liquidity Characteristics 50-2 An entity shall disclose liquidity characteristics of specific assets and liabilities if either of the following conditions is met: a. The entity's operating cycle exceeds one year. b. The entity uses an unclassified balance sheet. FASB ASC 17-6 Disclosure of Foreign Activities Search foreign activities and SEC 942-235-299 SEC Rules, Regulations, and Interpretations >>
Regulation S-X
> > > Regulation S-X Rule 9-05 S99-1 The following is the text of Regulation S-X Rule 9-05. (a) General requirement. Separate disclosure concerning foreign activities shall be made for each period in which either (1) assets, or (2) revenue, or (3) income (loss) before income tax expense, or (4) net income (loss), each as associated with foreign activities, exceeded ten percent of the corresponding amount in the related financial statements. (b) Disclosures. (1) Disclose total identifiable assets (net of valuation allowances) associated with foreign activities. (2) For each period for which an income statement is filed, state the amount of revenue, income (loss) before taxes, and net income (loss) associated with foreign activities. Disclose significant estimates and assumptions (including those related to the cost of capital) used in allocating revenue and expenses to foreign activities; 377
describe the nature and effects of any changes in such estimates and assumptions which have a significant impact on interperiod comparability. (3) The information in paragraph (b) (1) and (2) of this section shall be presented separately for each significant geographic area and in the aggregate for all other geographic areas not deemed significant. (c) Definitions. (1) Foreign activities include loans and other revenues producing assets and transactions in which the debtor or customer, whether an affiliated or unaffiliated person, is domiciled outside the United States. (2) The term revenue includes the total of the amount reported at §§ 210.9–04.5 and 210.9–04.13. (3) A significant geographic area is one in which assets or revenue or income before income tax or net income exceed 10 percent of the comparable amount as reported in the financial statements. >>> S99-2
Regulation S-X Rule 9-06 The following is the text of Regulation S-X Rule 9-06.
The information prescribed by § 210.12–04 shall be presented in a note to the financial statements when the restricted net assets (§ 210.4–08(e)(3)) of consolidated subsidiaries exceed 25 percent of consolidated net assets as of the end of the most recently completed fiscal year. The investment in and indebtedness of and to bank subsidiaries shall be stated separately in the condensed balance sheet from amounts for other subsidiaries; the amount of cash dividends paid to the registrant for each of the last three years by bank subsidiaries shall be stated separately in the condensed income statement from amounts for other subsidiaries. For purposes of the above test, restricted net assets of consolidated subsidiaries shall mean that amount of the registrant's proportionate share of net assets of consolidated subsidiaries (after intercompany eliminations) which as of the end of the most recent fiscal year may not be transferred to the parent company by subsidiaries in the form of loans, advances or cash dividends without the consent of a third party (i. e., lender, regulatory agency, foreign government, etc.). Where restrictions on the amount of funds which may be loaned or advanced differ from the amount restricted as to transfer in the form of cash dividends, the amount least restrictive to the subsidiary shall be used. Redeemable preferred stocks (§ 210.5–02.28) and minority interests shall be deducted in computing net assets for purposes of this test. FASB ASC 17-7 Common Interest Realty Associations Search common interest realty association 972-235- 20 through 50 Common Interest Realty Association 378
An association, also known as a community association, responsible for the governance of the common interest community, for which it was established to serve. A common interest realty association is generally funded by its members via periodic assessments by the common interest realty association so that it can perform its duties, which include management services and maintenance, repair, and replacement of the common property, among other duties established in the governing documents and by state statute. 50-1 In addition to disclosures required by generally accepted accounting principles (GAAP) for other entities, the notes to a common interest realty association's financial statements shall also include disclosures about all of the following: a. The common interest realty association's legal form (corporation or association) and that of the entity for which it provides services (for example, condominium, homeowners association, cooperative), areas it controls, and the number of units. (In place of the number of units, cooperative housing corporations may disclose the number of shares and time-share associations may disclose the number of weeks.) b. Services (such as maintenance) and subsidies provided by the developer c. The number of units (shares for cooperative housing corporations and weeks for timeshare associations) owned by the developer. > Future Major Repairs and Replacements 50-2 A common interest realty association shall disclose information in its notes to financial statements about its funding for future major repairs and replacements. Disclosures about such funding shall include all of the following: a. Requirements, if any, in statutes or the common interest realty association's documents (or mortgage or governmental bodies funding requirements, for example, Federal Housing Administration often has such requirements) to accumulate funds for future major repairs and replacements and the common interest realty association's compliance or lack of compliance with them b. A description of the common interest realty association's funding policy, if any, and compliance with that policy c. A statement that funds, if any, are being accumulated based on estimated future (or current) costs, that actual expenditures may vary from these estimates, and that the variations may be material d. Amounts assessed for major repairs and replacements in the current period, if any e. A statement indicating whether a study was conducted to estimate the remaining useful lives of common property components and the costs of future major repairs and replacements. Common interest realty associations that fund future major repairs and replacements by special assessments or borrowings when needs occur shall disclose that information. > Required Supplementary Information 50-3 Common interest realty associations shall disclose the following as unaudited supplementary information: a. Estimates of current or future costs of future major repairs and replacements of all existing components, such as roofs, including estimated amounts required, methods used to determine the costs, the basis for calculations (including assumptions, if any, about interest and inflation rates), sources used, and the dates of studies, made for this purpose, if any. There is no requirement for common interest realty associations to obtain studies prepared by professional engineers. The estimates may be made by the board of directors or estimates obtained from licensed contractors. 379
b. A presentation of components to be repaired and replaced, estimates of the remaining useful lives of those components, estimates of current or future replacement costs, and amounts of funds accumulated for each to the extent designated by the board Room for Debate Debate 17-1 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 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. 380
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 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 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 381
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 are 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 allows 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 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. 382
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 long-term 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 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 383
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. 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. 384
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. 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 17-11 The solution to this case requires a visit to the SEC’s home page at the time the case is assigned. Financial Analysis Case The answer depends on the company selected.
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FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 1 THE DEVELOPMENT OF ACCOUNTING THEORY
Introduction ◼
What is theory? ❑
Webster defines theory as: “Systematically organized knowledge, applicable in a relatively wide variety of circumstances, a system of assumptions, accepted principles and rules of procedure to analyze, predict or otherwise explain the nature of behavior of a specified set of phenomena.”
Normative theory Positive theory
Why is the development of a general theory of accounting important? ◼ What is the relationship of accounting research to accounting theory? ◼
THE EARLY HISTORY OF ACCOUNTING Zenon Papyri ◼ Renaissance ◼
❑
Fra Luca Pacioli
The evolution of joint ventures into ongoing businesses ◼ The impact of the industrial revolution and the progressive movement ◼ The concept of capital maintenance ◼ The accountant as a protector of business interests ◼
ACCOUNTING IN THE UNITED STATES SINCE 1930 ◼ Meetings between NYSE and AIA ◼ AAA ◼ SEC
Securities Act of 1933 Securities Exchange Act of 1934 ◼ Committee on Accounting Procedure
◼ Accounting Principles Board ◼ Financial Accounting Standards Board
THE ACCOUNTING PRINCIPLES BOARD Formation and structure ◼ Types of pronouncements ◼
❑
◼
APB Opinions
Accounting for the investment tax credit (1961) ❑
APB Opinions 2 & 4
Rule 203 ◼ Criticism of the APB ◼
Independence of members ❑ Structure ❑ Response time ❑
THE FINANCIAL ACCOUNTING STANDARDS BOARD ◼ The Wheat Committee ◼ The Trueblood Committee ◼ The FASB was established
Structure of the FASB Appoint and fund ------| | |
Financial Accounting Foundation
Govern
Board of Trustees
Appoint
Appoint and fund
Financial Accounting Standards Advisory Committee (approx. 20 members)
Admin. Staff
Financial Accounting Standards Board (5 members)
Appoint
Research Staff
Task Forces of the Standards Board
Electors
FASB ◼ Sarbanes-Oxley Section 108
◼ Mission ◼ Types of pronouncements
Statements of Financial Accounting Concepts Statements of Financial Accounting Standards Interpretations Technical Bulletins
FASB Accounting Standards Codification ◼ July 1, 2009 ◼ Single source of GAAP ◼ Effective for interim & annual periods ending
after September 15, 2009
FASB Accounting Standards Codification ◼ Goals:
Simplicity ❑ Accurate representation of GAAP ❑ Up-to-date research ❑
◼ Expectation
Reduce research time ❑ Mitigate noncompliance risk ❑ Real-time updates ❑ Assist FASB ❑
FASB Accounting Standards Codification ◼ July 1, 2009 ◼ No more SFAS ◼ Changes publicized through an ASU
Summarize key provisions ❑ Detailed amendments to FASB Codification ❑ Explain basis for decision ❑
FASB ◼ Emerging Issues ◼ Standards Overload ◼ Standard setting as a political process
◼ Economic Consequences
GAAP ◼
Evolution of phrase: Changed wording of auditor’s certificate brought about by meetings between NYSE and AIA ❑ The APB’s definition ❑ The Auditing Standards Executive Committee’s definition ❑
◼
SAS 69: determining acceptance of a specific principle is difficult ❑
No single reference
SFAS No. 162 2008 ◼ Hierarchy of GAAP ◼
GAAP Hierarchy LEVEL A: FASB Statements FASB Interpretations SEC Rules and Interpretive Releases Accounting Principles Board Opinions (unless amended) Account Research Bulletins (unless amended)
LEVEL B: FASB Technical Bulletins AICPA Industry Audit Guides that have been reviewed by the FASB
GAAP Hierarchy
LEVEL C: AcSEC Practice Bulletins that have been reviewed by the FASB Consensuses reached by the EITF
LEVEL D: AICPA Accounting Interpretations (no longer issued) FASB Implementation Guides Other widely recognized or prevalent accounting practices
SFAS No. 168 2009 ◼ Codification ◼ Hierarchy ◼
❑
Replaces 162
Rule 203 Ethics ◼ Must consider pronouncements as primary source of GAAP ◼
THE ROLE OF ETHICS IN ACCOUNTING ◼ The public accountant
watchdog
as a
Accounting in Crisis – The Events of the Early 2000s ◼
Enron and the Accounting Scandals
Accounting in Crisis – The Events of the Early 2000s ◼
Two major changes in the accounting profession have taken place in the wake of the accounting scandals: 1. Arthur Andersen ◼
◼
formerly one the Big 5 audit firms has gone out of business
Sarbanes-Oxley Act
2. ◼ ◼
President Bush signed into law July 2002 imposes a number of corporate governance rules on publicly traded companies
International Accounting Standards The concept of harmonization The IASB The IASB’s objectives:
◼ ◼ ◼ 1.
2.
◼
◼
To formulate and publish in the public interest accounting standards to be observed in the presentation of financial statements and to promote their worldwide acceptance and observance To work generally for the improvement and harmonization of regulations, accounting standards, and procedures relating to the presentation of financial statements.
41 Statements of Accounting Standards and 10 Statements of Financial Reporting Standards to date No enforcement authority
End of Chapter 1 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION
RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
Chapter 2 The Pursuit of the Conceptual Framework
Introduction ◼ What is the conceptual framework?
◼ The Early Theorists
❑Paton and Canning ❑DR Scott and his conceptual framework ❑Normative theory of accounting ❑“The Basis for Accounting Principles”
Hierarchy ◼ Orientation Postulate ◼ The Pervasive Principle of Justice ◼ The Principles of Truth and
Fairness ◼ The Principles of Adaptability and Consistency
Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting A Tentative Statement of Accounting Principles Affecting Corporate Reports
A Statement of An Accounting Principles Introduction to Corporate Accounting Standards
ARS No. 1 (1961) ◼ Hierarchy of postulates
❑Group A: Economic and Political ❑Group B: Accounting ❑Group C: Imperative ◼ Disasterous outcome
Early Authoritative and Semi-authoritative Organizational Attempts to Develop the Conceptual Framework of Accounting ARS No. 3 1962 Use of current values
APB Statement No. 4
ASOBAT 1966
Sophistication Information of users system Economic Income
The Trueblood Committee ◼
1. 2. 3. 4. ◼
Committee report specified the following four information needs of users:
Making decisions concerning the use of limited resources Effectively directing and controlling organizations Maintaining and reporting on the custodianship of resources Facilitating social functions and controls
Objectives of financial reporting
Statement on Accounting Theory and Theory Acceptance ◼ ◼
Rationale for the committee’s approach The approaches to accounting theory were condensed into 1. 2. 3.
◼
Classical Decision Usefulness Information Economics.
Criticisms of the approaches to theory
The FASB’s Conceptual Framework Project ◼
◼
The objectives identify the goals and purposes of financial accounting; whereas, the fundamentals are the underlying concepts that help achieve those objectives. These concepts are designed to provide guidance in: 1. 2.
3.
Selecting the transactions, events and circumstances to be accounted for Determining how the selected transactions, events, and transactions should be measured Determining how to summarize and report the results of events, transactions and circumstances.
SFAC No. 1 “Objectives of Financial Reporting By Business Enterprises” 1. 2.
3.
4.
5. 6. 7.
Assess cash flow prospects Report on enterprise resources, claims against resources and changes in them Report economic resources, obligations and owners equity Report enterprise performance and earnings Evaluate liquidity, solvency, and flow of funds Evaluate management stewardship and performance Explain and interpret financial information
No. 2 “Qualitative Characteristics of Accounting Information ◼ Addresses the question:
What makes accounting information useful? ◼ Develops a Hierarchy of Accounting Qualities
A Hierarchy of Accounting Qualities Users of Accounting Information
Decision makers and their characteristics (for example, understanding of prior knowledge)
Pervasive Constraint
Benefits > Costs
Understandability
User-specific qualities Decision Usefulness
Primary Decision-specific qualities
Relevance
Reliability
Timeliness
Ingredients of primary qualities
Predictive value
Verifiability
Neutrality
Feedback value
Comparability and Consistency
Threshold for recognition
Materiality
Representational Faithfulness
No. 5 “Recognition and Measurement in Financial Statements of Business Enterprises” Sets forth recognition criteria and guidance on what information should be incorporated into financial statements and when this information should be reported ◼ Defined comprehensive income as: ◼
Revenues Less: Expenses
Plus: Gains Less: Losses = Earnings
Earnings Plus or minus cumulative accounting adjustments Plus or minus other non-owner changes in equity = Comprehensive Income
No. 5 “Recognition and Measurement in Financial Statements of Business Enterprises” Measurement Issues
◼
1.
Definitions. ◼
2.
The item meets the definition of an element contained in SFAC No. 6.
Measurability. ◼
3.
It has a relevant attribute measurable with sufficient reliability.
Relevance. ◼
4.
The information about the item is capable of making a difference in user decisions.
Reliability. ◼
The information is representationally faithful, verifiable, and neutral.
SFAC No. 5 Gaps
◼ ◼
Failure to define “earnings” No resolution on debate of current value vs historical cost
No. 6 “The Elements of Financial Statements” ◼ Defines the ten elements of financial
statements that are used to measure the performance and position of economic entities ◼ These elements are discussed in more depth in Chapters 5 and 6.
SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements” ◼ ◼
Accounting measurement is a very broad topic. Consequently, the FASB focused on a series of questions relevant to measurement and amortization conventions that employ present value techniques. Among these questions are: What are the objectives of using present value in the initial recognition of assets and liabilities? And, do these objectives differ in subsequent fresh-start measurements of assets and liabilities? Does the measurement of liabilities at present value differ from the measurement of assets? How should the estimates of cash flows and interest rates be developed? What are the objectives of present value when used in conjunction with the amortization of assets and liabilities? How should present value amortizations be used when the estimates of cash flows change?
SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements”
Present value measurements that fully captures the economic differences between assets should include the following elements: 1.
An estimate of the future cash flows
2.
Expectations about variations in the timing of those cash flows
3.
The time value of money represented by the riskfree rate of interest
4.
The price for bearing the uncertainty
5.
Other, sometimes unidentifiable, factors including illiquidity and market imperfections
SFAC No. 7 “Using Cash Flow Information and Present Value in Accounting Measurements” ◼
1. 2. ◼
w o l F h s a C d e t c e
Approaches to present value Traditional Expected cash flow
Exp
Incorporating probabilities ❑ The objective is to estimate the value of the assets required currently to settle the liability with the holder or transfer the liability to an entity with a comparable credit standing
◼
Use of the interest method
Principles Based vs. Rules Based Accounting Standards ◼
Continuum ranging from ❑ highly rigid standards on one end
❑ to general definitions of economics-based concepts on the other end.
Example: Goodwill ◼
Previous practice: ❑ Goodwill is to be amortized over a 40 life until it is fully amortized.
◼
New FASB rule: ❑ Goodwill is not amortized. ❑ Any recorded goodwill is to be tested for impairment and written down to its current fair value on an annual basis.
Principles-Based ◼
◼
◼
◼
Better able to cope with speed of change of business environment Less Voluminous Encourages use of professional judgment with focus on what is right Seen as possibly discouraging financial engineering
Rules-Based ◼
◼
◼
◼
More workable in large, complex economies & countries Less room for interpretation Provides more guidance for practical implementation Less need for explanation in financial statements
FASB Questions
1.
Do you support the Board’s proposal for a principles-based approach to U. S. standard setting? Will that approach improve the quality and transparency of U. S. financial accounting and reporting?
2.
Should the Board develop an overall reporting framework as in IAS 1? If so, should that framework include a true and fair override?
3.
Under what circumstances should interpretive and implementation guidance be provided under a principles-based approach to U.S. standard setting? Should the Board be the primary standard setter responsible for providing that guidance?
4.
Will preparers, auditors, the SEC, investors, creditors, and other users of financial information be able to adjust to a principles-based approach to U.S. standard setting? If not, what needs to be done and by whom?
5. 6.
What other factors should the Board consider in assessing the extent to which it should adopt a principles-based approach to U.S. standard setting? What are the benefits and costs (including transition costs) of adopting a principlesbased approach to U.S. standard setting? How might those benefits and costs be quantified?
Principles Based vs. Rules Based Accounting Standards ❑The AAA’s position ◼ Economic substance, not form
AAA
❑Dissenting opinion ◼ US standards also include rules-based elements
Further developments ❑2003 SEC study submitted to Congress ◼ Included recommendations to FASB
❑2004 FASB response to recommendations 1. 2. 3. 4. 5. 6.
Issuing Objectives-Oriented Standards Conceptual Framework One U.S. Standard Setter GAAP Hierarchy Access to Authoritative Literature Comprehensive Review of Literature
International Convergence ◼ Norwalk Agreement ◼ September 18, 2002 FASB & IASB
pledged ❑Achieve compatibility ❑Maintain compatibility ◼ 3 Major aspects:
1. Financial Statements Presentation Project 2. Conceptual Framework Project 3. Standards Update Project
FASB-IASB Financial Statement Presentation Project ◼ Establish common standard ◼ Goals
❑Understand past and present financial position ❑Understand changes and causes of changes ❑Evaluate future cash flows
FASB-IASB Financial Statement Presentation Project ◼
3 Phases A. What constitutes complete set of statements? B. Fundamental issues for presentation of information C. Presentation of interim financial information in U.S. GAAP
Further Developments February 2006 Memorandum of Understanding (MOU)
❑
▪
▪ ▪
Shared objective: develop high-quality, common accounting standards “Road map” for elimination of reconciliation requirements Develop new common standards rather than eliminate differences
Convergence
1. Boards to reach conclusion on major differences in focused areas • 2008 goal 2. FASB & IASB seek to make continued progress in other areas
November 2009 Progress Report
Milestone targets for each project Commitment to reporting quarterly on progress
❑ ❑
▪ ❑
Make reports available on web
Host monthly joint board meetings
FASB & IFRS Statements ❑ 4 New SFASs ▪ SFAS No. 151 (Superseded) ▪ SFAS No. 153 (Superseded) ▪ SFAS No. 154 ▪ SFAS No. 163 ❑ SFAS No. 141 revised ❑ IASB new standards on borrowing costs & segment reporting
Phase B principles ❑ Financial statement presentation 1. Cohesive financial picture 2. Financing activities separated 3. Liquidity of assets & liabilities 4. Disaggregate line items 5. Understand ▪ Measurement of assets & liabilities ▪ Uncertainty & subjectivity ▪ Causes of changes in assets & liabilities
Financial Statements ❑ Comprehensive Income ❑ Financial Position ❑ Cash Flows
❑ Each statement to contain 2 primary section: 1. Business ▪ Operating ▪ Investing 2. Financing ▪ Debt ▪ Equity
Conceptual Framework Project 8 phases 1. Objectives and qualitative characteristics 2. Definitions of elements, recognition and derecognition 3. Measurement 4. Reporting entity concept 5. Boundaries of financial reporting, and presentation and disclosure 6. Purpose and status of framework 7. Application of framework to not-for-profit entities 8. Remaining issues, if any
End of Chapter 2 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 3 INTERNATIONAL ACCOUNTING
International Accounting Standards ◼ Financial accounting is influenced by the environment in which it operates ◼ Companies develop financial reports directed at their primary users ➢ Previously most were residents of the same country as the corporation ➢ Transnational financial reporting has become more commonplace because of the European Union, GATT and NAFTA
◼ U. S. companies must be able to compete in global markets with transnational financial reporting
International Business Accounting Issues ◼ A company’s first exposure to international accounting is frequently the result of a purchase or sale ◼ Problems: 1 Exchange gains or losses 2 Obtaining credit information 3 Evaluation of financial statements
◼ Next step may be to open an international division ◼ Another issue is raising capital in foreign markets ➢ Must prepare financial statements in a format acceptable by appropriate securities market
Factors Influencing the Development of Accounting Systems:
Level of Education
Legal System
Political System
Economic Development
Influences on the Development of Financial Reporting Type of economy
Agricultural Resource Based Tourist Based Manufacturing
Legal System
Codified Common Law
Political System
Democratic Totalitarian
Nature of Ownership
Private Enterprise Socialist Communist
Influences on the Development of Financial Reporting Growth Pattern of economy
Growing Stable Declining
Social Climate Stability of currency Sophistication of management Sophistication of financial community Existence of accounting legislation Education System
Approaches to Preparing Financial Statements for Use in Other Countries: 1 Same to all 2 Translate language 3 Translate language and currency 4 Two sets 5 World-wide standards
The International Accounting Standards Committee ◼ The preparation of financial statements for foreign users under option #5 is being increasingly advocated ◼ IASC ❑ formed in 1973 to aid in this process
◼ International Accounting Standards Board ❑ replaced IASC in 2001
Standard Setting by the IASC ◼ Original intent: ❑ avoid complex details ❑ concentrate on basic standards
◼ Steps in the process ❑ similar to FASB 1 Steering Committee 2 Identify issues and prepare point outline 3 Board prepares comments 4 Steering Committee prepares final Statement of Principles 5 Exposure Draft 6 Steering Committee reviews comments and prepares final standard
Standard Setting by the IASC ◼ Two treatments 1 Benchmark - point of reference 2 Alternative
◼ Improvements Project ❑ 2003 ❑ Removed some of the existing alternative accounting treatments ❑ Where an IAS retains alternative treatments ◼ IASB removed references to 'benchmark treatment' ◼ and allowed 'alternative treatment' ❑ using descriptive references ▪ 'cost model' ▪ 'revaluation model'
Restructuring the IASC ◼ In its early years, IASC acted mainly as a harmonizer ◼ Recently, it has begun to combine that role with the role of a catalyst
Harmonizer
Catalyst
Coordinator of national initiatives Initiator of new work at national level
Restructuring the IASB ◼ Future IASB role as catalyst and initiator should become more prominent ◼ Important for the IASB to focus objectives more precisely, as follows: 1. To develop international accounting standards that require highquality, transparent, and comparable information that will help participants in capital markets and others to make economic decisions; and 2. To promote the use of international accounting standards by working with national standard setters.
Restructuring the IASB ◼ Structural changes needed ❑
so that IASB can anticipate the new challenges facing it and meet those challenges effectively.
◼ Issues that need to be addressed: 1. Partnership with national standard setters. ◼ ◼
IASB should enter into a partnership with national standard setters so that IASB can work together with them to accelerate ➢ ➢
convergence between national standards and international accounting standards around solutions requiring highquality, transparent, and comparable information ❖ that will help participants in capital markets and others to make economic decisions.
Restructuring the IASB
2.
Wider participation in the IASB Board. ◼
A wider group of countries and organizations should take part in the IASB Board ➢
3.
Without diluting the quality of the Board's work
Appointment. ◼
◼
The process for appointments to the IASB Board and key IASB committees should be the responsibility of a variety of constituencies Those appointed must be competent , independent, and objective.
Restructuring the IASB ◼2001: ❑Responsibility for international standardssetting was transferred to the to the International Accounting Standards Board (IASB)
Restructuring the IASB ◼ The new structure: ❑The IASC Foundation ❑The International Accounting Standards Board ❑The International Accounting Standards Advisory Council ❑International Financial Reporting Interpretations Committee
KEY:
New Structure
Appoints
Reports To Advises
IASC Foundation 22 Trustees Appoint, Oversee, Raise Funds
Board: 15 Members Set Technical Agenda Approve Standards, Exposure Drafts, & Interpretations
Standards Advisory Council 49 members Advisory Groups For Major Agenda Projects
International Financial Reporting Interpretations Committee (12 members)
Revising the IASB’s Constitution ◼ Key issues to be reviewed: 1. Whether the objectives of the IASC Foundation should expressly refer to the challenges facing small and mediumsized entities (SMEs) 2. Number of Trustees and their geographical and professional distribution 3. The oversight role of the Trustees 4. Funding of the IASC Foundation 5. The composition of the IASB 6. The appropriateness of the IASB's existing formal liaison relationships 7. Consultative arrangements of the IASB 8. Voting procedures of the IASB 9. Resources and effectiveness of the International Financial Reporting Interpretations Committee (UMC): 10. The composition, role, and effectiveness of the SAC
The Uses of International Accounting Standards ◼ IASC noted that its standards are used in a variety of ways: 1 National requirements 2 Basis for national requirements
3 Benchmark to develop standards 4 By regulatory agencies 5 By companies
◼ Also International Organization of Securities Commissions (IOSCO) looks to the IASC to provide standards that can be used in multinational securities offerings
Current Issues ◼ Partnership with the IOSCO ❑ Generate standards acceptable to IOSCO
◼ December 17, 2003 ❑ IASB published 13 revised International Accounting Standards ❑ Reissued two others ❑ Gave notice of the withdrawal of its standard on price level accounting.
◼ Revised and reissued standards mark near-completion of the IASBs Improvements project ◼ 2005: reaffirmed support and development of IFRS
IASB Annual Improvements Project ◼ July 2006 ◼ Non-urgent issues ◼ Amendments
The Use of IASC Standards ❑Adopted by approx. 113 countries ▪ EU ▪ Australia ▪ New Zealand
❑Planned option by others ▪ Canada (2011) ▪ Japan (2011) ▪ Canada (2011)
❑US (?)
The Adoption Map
The Use of IASC Standards ❑2006 ▪ No requirement of new IFRSs under development or major amendments to existing IFRSs before 1/1/09 ▪ Provides 4 years of stability ▪ Australia ▪ New Zealand
❑IFRS No. 1: “First-time Adoption of International Financial Reporting Standards”
FASB Short-term International Convergence Project
◼ The goal of this project is to remove a variety of individual differences between U.S. GAAP and International Financial Reporting Standards that are not within the scope of other major projects.
◼ The project scope is limited to those differences in which convergence around a high-quality solution would appear to be achievable in the short-term, usually by selecting between existing IFRS and U.S. GAAP.
The Norwalk Agreement
◼ 12/18/2002: ❑ FASB and IASB held joint meeting in Norwalk, Connecticut ❑ Both standard setting bodies acknowledged… ◼
their commitment to the development of high-quality compatible accounting standards that can be used for both domestic and cross-border financial reporting.
❑ Also committed to use their best efforts to make their existing financial reporting standards compatible as soon as practicable and to coordinate their future work programs to help ensure that once compatibility is achieved, it will be maintained.
The Norwalk Agreement
◼ Both Boards agreed to: 1. Undertake a short-term project aimed at removing a variety of differences between U. S. GAAP and IFRSs. 2. Remove any other differences between IFRSs and U. S. GAAP that may remain on January 1, 2005 by undertaking projects that both Boards would address concurrently. 3. Continue the progress on the joint projects currently underway. 4. Encourage their respective interpretative bodies to coordinate their activities.
The Roadmap to Convergence ◼ 2005 agreement between FASB & IASB: ❑ Convergence best achieved with high-quality, common standards ❑ Develop a new common standard rather than try to eliminate differences ❑ Replace weaker standards with stronger standards
The Roadmap to Convergence ◼ 7 Milestones 1. 2. 3. 4. 5. 6. 7.
Improvements to accounting standards Funding of IASCF Improved ability to use interactive data for IFRS reporting Improved education and training in the US Limited use in narrow group of companies SEC to determine in 2011 if mandatory adoption is feasible Mandatory use ▪ ▪ ▪
2014 2015 2016
International vs. GAAP Accounting Standards VS ◼ Question: Should foreign companies be allowed to list their securities in United States markets ◼ Form 20-F reconciliations ◼ Pressure on the SEC to accept international accounting rules
Standards Overload ❑2009: IASB published IFRS for small to medium-sized businesses ▪ 95% of all companies ▪ Provide simplified standards
Framework for the Preparation and Presentation of Financial Statements ◼ Purpose - to set out concepts that underlie the preparation and presentation of financial statements by: 1 2 3 4 5
Assisting the IASC in developing future standards Promoting harmonization of accounting standards Assisting national standard setters Assisting preparers in applying international standards Assisting auditors in forming an opinion as to whether financial statements conform to international standards 6 Assisting users in interpreting financial statements prepared in conformity with international standards 7 Providing interested parties with information about the IASC’s approach to the formation of international accounting standards
Framework for the Preparation and Presentation of Financial Statement”
◼ The Framework specifies: 1 Objective of financial statements 2 Qualitative characteristics 3 Elements 4 The concepts of capital maintenance
The Objective of Financial Statements ◼ Information useful in making economic decisions ◼ General purpose financial statements ◼ The framework indicated that: 1
Users require evaluation of the ability of an enterprise to generate cash and the timing and certainty of that generation
2
The financial position of an enterprise is affected by the economic resources it controls, its financial structure, its liquidity and solvency and its capacity to adapt to change
3
Information on profitability is required to assess changes in the economic resources an enterprise controls in the future
4
Information of the financial position of an enterprise is useful in assessing its investing, financing and operating activities
5
Information about financial position is contained in the balance sheet and information about performance is contained in the income statement
The Objective of Financial Statements
◼ Underlying assumptions for the preparation of financial statements 1 Accrual basis 2 Going concern
Qualitative Characteristics ◼ Attributes that make accounting information useful 1 Understandability 2 Relevance 3 Reliability 4 Comparability
◼ Also recognized that timeliness and a balance between costs and benefits were constraints
The Elements of Financial Statements ◼ Asset ◼ Liability ◼ Equity ◼ Income ◼ Expense ◼ The concept of recognition – Probable – Measurable
The Concepts of Capital Maintenance ◼ Concepts: 1 Financial capital maintenance 2 Physical capital maintenance
◼ Selection of the measurement bases and the concept of capital maintenance chosen will determine the accounting model ◼ IASC does not intend to prescribe a model
Comparison of IASB & FASB Conceptual Frameworks
IASB 1. Objective of financial statements 2. Qualitative characteristics 3. Financial statement elements 4. Recognition of financial statement elements 5. Measurement of financial statement elements 6. Concepts of capital and capital management
FASB 1. 2. 3. 4. 5.
SFAC No. 1 SFAC No. 2 SFAC No. 5 SFAC No. 6 SFAC No. 7 Much more detailed – possible hindrance to convergence
Current Developments ◼ 2005 joint agenda project ◼ Goals: converge existing frameworks into common framework ◼ Standards should be principles based, rooted in fundamental concepts
IAS No. 1 “Presentation of Financial Statements” ◼ Considerations: a Fair presentation and compliance with IASC standards b Accounting policies c Going concern d Accrual basis of accounting e Consistency of presentation f Materiality and aggregation g Offsetting h Comparative information
IAS No. 1 “Presentation of Financial Statements” 2003 Amendments ◼ “Presents fairly” definition ◼ Elaboration of “misleading” results from complaince ◼ Standards on selection of accounting policies moved to IAS No. 8 ◼ Certain disclosures no longer required ◼ Specific disclosures required ◼ Statement of Changes in Equity disclosure requirements
IFRS No. 1 “First Time Adoption of International Reporting Standards” ◼ Compliance requirements ◼ Recognition of assets and liabilities ❑ Only when required by IFRSs ❑ Requires reclassifying if necessary ❑ Applies existing IFRSs in measuring
End of Chapter 3 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
Chapter 4 Research Methodology And Theories On The Uses Of Accounting Information
Introduction ❑ To have a science is to have a recognized domain and a set of phenomena in that domain ❑ Theory describes the underlying reality of that domain through input (observations) and outputs (predictions) INPUTS OBSERVATIONS
OUTPUTS PREDICTIONS
❑ Very little behavior is explained through existing accounting theory ❑ Theory vs theorizing ❑ Chapter introduces methods of developing theory and some theories on outcomes of providing accounting information
Research Methodology ❑Deductive approach ❑Inductive approach ❑Pragmatic Approach ❑Scientific Method ❑Other
Deductive Approach ❑ Essentially an “armchair” approach ▪
Going from the general to the specific
❑ Begins with the establishment of objectives ❑ Next definitions and assumptions are stated ❑ A logical structure for accomplishing the objectives based on the definitions and assumptions is developed ❑ Attempts to “theorize are generally based on the deductive approach ❑ Validity of this approach lies in the researcher’s ability to relate components ▪
If researcher is in error, conclusions will also be erroneous
Inductive Approach ❑Making observations and drawing conclusions ❑Generalizations are made about the universe based upon limited observations ❑APB Statement No. 4 utilized the inductive approach
Pragmatic Approach ◼ Based upon the concept of utility or usefulness ❑When a problem is found… ❑an attempt to find a solution is undertaken
◼ Most accounting theory was developed using this approach ◼ A Statement of Accounting Principles was a pragmatic approach
The Scientific Method ❑Involves the following steps: Draw a tentative conclusion Analyze and evaluate data Collect data necessary to test the hypotheses
State the hypotheses to be tested
Identify and state the problem to be studied ❑ Most accounting research found in academic journals uses the scientific method
Other Research Approaches ❑Ethical approach – Developed by DR Scott and involves the concepts of truth, justice and fairness
❑Behavioral approach – The study of how accounting information affects the behavior of users
The Outcomes of Providing Accounting Information ❑Fundamental analysis ❑The efficient market hypothesis ❑The capital asset pricing model ❑Normative vs positive accounting theory ❑Agency theory ❑Human information processing ❑Critical perspective research
Fundamental Analysis ❑Investor decisions - Buy - Hold - Sell
❑The goal of fundamental analysis ❑Investment analysis
The Efficient Market Hypothesis ❑ Holds that fundamental analysis is not a useful tool… ▪ because individual investors are not able to identify mispriced securities
The Efficient Market Hypothesis ❑ Based on the free market supply and demand model with the following assumptions: – All economic units have complete knowledge of the economy – All goods and services are completely mobile – All buyers and sellers are so small in relation to total supply and demand that neither has an influence on supply or demand – No artificial restrictions on demand, supply or prices of goods and services
The Supply and Demand Model
Price
Supply
Demand
Quantity
The Supply and Demand Model ❑Best illustrated in the securities market ❑Information available from many sources including: 1 Published financial reports 2 Quarterly earnings reports 3 News reports 4 Published competitor information 5 Contract awardings 6 Stockholder meetings
The Efficient Market Hypothesis ❑According to the supply and demand model, the price of a product is determined by knowledge of relevant information ❑The securities market is viewed as efficient if it reflects all available information and reacts immediately to new information
The Efficient Market Hypothesis ❑ The EMH indicates that an investor with a diversified portfolio cannot make an excess return by knowledge of available information ❑ There are three forms of the EMH which differ in respect to the definition of available information – Weak form – Semi-strong form – Strong form
Weak Form ❑ An extension of the random walk theory in the financial management literature ❑ The historical price of a stock provides an unbiased estimated of its future price ❑ Consequently, an investor cannot make an excess return by knowledge of past prices ❑ This form of the EMH has been supported by several studies
Semi-Strong Form ❑ All publicly available information including past prices is assumed to be incorporated into the determination of security prices ❑ An investor cannot make an excess return by knowledge of any publicly available information ❑ Implication is that the form of disclosure, whether in the financial statements, the footnotes, or financial press information is not important ❑ This form of the EMH has been generally supported in the literature
Strong Form ❑All available information, including insider information is immediately incorporated into the price of securities as soon as it is known leaving no room for excess returns ❑Most available evidence suggest that this form of the EMH is not valid ❑Challenges ▪ 2008 market crash
Efficient Market Hypothesis: Implications ❑ Lack of uniformity in accounting principles may have allowed corporate managers to manipulate earnings and mislead investors. ▪ How are earnings and stock prices related?
❑ Do changes in accounting principles affect stock prices?
The Capital Asset Pricing Model
◼ The goal of investors is to minimize risk and maximize returns. ◼ The rate of return on stock is calculated: Dividends + increases (or - decreases) in value Purchase Price
The Capital Asset Pricing Model
◼ Risk: ❑ The possibility that actual returns will deviate from expected returns
◼ U. S. treasury bills ❑ A risk free investment ❑ Return on these investments is the risk free return
◼ Diversification ❑ Stocks can be combined into a portfolio that is less risky than any of the individual stocks
The Capital Asset Pricing Model ◼ Types of risk are company specific and environmental ◼ Unsystematic risk ❑The risk that is company specific and can be diversified away
◼ Systematic risk ❑The nondiversifiable risk that is related to overall movements in the stock market
◼ Financial information about a firm can help determine the amount of systematic risk associated with a particular stock
The Capital Asset Pricing Model ◼ Assumption is that investors are risk aversive and will demand higher returns for taking greater risks ◼ Beta () ❑ The measure of the relationship of a particular stock with the overall movement of the stock market ❑ viewed as a measure of volatility - a measure of risk
◼ Securities with higher s offer greater returns than securities with relatively lower s
The Relationship Between Risk and Return Rs = R f + Rp Where: Rs = Expected return on a given risky security Rf = The risk free return rate Rp = The risk premium
The Relationship Between Risk and Return ◼ Investors will not be compensated for bearing unsystematic risk since it can be diversified away ◼ The only relevant risk is systematic risk ◼ β = measure of the parallel relationship of a particular common stock with the overall trend in the stock market ❑Stock’s sensitivity to market changes ❑Measure of systematic risk
Incorporating Risk Into the Equation β = :Rs = Rf + βs (Rm - Rf) Where: Rs = the stock’s expected return Rf = the risk-free return rate Rm = The expected market rate as a whole β = The stock’s beta calculated over some historical period
Implications of CAPM ◼ A security’s price will not be impacted by unsystematic risk ❑ Securities with higher s (higher risk) will be priced relatively lower than securities offering less risk
◼ Research has indicated that past s are a good predictor of future stock prices ◼ Criticized because it causes managers to seek only safe investments
Normative vs. Positive theory ◼ Normative theory – based upon a set of goals that its proponents maintain prescribe the ways things should be. ❑Must be accepted by the entire universe to be useful
◼ Positive theory – attempts to explain observed phenomena ❑One positive theory is termed agency theory
Positive Theory ◼ Agency theory ❑Based on economic theories of ◼ Prices ◼ Agency relationships ◼ Public choice ◼ Economic regulation
Positive Theory ❑ Agency theory is based on the assumption that individuals act to maximize their own expected utilities. ❑ As a result the relevant question is:
What is a particular individual’s expected benefit from a particular course of action? ❑ An agency is a consensual relationship between two parties whereby one agrees to act on behalf of the other ❑ Inherent in this theory is that there is a conflict of interest between the shareholders and the managers of a corporation
Positive Theory ◼ Agency relationships involve costs to the principles 1 Monitoring expenditures by the principal 2 Bonding expenses by the agent 3 Residual loss
◼ Agency theory holds that all individuals will act to maximize their own utility ❑ Monitoring and bonding costs will be incurred as long as they are less than the residual loss
Human Information Processing ◼ Annual reports provide vast amounts of information ◼ Disclosure of information is intended to help investors make buy - hold - sell decisions
Human Information Processing ◼ HIP studies ❑ Studies attempting to assess an individual’s ability to use accounting information ❑ Results - individuals have limited ability to process large amounts of information
◼ Consequences: ❑ Selective perception ❑ Difficulty in making optimal decisions ❑ Sequential processing
◼ Implications - extensive disclosures now required may be having opposite effect
Critical Perspectives Research ◼ Previous theories assumed that knowledge of facts can be gained by observation
◼ This area of research contests the view that knowledge of accounting is grounded in objective principles ◼ Belief in indeterminacy - the history of accounting is a complex web of economic, political and accidental consequences
Critical Perspectives Research ◼ Accountants have been unduly influenced by utility based marginal economics that holds: Profit = efficiency in using scarce resources ◼ Conventional accounting theory equates normative and positive theory. What should be and what is are the same
Critical Perspectives Research ◼ Critical perspective research concerns itself with the ways societies and institutions have emerged. ◼ Three assumptions: 1 Society has the potential to be what it isn’t 2 Human action can help this process 3 Critical theory can assist human action
Accounting Research, Education and Practice ◼ How are research, education and practice related in most disciplines? ❑For example, medicine?
◼ How are they related in accounting? ◼ Recent frauds have resulted in new schools of thought
End of Chapter 4 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 5 INCOME CONCEPTS
The Purpose of Income Reporting
Income is used… 1 as the basis of one of the principal forms of taxation. 2 in public reports as a measure of the success of a corporation’s operations. 3 as a criterion for the determination of the availability of dividends. 4 by rate-regulating authorities for investigating whether those rates are fair and reasonable. 5 as a guide to trustees charged with distributing income to a life tenant while preserving the principal for a remainderman. 6 as a guide to management of an enterprise in the conduct of its affairs.
Importance of Income Reporting ◼ FASB ◼ Purpose of financial accounting… ❑ To provide information to financial statement users that will assist them in assessing the amount, timing, and uncertainty of future cash flows
◼ Conflicting assertion… ❑ Corporate earnings information is better predictor of performance than cash-flow information
Importance of Income Reporting ◼ The EMH and stock prices ◼ Economic Vs. Accounting Income ❑ Related sciences ◼ concerned with the activities of business firms ◼ use similar variables ◼ differences over the timing and measurement of income
❑ Relative importance of income statement (accounting) and balance sheet (economics)
◼ “Whisper” numbers
In an Attempt to Reconcile
What is the nature of income? When should income be reported?
What is the Nature of Income? ◼ Three possibilities ❑ Psychic ◼ Satisfaction of human wants
❑ Real ◼ Increase in economic wealth
❑ Money ◼ Increases in monetary value
◼ The concept of well-offness or capital maintenance ❑ Problems
◼ Because of the difficulties in measuring real income Accountants have adopted a transactions approach to income recognition
Capital Maintenance Concepts
Financial capital maintenance - money amount transactions based
VS
Physical capital maintenance - productive capacity
Difference is in the treatment of holding gains & losses
Current Value Accounting ❑The concept of physical capital maintenance requires assets and liabilities to be stated at their current values ❑Approaches: 1 Entry price or replacement cost 2 Exit value or selling price 3 Discounted present value
Entry Price or Replacement Cost ◼ Replacement cost ❑Assets stated at cost to replace them ❑Income determining by matching revenues against current cost of replacing operating assets
◼ Possible alternatives – Edwards and Bell 1 2 3 4
Current operating profit Realizable cost savings Realized cost savings Realized capital gains
Exit Value or Selling Price ◼ Selling Price ❑Assets stated at anticipated disposal price
◼ Holding gains and losses receive immediate recognition ❑Abandons revenue recognition principle
◼ Measurement problems ❑Determining selling price of assets for which there is no ready market (PP&E) ❑Assumption of sales in normal market rather than forced liquidation
Discounted Present Value ◼ Relevant value on balance sheet: ❑PV of future cash flows expected to be received from asset ❑PV of future cash flows expected to be disbursed for a liability
◼ 3 measurement problems ❑Depends on estimate of future cash flows ◼ Both cash flows and timing must be determined
❑Selection of appropriate discount rate ❑Firm’s assets are interrelated
Income Recognition ◼ Transactions approach ❑Elements of financial statements should be reported when there is evidence of arms-length transaction ❑Realization principle: income should be recognized when earnings process is essentially complete (an exchange transaction has taken place) ❑Makes no attempt to place expected value on firm or report on expected changes in values of assets and liabilities ❑Criticized for not reporting all relevant information
Measurement ◼ What is measurement? ◼ Problems with the measurement unit ◼ Arbitrary decisions
Accounting for Inflation ◼ Instability of the accounting measuring unit is due to the effects of inflation or deflation ◼ General purchasing power adjustments
Revenue Recognition Recognition
◼ ◼
Realization
The income producing activities cycle Revenue recognition criteria 1. 2.
◼
The revenue has been earned The revenue has been “realized” or is “realizable
SAB No. 101 criteria 1. 2. 3. 4.
Persuasive evidence of an arrangement exists Delivery has occurred The vendor’s fee is fixed or determinable Collectibility is probable.
Revenue Recognition ◼ The crucial event test ◼ As a result revenue is generally recognized at the point of sale ❑may be advanced or delayed due to surrounding circumstances 1 During production 2 At close of production 3 Services performed 4 Cash 5 Occurrence of some event 5 Special recognition circumstances
Recent Developments ◼ Preliminary Views on Revenue Recognition in Contracts with Customers ❑December 2008 ❑FASB and IASB joint discussion paper ❑Single, contract-based model for recognizing revenue ❑Similar to current GAAP
Other Issues ◼ Delayed or advanced revenue recognition ◼ Revenue recognized ❑ During production process
❑ At completion of production ❑ As services are performed ❑ As cash is received ❑ On occurrence of some event
Matching Cost
Expense Loss
Product VS Period Costs
Matching Cost
Leads to or Results In
Asset
Used up Resulting in Revenue
Used up Resulting in No Revenue
Expense
Loss
Concepts Affecting Revenue Recognition
Conservatism Materiality
Earnings Quality, Earnings Management and Fraudulent Financial Reporting ◼ Earnings quality ❑ The correlation between a company’s accounting and economic income ❑ The existence of the previously discussed issues has led some to the conclusion that economic income is a better predictor of cash flows.
◼ Assessing earnings quality
Earnings Quality, Earnings Management and Fraudulent Financial Reporting ◼ Assessing earnings quality: 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?
2 Review recent changes in accounting principles and changes in estimates to determine if they inflate earnings. 3 Determine if discretionary expenditures, such as advertising, have been postponed by comparing them to previous periods. 4 Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income statement.
Earnings Quality, Earnings Management and Fraudulent Financial Reporting 5
6
Determine the replacement cost of inventories and other assets. Assess whether the company generating sufficient cash flow to replace its assets? Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings 7 and cash flows. 8
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
Earnings Quality, Earnings Management and Fraudulent Financial Reporting ◼
Earnings management ❑
The attempt to influence short-term reported income
Earnings Quality, Earnings Management and Fraudulent Financial Reporting ◼
Arthur Levitt has outlined five earnings management techniques that he described as threatening the integrity of financial reporting: 1. Taking a bath 2. Creative acquisition accounting 3. Cookie jar reserves 4. Abusing the materiality concept 5. Improper revenue recognition
Distinction Between Conservative, Neutral, Aggressive and Fraudulent Earnings Management 1.
Conservative accounting
Overly aggressive recognition of loss or reserve provisions Overvaluation of acquired in process research and development activities
2.
Neutral earnings
Earnings that result from using a neutral perspective
3.
Aggressive accounting
Understating loss or reserve provisions
4.
Fraudulent accounting
Recording sales before they satisfy the earned and measurability criteria Recording fictitious sales Backdating sales invoices Overstating inventory
Red flags of possible fraudulent reporting: 1.
A predominantly insider board of directors
2.
Management compensation tied to its stock price
3.
Frequent changes of auditors
4.
Rapid turnover of key personnel
5.
Deteriorating earnings
6.
Unusually rapid growth
7.
Lack of working capital
Red flags of possible fraudulent reporting: 8.
The need to increase the stock price to meet analysts’ earnings projections
9.
Extremely high levels of debt
10.
Cash shortages
11.
Significant off-balance sheet financing arrangements
12.
Doubt about the company’s ability to continue as a going concern
13.
SEC or other regulatory investigations
14.
Unfavorable industry economic conditions
15.
Suspension or delisting from a stock exchange
End of Chapter 5 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 6 Financial Statements I: The Income Statement
Introduction Various groups are affected by, and have a stake in, the financial reporting requirements of the FASB and the SEC
Introduction Investors in equity securities are the central focus of the financial reporting environment
Introduction ◼ Investing involves ❑ giving up current resources
❑
◼
for future uncertain resources.
Therefore, investors require information assessing future cash flows.
The Economic Consequences of Financial Reporting ◼ Financial reporting has economic consequences including: 1 Financial information can affect the distribution of wealth among investors. ➢ More informed investors, or investors employing security analysts, may be able to increase their wealth at the expense of less informed investors.
The Economic Consequences of Financial Reporting 2 Financial information can affect the level of risk accepted by a firm. ➢ Focusing on short-term, less risky, projects may have long-term detrimental effects.
3 Financial information ➢ ➢
can affect the rate of capital formation in the economy and result in a reallocation of wealth between consumption and investment within the economy.
The Economic Consequences of Financial Reporting
4 Financial information can affect how investment is allocated among firms.
◼
These economic consequences may have a differential impact on different user groups and future deliberations of standards must consider these economic consequences
Income Statement Elements ◼ SFAC No. 1: Primary focus of financial reporting is to provide information about a company’s performance ◼ SFAC No. 2: Predictive value
Income Statement Elements Vehicle for relaying performance assessments to investors ◼ SFAC No. 6: defined the elements of the income statement ◼
❑
❑ ❑ ❑
Revenues Gains Expenses Losses
Differing Approaches Changes in Assets/Liabilities Approach
Inflow and Outflow
Determines earnings as measure of change in net economic resources for period
Income is measure of effectiveness
Depends on definition of assets and liabilities
Depends on definition of revenues and expenses
Recognizes deferred items only when actually economic resources or obligations
Results in creation of deferrals and reserves
Limited to net economic resources
May include costs to match with revenues even if they do not represent change in net resources
Statement Format ◼ The preparation of the income statement has been impacted by differences of opinion on the definition of ongoing operations. ◼ Two views: All inclusive 2 Current operating performance 1
Current Income Statement Format ◼ Proscribed in APB Opinion No. 9 as: Revenues Less: Cost of goods sold = Gross profit Less: Administrative and selling expenses Plus: Other gains Less: Other losses
= Income from continuing operations Discontinued operations Extraordinary items Change in accounting principle = Net income
Excludes prior-period adjustments
Income From Continuing Operations
◼ Normal and recurring revenues and expenses ❑ Sustainable income ❑ Income tax (recurring items)
◼ Nonrecurring items ❑ Discontinued operations ❑ Extraordinary items ❑ Change in accounting principle
Tootsie Roll and Hershey ◼ Tootsie Roll Industries and The Hershey Company are internationally known candy manufacturers.
◼
We will use information from the two companies’ fiscal 2004 2008 annual reports to illustrate the disclosure of information in this and subsequent chapters.
Discontinued Operations ◼ Why special treatment? ◼ Arise from a disposal of a segment of a business ◼ Comprised of two elements ❑ Gain or loss on disposed assets ❑ Gain or loss on operations during the disposal periods
◼ When to report ❑ Measurement date ❑ Disposal date
SFAS No. 144 ◼ Changed reporting of discontinued operations: ❑ Unit must qualify as a component (distinguishable assets and cash flows ❑ Operations and cash flows of component must be eliminated ❑ Company does not retain any significant involvement in operations of component
◼ Neither Hershey or Tootsie Roll disclosed any discontinued operations
Accounting for Discontinued Operations Under Continuing Review ◼ FASB Exposure Draft ❑ September 2008 ❑ Amending the Criteria for Reporting a Discontinued Operation
◼ IASB Exposure Draft ❑ Discontinued Operations
◼ Definitions in SFAS No. 144 and IFRS No. 5 not convergent ◼ Proposed definition: ❑ An operating segment that has been disclosed of or is up for sale; or ❑ A business that meets the criteria to be classified as held for sale on acquisition.
Extraordinary Items ◼ Original definition ◼ Problems ◼ APB Opinion No. 30 ❑ Unusual nature ❑ Infrequency of occurrence ◼ Problem: ❑ Requirements do not always separate recurring and non-recurring items ❑ As a result, there is a tendency to increase the variability of operating income and decrease the predictive ability of earnings ◼ The events of 9/11 ◼ Neither company discloses any extraordinary items for the years presented
Accounting Changes ◼ The accounting standard of consistency requires that similar transactions should be reported similarly each year ❑ Occasionally an entity may find that reporting needs are better served by changing a method of accounting ❑ If so, the comparability of financial statements is impaired
◼ Basic question: Should previously issued financial statements be amended?
Types of Accounting Changes ◼ Change in accounting principle ❑ How reported ◼
APB Opinion No 20 ❑
◼
Changes required only in current statements
SFAS No 154 ❑
Requires changes in previously issued statements
◼ Change in an accounting estimate ❑ Reported prospectively
◼ Change in a reporting entity ❑ Must be disclosed retroactively
◼ Errors (not viewed as accounting changes) ❑ Nature and effect must be disclosed
Earnings Per Share ◼ Quick and efficient way to compare firms’ performances ◼ Basic calculation Net income - Preferred dividends Average # of common shares outstanding
◼ APB Opinion No. 15 ◼ Simple vs. complex capital structure ◼ Required calculation of primary and fully diluted earnings per share ◼ Criticism of APB No. 15 ❑ Arbitrary, too complex, and illogical
◼ IAS No. 33 and SFAS No. 128
Diluted Earnings Per Share ◼ Objective ❑ Historical - basic ❑ Pro forma - diluted
◼ Calculation: ❑ Includes all potential dilutive securities 1. Options and warrants - treasury stock method 2. Written put options – reverse treasury stock method 3. Convertible securities ❑ “as-if-converted”
4. Contingently issuable securities
Usefulness of EPS ◼ Objectives of EPS reporting are to provide investors an indication of : 1
Value of the firm
2
Expected future dividends
◼ Question: Historical or forecasted? ◼ Summary indicator
Comprehensive Income ◼ Comprehensive income definition: ❑ The change in net assets of an entity from non-owner transactions
◼ FASB ❑ May 26, 2010 – released proposed ASU Statement of Comprehensive Income ◼ Would require most entities to provide a new primary financial statement, referred to as the statement of comprehensive income
◼ IASB ❑ May 27, 2010 – released Presentation of Financial Statements
◼ All components of net income and other comprehensive income to be reflected with equal prominence in one continuous statement of comprehensive income
Prior Period Adjustments ◼ An adjustment to beginning retained earnings balance ◼ Original criteria in APB No. 9 ❑ Examples were income tax disputes and litigation
◼ SEC Staff Bulletin No. 8 and APB Opinion No. 16 ❑ Correction of an error ❑ Adjustments from realization of operating loss carryforward of purchased subsidiary
Proposed Format of Statement of Comprehensive Income ◼ Separate categories for disclosure of ❑ Operating business activities ❑ Financing activities ❑ Investing activities ❑ Tax payments
◼ Subtotal for each category ◼ All income and expense items to be classified into operating, investing, and financing ❑ Disaggregate line items by function ◼
Function: the primary activities in which an entity is engaged
❑ Further disaggregate line items by nature ◼
Nature: the economic characteristics or attributes that distinguish assets, liabilities, and income and expense items that do not respond equally to similar economic events
The Value of Corporate Earnings ◼ The financial analysis of a company’s income statement focuses on a company’s operating performance by focusing on such questions as: 1. 2. 3. 4. 5.
What are the company’s major sources of revenue? What is the persistence of a company’s revenues? What is the company’s gross profit ratio? What is the company’s operating profit margin? What is the relationship between earnings and the market price of the company’s stock?
Sources of Revenue ◼ The financial analysis of a diversified company requires a review of the impact of various business segments on the company as a whole. ◼ Hershey reports segmental information for two segments:
❑ domestic ❑ international ◼ Tootsie Roll reports segmental information for two segments:
❑ domestic ❑ international ◼ Neither company discloses any information about major customers.
Persistence of Revenues 5-Year Revenue Trend Analysis 120% 115% 110% 105%
100% 100%
100% 95% 90% 2004 2005 2006 2007 2008 Hershey
Tootsie
Management’s Discussion and Analysis ◼ The MD&A section of a company’s annual report can provide valuable information on the persistence of a company’s earnings and its related costs. ❑ SEC requires companies to disclose any changes or potential changes in revenues and expenses to assist in the evaluation of period-to-period deviations. ◼ Tootsie Roll indicated decrease in gross profit percentage from 2007 to 2008
Gross Profit Analysis Gross Profit Percentage = Gross profit ÷ net sales 5-Year Gross Profit Trend Analysis 50.0% 40.0%
39.5% 37.8% 41.5% 38.7% 34.2% 38.7% 38.0% 33.0% 32.9% 34.2%
30.0% 20.0%
10.0% 0.0% 2004
2005
Hershey
2006
2007
Tootsie
2008
Net Profit Analysis Net Profit Percentage = Net Income ÷ Net Sales 5-Year Net Profit Trend Analysis 20.0% 15.0%
15.3% 15.8% 13.0% 13.3% 10.1% 11.3%
10.5%
10.0%
7.9% 6.1% 4.3%
5.0%
0.0% 2004
2005
Hershey
2006
2007
Tootsie
2008
The Value of Corporate Earnings ◼The relationship between corporate earnings and stock prices ◼Measured by price earnings ratio P/E Ratio = Current market price per share ÷ EPS
Hershey Tootsie
= 24.64 = 36.59
Price-Earnings Ratios Operating Profit Percentage = Operating profit ÷ Net Sales
5-Year Net Profit Trend Analysis 45.00
35.00 25.00
41.04
36.59
30.13
29.10 28.43 23.43 22.10 20.0920.41
24.64
15.00 5.00
(5.00) 2004
2005
Hershey
2006
2007
Tootsie
2008
International Accounting Standards ◼ In addition to release of IAS No. 33 on EPS, IASB has: 1. Defined the concepts of performance and income in “Framework for the Preparation and Presentation of Financial Statements” 2. Discussed the content and format of the income statement in IAS No. 1, “ Presentation of financial Statements” 3. Discussed some components of the income statement in an amended IAS No. 8, now titled "Accounting Policies, Changes in Accounting Estimates and Errors" 4. Defined the concept of revenue in IAS No. 18, “Revenue” 5. Amended IAS No. 33
6. Discussed the required presentation and disclosure of a discontinued operation in IFRS No. 5, “Non-Current Assets Held for Sale and Discontinued Operations” 7. Issued a proposed amendment to IAS No. 1
IASB Definitions of Performance and Income ◼Profit is used ❑to measure performance ❑or as the basis for other measures
◼Measurement of income is dependent on ❑the concept of capital maintenance used by the enterprise ◼ Physical capital maintenance ◼ Financial capital maintenance
IASB Definitions of Performance and Income ◼ The IASB definition of income encompasses both revenue and expenses ◼ The IASB has not made the distinction between ordinary and nonordinary operations contained in SFAC No. 6 ◼ A proposed standard would require a “Statement of Non-owner Movements in Equity” ◼ Encourages an analysis of income and expenses based on their nature or function in the enterprise
International Accounting Standards ◼ IAS No. 1 ❑Requires income statement that includes ◼ Revenue ◼ Results of operations ◼ Finance costs ◼ Gains & losses from equity investments ◼ Tax expense ◼ Profits or losses from ordinary activities ◼ Minority interest ◼ Net profit
❑Does not require discontinued operations or accounting changes to be reported separately ❑Does not allow items to be classified as ordinary
International Accounting Standards ◼ IAS No. 8 ❑Goal is consistency ❑Material errors to be corrected retrospectively
◼ IAS No. 18 ❑Concept of revenue measurement
◼ Amended IAS No. 33 ❑Additional disclosures and guidelines
◼ Current FASB-IASB project ❑Revenue recognition
International Accounting Standards ◼ IAS No. 5 replaced IAS No. 35 ❑Defines discontinued operations ❑New requirements
End of Chapter 6 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 7 FINANCIAL STATEMENTS II:
Introduction Financial reports can be divided into two categories
◼
1.
Results of the flows of resources over time (flows)
2.
The status of resources at a point in time (stocks)
Statement of Retained Earnings
Balance Sheet
Past Emphasis ◼ Income statement ❑
based on the assumption that flows were more important than stocks
◼ Frequently resulted in the
measurement of stocks at residual values
FASB ◼ asset - liability approach ◼ changes in balance sheet amounts becoming
more important in income determination
In this chapter Balance sheet and the associated measurement techniques for its elements Statement of cash flows and its evolution over time
The Balance Sheet ◼ Should disclose wealth of a company at a point in
time ❑
Wealth is present value of all ◼ resources ◼ obligations
The Balance Sheet This measurement technique is limited ◼ Consequently, a variety of measurement techniques are used to measure the elements of the balance sheet ◼
Historical (Historical cost) Current oriented (Current value) Future oriented (Expected realizable value)
Balance Sheet Elements ◼
The elements of the balance sheet were defined in SFAC No. 6 as:
Assets Liabilities Equity ◼ ◼
Definitions arise from the FASB’s asset - liability approach to income determination Departure from previous definitions that resulted in valuations arrived at via the residual effect of income determination
Components of the Balance Sheet Assets
Liabilities
Current assets Investments Property, plant, and equipment Intangible assets Other assets
Current liabilities Long-term debt Other liabilities
Stockholder’s Equity Capital stock Additional paid-in capital Retained earnings
Asset Valuation Asset
Measurement basis
Cash
Current value
Accounts receivable
Expected future value
Marketable securities
Fair value
Inventory
Current or past value
Investments
Fair value, amortized cost, or equity method
Prepaid items
Historical cost
Property, plant and equipment
Depreciated past value
Liabilities and Their Associated Measurement Techniques Liability
Measurement
Current Liabilities
Liquidation Value
Long-term & Other Liabilities
Liquidation Value or Present Value
Do measurement techniques bias statements in favor of current investors?
Stockholders’ Equity Accounts and Their Associated Measurement Techniques Account
Measurement basis
Common Stock
Historical Cost (Par Value vs Selling Price)
Preferred Stock
Historical Cost
Retained Earnings & Other Comprehensive Income
Dependent upon income Recognition
Fair Value Measurements under SFAS No. 157 (Now FASB ASC 820) ◼ New definition for fair value ◼ Fair value Hierarchy for sources of
information ◼ New disclosures of assets and liabilities ◼ Modification of presumption of transaction price
Illustration of Tabular Disclosures for Assets Remeasured on a Nonrecurring Basis ($ in millions) Description
Fair Value Measurements Using Year Ended 12/31/XX
Long-lived assets held and used
$75
Goodwill
30
Long-lived assets held for sale
26
Quoted Prices in Active Markets for Inputs Identical 1 Assets (Level 1)
Significant Other Observable (Level 2)
Significant Unobservable Inputs (Level 3)
$75
$(25) $30
26
Total Gains (Losses)
(35)
(15) $(75)
Modification of Transaction Price Presumption ◼ SFAS No 157 did away with presumption ◼ Entities should consider whether certain
factors might indicate that transaction price does not represent fair value
FASB Staff Position FAS No. 157-4 ◼ SEC study on fair value accounting ❑
Recommended existing fair value accounting and mark-to-market standards not be suspended
◼ FSP FAS 157-4
Provided guidance on how to determine when the volume and level of activity for an asset or liability has significantly decreased ❑ Identified circumstances in which a transaction is not orderly ❑
Proposed Format of Statement of Financial Position ◼ FASB-IASB Project (Phase B) ◼
Groups assets and liabilities together Operating ❑ Investing ❑ Financing ❑
◼ Provides separate section
for stockholders’ equity
Evaluating A Company’s Financial Position Return on Asset Net income Average total assets Profit margin Net income Net sales Asset turnover ratio Net sales Average total assets
Hershey & Tootsie Return on Assets Hershey 2008
2007
$311,405 ($3,634,719 + 4,247,113)/2 =7.90%
$214,154 ($4,247,113 + 4,157,565)/2 =5.10%
Tootsie 2008
2007
$38,777 ($812,092 + 812,725)/2 =4.77%
$51,625 ($812,725 + 791,639)/2 =6.44%
Hershey and Tootsie: Return on Assets Return on Assets 7.90%
8.00% 6.00%
5.10%
6.44% 4.77%
4.00% 2.00% 0.00% 2007 Hershey
2008 Tootsie
Hershey & Tootsie Other Ratios
Profit margin Asset turnover
Hershey 9.14% 1.30
Tootsie 7.93% 0.606
Evolution of the Statement of Cash Flows ◼
Prior to 1971 ❑
only two required financial statements
Firms were preparing funds statements ◼ No guidelines - Methods of preparing statement: ◼
1 2 3
Cash Working capital All financial resources
APB No. 3 - recommended ◼ APB No. 19 - mandatory - all financial resources ◼
APB Opinions 3 and 19 ◼ Designed to answer the following questions 1 2 3
4 5 6 7 8 9
Where did the profits go? Why weren’t dividends larger? How was it possible to distribute dividends in the presence of a loss? Why are current assets down when there was a profit? Why is extra financing required? How was the expansion financed? Where did the funds from the sale of securities go? How was the debt retirement accomplished? How was the increase in working capital financed?
Cash Flow Information ◼
Should enable financial statement users to Predict the amount of cash that is likely to be distributed as dividends or interest ❑ Evaluate risk ❑
◼
Presentation of cash flow information assists in evaluating ❑
Liquidity ◼
❑
Solvency ◼
❑
nearness to cash going concern
Financial flexibility ◼
react to crisis
Historical Perspective ◼
◼
Discussion memorandum ❑ “Reporting Funds Flows, Liquidity, and Financial Flexibility” ❑ preceded the issuance of SFAS No. 95 Questions raised in this DM included: 1. Which concept of funds should be adopted? 2. How should transactions not having a direct impact on funds be reported? 3. Which of the various approaches should be used for presenting funds flow information? 4. How should information about funds flow from operations be presented? 5. Should funds flow information be separated into outflows for (a) maintenance (b) expansion of operating capacity, and (c) nonoperating purposes
Historical Perspective ◼ Exposure Draft ❑
“Reporting Income, Cash Flows and Financial Position of Business Enterprises”
◼ SFAC No. 5 ❑
“Recognition and Measurement in Financial Statements of Business Enterprises”
Purpose of the Statement of Cash Flows ◼ Provide relevant information about
cash receipts and cash payments of an enterprise ◼ Objectives of accounting discussed in SFAC
No’s. 1 and 5 led to conclusion ❑
Statement of cash flows should replace the previously required statement of changes in financial position
Statement Format ◼ Report changes during an accounting
period in cash and cash equivalents for Net cash flows from operations ❑ Investing transactions ❑ Financing transactions ❑
◼ Fiscal 2008:
Hershey had a net decrease in cash of $92,095,000 ❑ Tootsie had a net increase in cash of $11,302,000 ❑
Cash Flows From Operating Activities ◼ Cash effect from transactions
that enter into the determination of net income ❑
exclusive of financing and investing activities
◼ Direct vs Indirect method ◼ SFAS No. 95 ❑
Encouraged companies to report operating activities in major classes
◼ Hershey vs Tootsie 2008
Hershey $519,561,000 ❑ Tootsie $57,042,000 ❑
Cash Flows From Investing Activities ◼ Making and collecting loans ◼ Acquiring and disposing of debt
or equity securities of other companies ◼ Acquiring and disposing of property, plant, and equipment and other productive resources ◼ Hershey vs Tootsie 2008 Hershey ($198,204,000) ❑ Tootsie ($7,074,000) ❑
Cash Flows From Financing Activities Results from… Obtaining resources from owners ◼ Providing owners with a return of and a return on their investment ◼ Borrowing money and repaying the amount borrowed ◼ Obtaining and paying for other resources from long-term creditors ◼ Hershey vs Tootsie 2008 ◼
Hershey ($413,452,000) ❑ Tootsie ($38,666,000) ❑
Proposed Format of Statement of Cash Flows
◼ Phase B of FASB-IASB Presentation Project ◼ Expanded version of direct method ◼ Additional disclosures for each category
◼ New schedule, in notes, to reconcile cash
flows to operating income
Proposed Format of Statement of Cash Flows
◼ Categories: ❑
Business ◼ ◼
Operating Investing
Financing ❑ Income Taxes ❑ Discontinued Operations ❑ Equity ❑
Financial Analysis of Cash Flow Information ◼
A major objective of accounting to provide data allowing the presentation of cash flows to investors and creditors ❑ to allow evaluation of risk ❑
Net income is not directly associated with cash ◼ Investors expect return equal to market rate of interest for investments with equal risk ◼
discounted future cash flows > investment
Uses of Cash Flow Information Past cash flows are the best indicators of future cash flows ◼ Empirical research indicates cash flow information ◼
has an incremental value over earnings ❑ and is superior to disclosure of changes in working capital ❑
Uses of Cash Flow Information Net cash provided (used) from operating activities -Net cash used in acquiring PP&E -Cash dividends paid
Free Cash Flow Indicator of a company’s ability to pay off debt & maintain growth.
Free Cash Flows Hershey
Tootsie
2007
2008
2007
2008
$336,875
($6,031)
$57,577
$5,130
(in millions)
◼ Hershey went from positive to negative ◼ Tootsie remained positive but metric
deteriorated
International Accounting Standards ◼ The IASB has discussed: 1
The statement of financial position and the various measurement bases used in accounting Defined assets, liabilities and equity in “Framework for the Preparation and Presentation of Financial Statements”
The information to be disclosed on the balance sheet and statement of cash flows in a revised IAS No. 1 3 The presentation of the statement of cash flows in IAS No. 7, “Cash Flow Statements” 2
Preparation and Presentation of Financial Statements Economic decisions made by users require an evaluation of the ability of an enterprise to generate cash Financial position of an enterprise is affected by its ➢ financial structure ➢ liquidity and solvency ➢ capacity to adapt to change (financial flexibility) Measurement bases include ➢ historical cost (most common) ➢ current cost ➢ realizable value ➢ present value Definitions of assets, liabilities and equity are similar to U. S. GAAP
IAS No. 1: Presentation of Financial Statements Recommends disclosures similar to U. S. GAAP ◼ Revised IAS No. 1 ◼
❑
requires assets to be classified as current and noncurrent ◼ unless a liquidity presentation provides more relevant and reliable
information ❑
recognizes that there are differences in the nature and function of assets, liabilities, and equity ◼ so fundamental that they should be presented on the face of the
balance sheet. ◼
Specifies specific categories of items to be disclosed
IAS No. 7 Operating, financing and investing activities are to be disclosed ◼ Indirect or direct method of disclosing operating activities may be used ◼
❑
stated a preference for the direct method.
◼ Cash flows from extraordinary items
required to be disclosed separately as operating, investing or financing. ◼ Acquisition or disposal of subsidiaries ◼ Will significantly change presentation of statement of cash flows.
End of Chapter 7 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 8 WORKING CAPITAL
Working Capital Net short-term investment needed to carry on day-to-day activities ◼ Computed ◼
Minus
Current Assets
Current Liabilities
Working Capital Issues 1.
2.
3.
Inconsistencies in the measurements of its components Differences of opinion over what should be included as the elements Lack of precision in defining the elements ❖
particularly with respect to the terms “liquidity” and “current”
Purpose of the Chapter Examine the foundation of the working capital concept 2 Review the concept and its components as currently understood 3 Illustrate how the adequacy of a company’s working capital can be evaluated 4 Discuss possible modifications 1
Development of the Working Capital Concept Fixed vs. circulating capital ◼ The double-account system ◼ Creditor vs. investor point of view ◼ Liquidity as the basis for asset classification on the balance sheet ◼ Will be vs. could be ◼ Anson Herrick and ARB No. 3 - the operating cycle ◼ Current usage - indication of liquidity and degree of protection to short-term creditors ◼
Components of Working Capital ◼ ARB No. 43
Definition of working capital ❑ Examples of current assets and current liabilities ❑ Affirmed in No. 115 (FASB ASC 330) ❑
Current Assets Cash ◼ Cash equivalents ◼ Temporary investments ◼ Alternative methods ❑ Historical cost ❑ Fair value ❑ Lower of cost or market ◼
◼
◼
◼
SFAS No. 12 ❑ Why adopted Problems with SFAS No. 12 Temporary investments under SFAS No. 115 (FASB ASC 320) ❑ Trading securities ❑ Available-for-sale securities ❑ Held-to- maturity securities ❑ Transfer between categories
Current Assets ◼ Receivables ❑
Categories
Trade ◼ Nontrade ❑ Bad debts ❑ SFAS No. 114 ◼
◼ Inventories
Inventory quantity ❑ Flow assumption ❑ Market fluctuations ❑
◼ Prepaids
Current Liabilities ▪Payables ▪Deferrals ▪Current maturities of long-term debt
Current Maturities
Payables
Financial Analysis of a Company’s Working Capital Position
◼ How do liquidity problems
occur? ◼ Evaluate with ratio analysis
Working Capital Current Assets
◼ Problems with its use
Current Liabilities
Working Capital Hershey Current Assets
Current Liabilities
Working Capital
2008
$1,344,945 -
1,270,212
=
$ 74,733
2007
$1,426,574 -
1,618,770
=
($192,196)
Tootsie Roll Current Assets
Current Liabilities
Working Capital
2008
$187,979 -
59,252
=
$ 128,727
2007
$199,726 -
57,972
=
$141,754
Working Capital for both companies’ has worsened, although Tootsie Roll is in a better position in both years, with respect to this metric alone.
Current Ratio
Current assets Current liabilities
Current Ratio Hershey 2008
$1,344,945 $1,270,212 =
1.06:1
2007
$1,426,574 = $1,618,770
0.88:1
Tootsie Roll 2008
$187,979 $59,252 =
3.17:1
2007
$199,726 = $57,972
3.45:1
Hershey’s current ratio is improving, while Tootsie Roll’s current ratio is worsening. Tootsie Roll’s current ratio is better than Hershey’s for both years.
Acid Test (Quick) Ratio
Cash + Marketable Securities + Receivables Current liabilities
Acid Test (Quick) Ratio Hershey 2008
$37,103 + 455,153 $1,279,212
=
0.39:1
2007
$129,198 + 487,285 $1,618,770
=
0.38:1
2008
$68,908 + 17,963 + 31,213 $59,252
=
1.99:1
2007
$57,606 + 41,307 + 32,371 $57,972
=
2.26:1
Tootsie Roll
Quick ratio is worsening for both companies. Tootsie Roll’s quick ratio is significantly better than Hershey’s for both years.
Cash Flow from Operations to Current Liabilities
Net cash provided from operating activities
Average current liabilities
Cash Flow from Operations to Current Liabilities Hershey 2008
$519,561 ($1,270,212 + 1,618,770) /2
=
0.36:1
2007
$788,836 ($1,618,770 + 1,453,538) /2
=
0.51:1
2008
$57,042 ($59,252 + 57,972) /2
=
0.97:1
2007
$90,064 ($57,972 + 62,211) /2
=
1.50:1
Tootsie Roll
This metric is deteriorating for both companies.
Receivables ◼ Accounts receivable turnover ratio
Net Credit Sales
Average Accounts Receivable ◼ Days in receivables
365 Accounts Receivable Turnover Ratio
Accounts Receivable Turnover Ratio Hershey 2008
$5,132,768 ($455,153 + 16,700 + 487,285,+ 17,800) /2
=
10.51
2007
$4,946,716 ($487,285 + 17,800 + 584,033 + 18,700) /2
=
8.93
2008
$492,051 ($31,213 + 1,923 + 32,371 + 2,287) /2
=
14.52
2007
$492,742 ($32,371 + 2,287 + 41,211 + 2,322) /2
= 12.60
Tootsie Roll
This metric is improving for both companies.
Days in Receivables Ratio Hershey 2008
365 10.51
=
34.73
2007
365 8.93
=
40.87
2008
365 14.52
=
25.14
2007
365 12.60
=
28.97
Tootsie Roll
Inventory ◼ Inventory turnover ratio
Cost of Goods Sold
Average Inventory ◼ Average days in inventory
365 Inventory Turnover Ratio
Inventory Turnover Ratio Hershey 2008
$3,375,050 ($592,530 + 600,185) /2
=
5.66
2007
$3,315,147 ($600,185 + 648,820) /2
=
5.31
Tootsie Roll 2008
$333,314 ($34,862 + 20,722 + 37,031 + 20,371) /2
=
5.90
2007
$327,695 ($37,031 + 20,371 + 63,957) /2
=
5.40
This metric is improving for both companies.
Days in Inventory Hershey 2008
365 5.66
=
64.49
2007
365 5.31
=
68.74
2008
365 5.90
=
61.86
2007
365 5.40
=
67.59
Tootsie Roll
Accounts Payable ◼ Accounts payable turnover ratio
Inventory Purchases
Average Accounts Payable ◼ Average days payables outstanding
365 Accounts Payable Turnover Ratio
Accounts Payable Turnover Ratio Hershey 2008
$3,375,050 – 7,655 ($249,454 + 223,019) /2
=
14.25
2007
$3,315,147 – 48,635 ($223,019 + 155,517) /2
=
17.26
2008
$333,314 – 1818 ($13,885 + 11,572) /2
=
26.04
2007
$327,695 – 6,555 ($11,572 + 13,102) /2
= 26.03
Tootsie Roll
This metric is worsening for Hershey and is flat for Tootsie Roll. Tootsie Roll’s payables are satisfied more quickly than Hershey’s.
Days in payables outstanding Hershey 2008
365 14.25
= 25.61 days
2007
365 17.26
=
21.15 days
Tootsie Roll 2008
365 26.04
= 14.01 days
2007
365 26.03
=
14.02 days
Summary of Hershey’s Working Capital Position 1.
2.
3.
4.
Customers pay accounts receivable in approximately 35 days. Inventory remains on hand for approximately 64 days. Current operations are generating sufficient cash to repay current liabilities. Accounts payable are being satisfied in approximately 26 days.
Summary of Tootsie’s Working Capital Position 1.
2.
3.
4.
Accounts receivable are paid in approximately 25 days. Inventory remains on hand for approximately 62 days. Current operations are generating sufficient cash to repay current liabilities. Accounts payable are being satisfied in approximately 14 days.
International Accounting Standards ◼ The IASC has issued
pronouncements on the following issues affecting working capital: 1
Revised IAS No. 1, “Presentation of Financial Statements” ❖
2
3
presentation of current assets and current liabilities
IAS No. 39, “Financial Instruments: Recognition and Measurement” IAS No. 2 , “Inventories”
IAS No. 1 ◼
◼
◼ ◼ ◼
The IASC did not attempt to deal with the valuation issues discussed earlier in the chapter Discussed two views of current assets and current liabilities: 1 A measure of liquidity 2 Identification of circulating resources and obligations Since these views are contradictory, it has lead to classifications of items by convention Allows, but does not require, companies to decide whether or not to sub-classify assets and liabilities as current FASB staff review indicated that it was quite similar to U. S. GAAP
IAS No. 25 ◼
◼
◼
Allows investments classified as current to be accounted for by market value or LCM Value may be determined individually, by investment category, or on a total portfolio basis Preference for the total portfolio or investment category methods
IAS No. 2 ◼
◼
Objective of inventory reporting is to determine proper amount of cost to recognize as an asset Specific identification method preferred ❑ If not feasible, FIFO or weighted average preferred ❑ Revised IAS No. 2: LIFO is no longer allowed ❑ Inventory must be written down to net realizable value on item-byitem basis
End of Chapter 8 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 9 LONG TERM ASSETS I: PROPERTY, PLANT AND EQUIPMENT
Property, Plant, and Equipment Represent a major source of future service potential ◼ Valuation is important because ◼
indication of physical resources available to the firm ❑ and may give some indication of future liquidity and funds flow. ❑
Accounting Objectives 1 2
3
4
5
Accounting and reporting to investors on stewardship Accounting for the use and deterioration of plant and equipment Planning for new acquisitions through budgeting Supplying information for taxing authorities Supplying rate-making information for regulated industries
Accounting for Cost ◼ Initial cost: sacrifice of resources given up now to
accomplish future objectives ◼ Preferred measurement technique:
discounted present value of future receipts ❑
Indicates future services potential
Accounting for Cost ◼ Some problems
Group purchases ❑ Self constructed assets ❑ Removal of existing assets ❑ Non-monetary exchange ❑ Donated or discovery values ❑
Group Purchases ◼ Total acquisition cost must
be allocated to the individual assets ◼ Usual method: ❑
base the allocation on the relative fair market values
Self Constructed Assets ◼
What is cost? ❑
Include all incremental costs ◼
Allocation of fixed overhead None ❑ Incremental ❑ Same basis as other products ❑
◼
Interest ❑
SFAS No 34 (FASB ASC 835-20) issues ◼ ◼
The concept of qualified assets The amount to capitalize
Removal of Existing Assets ◼ Charge removal cost less
proceeds to cost of land
Assets Acquired in Noncash Transactions ◼
APB No. 29 (FASB ASC 845)
◼
Fair value for most ❑ Book value when the exchange is not the culmination of the earnings process Recording gains and losses on nonmonetary assets with Commercial substance under SFAS 153 ❑ Definition ❑
❑
Record at book value
Donated and Discovery Values ◼ How they occur
◼ Accounting Under SFAS No. 116
(FASB ASC 605-10-15-3)
Financial Analysis of Property Plant and Equipment ◼
The impact of PP & E on the return on assets ratio Sustainability of earnings ❑ Evaluating a company’s replacement of assets policy ❑
Financial Analysis of Property Plant and Equipment PP&E Acquisitions (in millions) 300
262.6 189.7
200 100
34.4
14.8
0 2008 Hershey
2007 Tootsie
Financial Analysis of Property Plant and Equipment PP&E Acquisitions (As % of total assets) 10.0%
7.6%
8.4%
5.3% 5.0%
3.9%
0.0% 2008 Hershey
2007 Tootsie
Financial Analysis of Property , Plant and Equipment ◼
The companies’ return on assets percentages are not being distorted by a failure to systematically replace their long-term assets
Cost Allocation Capitalization implies future service potential ◼ Matching concept requires expiration of future service potential to be recorded in the period incurred ◼
❑
◼
Actual expiration of future service potential difficult to ascertain ❑
◼
“cost allocation”
method of cost allocation should be systematic and rational
Depreciation is a form of cost allocation
The Depreciation Process ◼ Issues:
Establishing the proper depreciation base 2 Determining useful service life 3 Choosing a cost allocation method 1
❖ ❖ ❖
Straight-line Accelerated Units of Activity
Capital Vs. Revenue Expenditures Whether to capitalize or charge to expense expenditures required for an existing long-term asset ◼ Criteria ❑
Prolong life or increase efficiency
❑
Ordinary and necessary
Capitalize Expense
Recognition and Measurement Issues
◼ User needs are currently not being satisfied
◼ Suggests a current value approach
Impairment of Value ◼ Long-term asset accounting should be similar to
accounting for other assets ❑
Asset should be written down when value diminishes
◼ SFAS No.121 ❑
Impairment occurs when carrying amount is not recoverable
Future cash flows < Book value ❑
Recognize loss when book value is not recoverable
SFAS No. 144: Accounting for the Impairment or Disposal of Long-Lived Assets
W
? y h
◼
◼
Issued because SFAS No. 121 did not address accounting for a segment of a business accounted for as a discontinued operation under APB Opinion 30. ❑ Consequently, two accounting models existed for long-lived assets to be disposed of. The Board decided to establish a single accounting model ❑ based on the framework established in SFAS No. 121, for long-lived assets to be disposed of by sale.
SFAS No. 144: Accounting for the Impairment or Disposal of Long-Lived Assets (See FASB ASCs 360-35-15 to 49) ◼
Applies to all dispositions of longterm assets ❑
❑
1. 2.
3.
Excludes current assets, intangibles and financial instruments because they are covered in other releases. According to its provisions assets are to be classified as: Long-term assets held and used Long-lived assets to be disposed of other than by sale Long-Lived Assets to Be Disposed Of by Sale
SFAS No. 144: Accounting for the Impairment or Disposal of Long-Lived Assets ◼
◼
◼
Long-term assets held and used are to be tested for impairment using the SFAS No. 121 criteria if events suggest there may have been an impairment. The impairment is to be measured at fair value by using the present value procedures outlined in SFAC No. 7. For long-term assets held and used, it might be necessary to review the original depreciation policy to determine if the useful life is still as originally estimated.
SFAS No. 144 (FASB ASC 360): Accounting for the Impairment or Disposal of Long-Lived Assets ◼
◼
◼
Next the assets are grouped at the lowest level for which identifiable cash flows are independent of cash flows from other assets and liabilities Losses are allocated to the assets in the group on a pro-rata basis. Any losses are disclosed in income from continuing operations
SFAS No. 143 (FASB ASC 410-20): Accounting for Asset Retirement Obligations ◼
◼
Objective: to provide accounting requirements for all obligations associated with the removal of long-lived assets
For each asset retirement obligation Initially record the fair value (present value) of the liability to dispose of the asset when a reasonable estimate of its fair value is available. ❑ Required to use SFAC No. 7 criteria for recognition of the liability ❑
◼
Present value of the asset at the credit adjusted rate. ❑
Defined as the amount a third party with a comparable credit standing would charge to assume the obligation.
SFAS No. 143 (FASB ASC 410-20): Accounting for Asset Retirement Obligations ◼ Capitalized asset retirement cost ❑
allocated in a systematic and rational manner as depreciation expense over the estimated useful life of the asset.
◼ Initial carrying value of the liability ❑
increased each year by use of the interest method ◼
❑
using the credit adjusted rate
classified as accretion expense and not interest expense.
International Accounting Standards ◼
The IASB has issued pronouncements on the following issues: 1.
2. 3. 4.
5.
The overall issues associated with accounting for property, plant, and equipment assets in a revised IAS No. 16, "Property, Plant and Equipment." Interest capitalization in IAS No. 23, “Borrowing Costs. Impairment of Assets in IAS No. 36, “Impairment of Assets.” Accounting for Investments in Property in IAS No 40, “Investment Properties.” The accounting treatment for assets held for disposal in IFRS No. 5, “Non-Current Assets Held for Sale and Discontinued Operations.”
IAS #16: Property, Plant and Equipment
◼
Revised IAS No. 16 did not change the fundamental approach to accounting for property plant and equipment. ❑ ❑ ❑ ❑ ❑ ❑
Recognize items as assets when economic benefit will flow to enterprise and cost can be measured Preference is to depreciate historical cost of assets Allows revaluations to current market value Requires recording of impairments Depreciation charge should reflect pattern of benefits If change in pattern of benefits is noted, change depreciation method to reflect new pattern
IAS #16: Property, Plant and Equipment ◼
The major clarifications in revised IAS No. 16: 1.
2.
Requiring a components approach for depreciation The acquisition cost of property, plant, and equipment should include ❖
❖
3.
Amount of an IAS 37 provision for the estimated cost of dismantling and removing the asset and restoring the site Include both provisions when the asset is acquired and incremental provisions recognized while the asset is used
Accounting for incidental revenue (and related expenses) during construction or development of an asset will depend on ❖
❖
Whether the incidental revenue is a necessary activity in bringing the asset to the location and Working condition necessary for it to be capable of operating in the manner intended by management
IAS #16: Property, Plant and Equipment 4.
◼
5.
◼ ◼
Exchanges of similar items of property, plant, and equipment recorded at fair value gain or loss will be recognized ➢
◼
Measurement of residual value defined: the current prices for assets of a similar age and condition to the estimated age and condition of the asset when it reaches the end of its useful life.
unless neither the fair value of the asset given up nor the fair value of the asset acquired can be measured reliably
Subsequent expenditure is capitalized only if the expenditure increases the asset's future economic benefits above those reflected in its most recently assessed level of performance
IAS No. 23: Impairment of Assets ◼
◼
◼
Requires: ❑ an impairment loss to be recognized on items of property, plant and equipment ❑ whenever the recoverable amount of an asset is less than its book value The recoverable amount is the higher of ❑ asset’s selling price ❑ or value in use (present value of future cash flows) Revised 2007: Removed option of immediately recognizing all borrowing costs as expense
IAS No. 36
◼
◼
Make sure assets are carried at no more than recoverable amount Define how recoverable amount is calculated
IAS No. 40: Investment Property ◼ Defined as land or buildings held to
earn rentals or for capital appreciation ◼ May account by either: ❑
Fair value with changes reflected in income
IFRS No. 5: Non-Current Assets Held for Sale and Discontinued Operations ◼
Establishes a classification for non-current assets 'held for sale' ❑
◼
using the same criteria as those contained in US FASB Statement 144 Accounting for the Impairment or Disposal of Long-Lived Assets.
Therefore, operations that are expected to be wound down or abandoned would not meet the definition ❑
but may be classified as discontinued once abandoned.
IFRS No. 6: Exploration & Development Assets ◼ Required to be measured initially at cost.
◼ Typical allowable expenditures:
Topographical, geological, geochemical, and geophysical studies ❑ Exploratory drilling, trenching, sampling ❑
End of Chapter 9 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION
RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 10 LONG-TERM ASSETS II: INVESTMENTS AND INTANGIBLES
Introduction ◼ Reasons for making long-term investments in
corporate securities ◼ Classification as long-term is based on the concept of managerial intent ◼ Intangibles
Investments in Equity Securities ◼ What are equity securities? ◼ Methods of accounting
Consolidation ❑ The equity method ❑ The cost method ❑ The fair value method ❑ The market value method ❑
Consolidation ◼ The concept of control ◼ SFAS No. 94: Ownership of majority voting
interest ◼ Discussed in more detail in Chapter 16
The Equity Method ◼ The concept of significant
influence The twenty percent guideline ❑ Other methods of determining ❑
◼ How to account for
Earnings ❑ Dividends ❑
◼ SFAS No. 115 (FASB ASC 320) ❑
Allows fair value method for some investments
The Equity Method ◼ Circumstances which limit significant influence
when holding a 20 percent investment Opposition by the investee ❑ Surrender of significant rights ❑ Majority ownership by small group ❑ Inability to obtain the financial information to apply the equity method ❑ Failure to obtain representation on the Board of Directors ❑
The Cost Method
◼ Lack of significant influence ◼ Investment carried at historical cost ◼ Dividends reported as revenue
The Lower Cost or Market Method ◼ SFAS No. 12 (since superseded): LCM ❑
Current and long-term portfolios
◼ Conservatism
◼ Criticism ❑
Did not result in consistent treatment
The Fair Value Method: SFAS No. 115 (FASB ASC 320) ◼ The concept of readily determinable fair
value 1
2
3
Availability of information on current price in U. S. markets Availability of information on current prices in a foreign market Mutual fund information
The Fair Value Method ◼ Categories 1 2 3
Trading Available-for-sale Transfers between categories ➢ ➢
◼
Available-for-sale to trading Trading to available-for-sale
Rationale for the fair value method
Market Value Method ◼ When to use ◼ Accounting treatment
Dividends recognized as income ❑ Unrealized gains and losses recognized in earnings ❑
Recent Developments ◼
May 26, 2010: FASB issued proposed Accounting Standards Update Classification to be determined at acquisition or issuance ❑ Financial assets with variable cash flows to be accounted for at fair value ❑ Changes in fair value of certain securities ❑ Financial assets held for collection of cash ❑
◼ ◼ ◼
Both amortized cost and fair value presented on balance sheet Some fair value changes to be recognized in net income Other FV changes to be recognized in other comprehensive income
Accounting for Investments in Equity Securities 20
Percentage of 0 ownership Accounting Method
Fair Value Method (if fair value is readily determinable) Cost method (if fair value is not readily determinable) Market Value Method (for certain companies)
50
Equity Method
100
Consolidation
SFAS No. 159 (FASB ASC 825) ◼ Most financial assets &
liabilities may be measured at fair value. ◼ Measured using exit prices on balance sheet date. ◼ Fair value is price a company would receive to sell an asset or pay to transfer a liability. ◼ Unrealized holding costs must be reported.
Investment in Debt Securities ◼ Trading ◼ Available-for-sale ◼ Held-to-maturity
◼ Trading and available-for-sale accounted for
in a manner similar to equity securities - fair value
Held-to-Maturity ◼ Criteria ◼ Initial measurement ◼ Subsequent accounting
◼ Transfers
Trading ❑ Available-for-sale ❑
◼ Problem - Criteria permit earnings
management
Permanent Decline in Value of Available-for-Sale and Held-to-Maturity Securities
◼ Write-down to fair value ◼ Loss included in earnings
and a new cost basis is established ◼ No future recovery included in cost
Impairment of Investments in Unsecuritized Debt Impairment is based on the present value of expected future cash flows ◼ In subsequent periods, impairment is remeasured and may be accounted for by one of the following procedures ◼
1
Increases attributable to passage of time are reported as interest income ➢
2
balance is recorded as an adjustment to bad debt expense
Entire amount is recorded as an adjustment to bad debt expense
Impairment of Investments in Unsecuritized Debt ◼
Critics have argued that impairment reflects a change in the character of the loan ❑
◼
interest should reflect the fair value associated with risk
Allows earnings management
Transfers of Financial Assets ◼ Financial assets:
debt and equity securities ◼ Accounting for financial assets was first outlined in SFAS No. 125 ❑
Recently replaced by SFAS No. 140.
Transfers of Financial Assets ◼
According to SFAS No. 140, the investor transfers or surrenders control over transferred assets if and only if all of the following 3 conditions are met: The transferred assets have been isolated from the transferor Each transferee has the right to pledge or exchange the assets it received
1.
2.
➢
no condition both constrains the transferee from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor.
Transfers of Financial Assets 3.
The transferor does not maintain effective control over the transferred asset
➢
➢
by having an agreement that obligates it to repurchase or redeem the asset before maturity or by having an agreement that allows it to repurchase or redeem assets that are not readily obtainable.
Transfers of Financial Assets ◼
A transfer of financial assets ❑ ❑
accounted for as a sale to the extent that consideration other than beneficial interests in the transferred asset is received in exchange. ◼
Liabilities and derivatives incurred in a transfer of financial assets ❑
◼
Servicing assets and liabilities ❑ ❑
◼
initially measured at their fair market values.
measured by amortization over the period of servicing income or loss assessment for asset impairment or increased obligation based on their fair market values.
Liabilities are derecognized ❑ ❑
only when repaid or when the debtor is legally relieved of the obligation. In-substance defeasance is not permitted.
Intangibles ◼ Definition ◼ Classification by the APB
Identifiability ❑ Manner of acquisition ❑ Expected period of benefit ❑ Separability ❑
©
Classifications VS Externally acquired
Internally developed
VS Identifiable
Unidentifiable
Accounting Treatment ◼ Cost ◼ Subsequent amortization
Limited term of existence ❑ No term of existence ❑
◼ Factors to consider
Goodwill ◼ The concept ❑
Theoretical value
◼ Accounting
How to record? ❑ How to amortize? ❑ The cases for and against immediate write-off ❑
SFAS No. 142 (FASB ASC 350): Goodwill and Other Intangible Assets ◼ Changes accounting for goodwill
from an amortization period not to exceed 40 years ❑ to an approach that requires, at a minimum, annual testing for impairment. ❑
◼ The goodwill impairment test is
to be performed at the reporting unit level.
SFAS No. 142: Goodwill and Other Intangible Assets Disclosure Requirements
◼
test for goodwill impairment is a two-step process that involves:
❑
A comparison of the fair value of the reporting unit to its carrying value.
1. ➢ ➢
2.
In the event fair value exceeds carrying value, no further testing is required. If the carrying value of the reporting unit exceeds its fair value, step two is required.
A calculation of the implied fair value of goodwill by measuring the fair value of the net assets other than goodwill and subtracting this amount from the fair value of the reporting unit.
Research and Development Costs ◼ Definition
Research ❑ Development ❑
◼ Expense as incurred
International Accounting Standards ◼
The IASB has issued pronouncements on the following issues:
1. Accounting for investments in associates in a revised IAS No. 28, “Account-ing for Investments in Associates.” 2. Accounting for financial assets in IAS No. 32, “Financial Instruments: Presentation.” 3. Accounting for intangibles in IAS No. 38, “Intangible Assets.” 4. The recognition and measurement of financial assets in a reissued IAS No. 39, “Financial Instruments: Recognition and Measurement.”
International Accounting Standards 5. Accounting for goodwill in SFRS No. 3, “Business Combinations,” which replaced IAS No. 22. 6. The disclosure of information on financial instruments in IFRS No. 7, “Financial Instruments: Disclosures.” 7. Accounting for financial assets in IFRS No. 9, “Financial Instruments,” as a first step in its project to replace IAS No. 39.
IAS No. 28: Accounting for Investments in Associates ◼
Revised IAS No. 28
IASB did not change the fundamental accounting for accounting for associates in using the equity method. ❑ Main objective for the revision was to reduce alternatives. ❑
◼
Equity investments may be carried at
cost ❑ revalued amounts ❑ or lower of cost or market ❑
◼
If carried at revalued amount ❑
must frequently revalue and revalue on, at least an investment category basis
IAS No. 28: Accounting for Investments in Associates ◼ Revaluation increases ❑
recorded in stockholders’ equity, decreases in income unless they are recoveries
◼ Recognize non-temporary declines in
value
SFRS No 3: Business Combinations ◼
IASB indicated that goodwill should be recognized by the acquirer as an asset from the acquisition date ❑ and be initially measured ❑
◼
◼
as the excess of the cost of the business combination over the acquirer's share of the net fair values of the acquiree's identifiable assets, liabilities and contingent liabilities.
Prohibits the amortization of goodwill. ❑
Goodwill must be tested for impairment at least annually in accordance with IAS No. 36, “Impairment of Assets.”
IAS No. 38: Intangible Assets The original exposure draft was withdrawn and a new ED was issued in August, 1997. Applies to purchased and internally developed intangible assets. Recognize an intangible asset only if
◼ ◼ ◼ a) b)
c)
◼
the asset is identifiable the future economic benefits specifically attributable to the asset will flow to the enterprise, and cost is reliably measurable.
Recognition criteria apply to both purchased and internally generated intangibles.
IAS No. 38: Intangible Assets ◼
◼
After initial recognition in the financial statements, an intangible asset should be measured under one of the following two treatments: 1. Benchmark treatment: historical cost less any amortization and impairment losses; or 2. Allowed alternative treatment: revalued amount (based on fair value) less any subsequent amortization and impairment losses. The main difference from the treatment for revaluations of property, plant and equipment under IAS 16: ❑ revaluations for intangible assets are permitted only if fair value can be determined by reference to an active market. ❑ Active markets are expected to be rare for intangible assets
IAS No. 38: Intangible Assets ◼
◼
The statement requires intangible assets to be amortized over the best estimate of their useful life ❑ includes the presumption that the useful life of an intangible asset will not exceed 20 years from the date when the asset is available for use. In rare cases, where persuasive evidence suggests that the useful life of an intangible asset will exceed 20 years ❑ amortize the intangible asset over the best estimate of its useful life and: 1. 2.
Test the intangible asset for impairment at least annually in accordance with IAS 36, Impairment of Assets Disclose the reasons why the presumption that the useful life of an intangible asset will not exceed 20 years is rebutted and also the factor(s) that played a significant role in determining the useful life of the asset.
IAS No. 9 ◼ Research
ongoing investigations with the prospect of gaining new knowledge ◼ Development ❑ applications of research findings to a plan of production ◼ Research costs are recognized as expenses ◼ Development costs may be capitalized if certain criteria are met ◼ If capitalized - amortized to reflect pattern of benefits ❑
IAS No. 22 ◼ Outlined accounting treatment
for investments with the ability to significantly influence. ◼ Requirements similar to U. S. GAAP
IAS No. 32: Financial Instruments: Disclosure and Presentation ◼
◼
◼
Financial asset a) Cash b) Right to receive cash c) Right to exchange financial asset under favorable conditions or equity
Must disclose how financial assets might affect the amount, timing and certainty of future cash flows, associated accounting policies and measurement bases. Must also disclose exposure to credit risk and fair value
IAS No. 36 ◼ Requires an impairment loss to be
recognized on investments and intangibles whenever the recoverable amount of an asset is less than its book value The recoverable amount is the higher of the asset’s selling price, or value in use (present value of future cash flows) ❑ An impairment loss is recognized as an expense on the income statement ❑
IFRS No. 7 ◼ Requires disclosures of risks arising
from financial instruments ◼ Requires quantitative disclosures based on internal information
IFRS No. 9 ◼ November 12, 2009 ◼ First step to replace IAS No. 39 ◼ New requirements for classifying and
measuring financial assets ◼ All financial assets initially measured at fair value plus ◼ All financial assets divided into Those measured at amortized cost ❑ Those measured at fair value ❑
End of Chapter 10 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION
RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 11 LONG-TERM LIABILITIES
Introduction ◼ The importance of long-term debt analysis
Debt
VS
Equity
Theories of Liabilities ◼ Entity theory:
Assets
=
Equities
◼ Proprietary theory:
Assets
-
Liabilities
◼ Current GAAP:
APB Statement No. 4 ❑ SFAC No. 6 ❑
=
Equities
Recognition and Measurement of Liabilities ◼ Theoretical measurement criteria ❑
Present value of future cash flows
Debt vs. Equity ◼ Definition requires classification of
all right-hand side items into either liabilities or equity ◼ Complex financial instruments now in existence make this difficult ◼ Need additional criteria
Consolidated Set of Decision Factors Maturity date ◼ Claim on assets ◼ Claim on income ◼ Market valuation ◼ Voice in management ◼ Maturity value ◼ Intent of the parties ◼
Consolidated Set of Decision Factors Preemptive right ◼ Conversion factor ◼ Potential dilution of EPS ◼ Right to enforce payment ◼ Good business reasons for issuing ◼ Identity of interest between security holders ◼
FASB Position on Debt and Equity FASB recognized that problems exist ◼ resurrected discussion memorandum: ◼
❑
◼
"Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both. "
The impetus is increasing use of complex financial instruments ❑
have both debt and equity characteristics
FASB Position on Debt and Equity ◼ Tentative conclusions have
led to development of an approach based on characteristics of liabilities and equity. Step 1: determine whether the component includes an obligation. ❑ Financial-instrument components that embody obligations that require settlement by a transfer of cash or other assets ❑
◼
Classify as liabilities ❑
because they do not give rise to the possibility of establishing an ownership interest by the holder.
FASB Position on Debt and Equity ◼ Obligations permitting or
requiring settlement by the issuance of stock give rise to liability-equity classification questions. Classify component as liability if the relationship is that of a debtor or creditor. ❑ The proceeds of issuance of a compound financial instrument that includes both liability and equity components should be allocated to its liability and equity components using the relative fair-value unless that is impracticable. ❑
FASB Position on Debt and Equity ◼
SFAS 150 (FASB ASC 480) 2003 “Components” approach ❑ Classifies certain freestanding financial instruments as liabilities ❑
Major Classifications of Long Term Debt Deferred Taxes
Pensions
Bonds Payable
Leases
Bonds Payable ◼ Why businesses issue bonds 1 2
3 4
Only available source of funds Debt financing has a relatively lower cost Debt has a tax advantage Voting privilege not shared
◼ Trading on the equity
Bond Classifications Mortgage
VS
Debenture
Registered
VS
Coupon
Bond Selling Prices ◼ Stated vs. effective interest
rate ◼ Premium or discount ◼ How is a bond selling price determined?
Example ◼ XYZ Corporation sells
$100,000 of 10-year bonds ❑ Stated interest rate of 10% to yield 9% ❑ Interest on these bonds is payable annually each December 31 ❑
Example To calculate the bond selling price PV of Principle $100,000 X 0.422411 PV of Interest $10,000 X 6.417658 Bond selling price ◼
= $ 42,241.10
=
64,176.58
$106,417.68
For 12%, the same type of calculation will result in a bond selling price of $88,699.53.
Bond Issue Costs ◼ Definition ◼ Accounting treatment
APB Opinion 21 (FASB ASC 470-35-10-2) ❑ SFAC No. 6 ❑ SFAS No 159 (FASB ASC 825-10-25) ❑
Bond Interest Expense ◼ Straight line
◼ Effective interest
Zero Coupon Bonds ◼ Definition ◼ $100,000 @12% for 10-years
Issue price is $32,197 ❑ Discount is $67,803 ❑
◼ Accounting treatment ◼ Why popular?
Call Provisions ◼
Early extinguishment of debt ❑ ❑ ❑ ❑
◼
SFAS No. 76 (superseded) ❑ ❑ ❑
◼
Debt retirement Debt refunding ARB No. 43 possibilities APB No. 26 requirements (FASB ASC 470-5) Debtor has paid creditor Debtor legally released (legal defeasance) Debtor places assets in trust fund (in-substance defeasance)
SFAS No. 125 (superseded) ❑
In-substance defeasance not longer acceptable
Convertible Debt ◼ Reason for issuing ◼ Complex financial instrument ◼ One treatment is to ignore conversion feature
Currently required under APB Opinion No. 14 (FASB ASC 470-20) ❑ Understatement of interest expense & overstatement of bond indebtedness? ❑
Convertible Debt ◼ 2nd view: 1. 2.
Conversion feature is equity Should be separated from bond & included in SE
◼ 3rd View 1.
Classify according to governing characteristic
Convertible Debt ◼ FASB suggested 4 alternative
methods 1
2
3
4
Classify based on the contractual terms in effect at issuance. Classify as a liability if the instrument embodies an obligation to transfer financial instruments to the holder if the option were exercised. Classify in accordance with the fundamental financial instrument having the highest value. Classify based on the most probable outcome.
Long-Term Notes Payable Notes exchanged solely for cash are presumed to carry an appropriate rate of interest ◼ Exchanges of notes for property, goods and services cannot be recorded at an inappropriate rate of interest ◼ If interest rate is clearly inappropriate ◼
❑ ❑ ❑
FMV of property exchanged FMV of note Impute an interest rate
Short-Term Debt Expected to be Refinanced ◼ To classify as long-term must meet two
conditions: 1 2
Intent to refinance Ability to refinance
Deferred Credits ◼ Question:
Are they liabilities? ◼ Usually based on the necessities of double-entry accounting
Contingencies ◼ Gain ◼ Loss
Probable ❑ Reasonable Possible ❑ Remote ❑
◼ Accounting treatment
◼ SFAS No. 5 - conservatism
Other Liability Measurement Issues ◼
Off balance sheet financing SFAS No. 105 (superseded by FASB 133 – FASB ASC 815) ❑ SFAS No. 107 (FASB ASC 825) ❑
◼
◼
Requires disclosure of fair value
SFAS No. 133 – FASB ASC 815 Risks of loss due to credit risk and market risk ❑ Disclosures ❑
Other Liability Measurement Issues ◼ Derivatives
Definition ❑ Types: ❑
1 2 3
4 5
Forward Future Option Swap Hybrid
SFAS No. 133 (FASB ASC 815) ◼
◼ ◼
Derivative instrument: ❑ any financial contract that provides the holder with the right (or obligation) to participate in the price change of an underlying asset Must recognize all derivatives as assets and liabilities and measure them at fair value Derivative may be specified as: a b c
Fair value hedge Cash flow hedge Hedge of foreign currency exposure ◼
◼
Gains or losses for hedges of net investments in foreign subsidiaries reported as translation adjustments in OCI All others as income
Troubled Debt Restructurings ◼ FASB study on arrangements
between
debtors to avoid bankruptcy. ◼ Questions: 1.
2.
3.
Do these arrangements require reductions in original carrying amount of debt? If so when should the effect be reported in the financial statements? Should interest on the new amount t of the debt be recognized before it is payable?
Troubled Debt Restructuring ◼
SFAS No 15 (FASB ASC 310-40 and FASB ASC 470-60) ❑
◼
Defines a troubled debt restructuring as an arrangement that grants a concession by a creditor to a debtor that it might not otherwise consider.
These concessions include: 1. 2. 3.
Modification of terms Granting of equity interest by the debtor to the creditor Transfer of receivables from the debtor to the creditor
Troubled Debt Restructurings ◼
Accounting : ❑
Modification of terms ◼ Determine if gain has occurred for debtor or loss by creditor. Debtor gain is extraordinary = calculated as total future payments compared to current carrying value ❑ Creditor loss is determined by calculating present value of all future payments compared to original carrying value ❑
◼
◼
If not, determine effective interest rate
Asset or equity swap ❑
Compare fair market value of item exchanged and recorded (if any) gain by debtor and bad debt expense by creditor
Financial Analysis of Long-Term Debt ◼Goal is to assess
Liquidity (covered in Chapter 7)
❑
Financial Analysis of Long-Term Debt Solvency
❑
Long term debt to assets ratio Long-term debt Total assets
Interest coverage ratio Operating income before interest and taxes Interest expense
Debt service coverage ratio Cash flow from operating activities before interest and taxes Interest expense
Financial Analysis of Long-Term Debt Financial flexibility
❑
◼
Performa financial statements
Long-Term Debt to Assets Ratios 60.0%
55.43% 47.20%
50.0% 40.0% 30.0% 20.0%
14.54%
14.34%
10.0% 0.0% 2007 Hershey
2008 Tootsie Roll
Interest Coverage Ratios 180.0 160.0 140.0 120.0 100.0 80.0 60.0 40.0 20.0 0.0
176.0 132.4
7.2 2007 Hershey
7.8 2008 Tootsie
Debt Service Ratios 200.0 180.0 160.0 140.0 120.0 100.0 80.0 60.0 40.0 20.0 0.0
190.6
9.6 2007 Hershey
185.2
8.2 2008 Tootsie Roll
International Accounting Standards ◼ The IASC addressed the following issues relating
to long-term liabilities: 1.
2.
3.
4. 5.
Debt and equity classifications in IAS No. 32, "Financial Instruments: Disclosure and Presentation." Contingencies in IAS No. 37, “Provisions, Contingent Liabilities and Contingent Assets” Financial instruments in IAS No. 39, “Financial Instruments Recognition and Measurement” IFRS No. 7, “Financial Instruments: Disclosures” Exposure Draft: Fair Value Option for Financial Liabilities
IAS No 32: Financial Instruments: Disclosure and Presentation ◼
◼
◼
Disclosure provisions replaced by IFRS No. 7 Financial liabilities: ❑ contractual obligations to deliver cash or another financial asset to another enterprise ❑ or to exchange financial instruments with another enterprise under conditions that are potentially unfavorable Equity instruments ❑ contracts that evidence a residual interest in the assets of an enterprise after deducting all of its liabilities
IAS No 32: Financial Instruments: Disclosure and Presentation Requires companies to disclose information about their financial liabilities including:
◼
1.
2.
3.
4.
How they might affect the amount, timing, and certainty of future cash flows The associated accounting policies and basis of measurement applied. The exposure of an enterprise's liabilities to interest rate risk Information about the fair value of an enterprise’s financial liabilities
IAS No. 37: Provisions, Contingent Liabilities and Contingent Assets ◼ Recognize a contingency
when it is probable (more likely than not) that resources will be required to settle an obligation ❑ and that the amount can be reasonably estimated ❑
IAS No 39: Financial Instruments – Recognition and Measurement ◼
◼
◼
◼
Financial liabilities are recognized and initially measured at cost
Subsequently, most are amortized ❑ derivatives and liabilities are remeasured at fair market value Remeasured liabilities may either be : 1 Recognized entirely in net profit or loss for the period 2 Recognized in net profit or loss for only financial liability held for trading purposes IASB expects to amend through IFRS No. 9 project by end of 2010
IFRS No. 7 ◼
Requires disclosure of ❑
❑
◼
Balance sheet and income statement disclosures: ❑ ❑
◼
Financial liabilities at fair value Financial liabilities at amortized cost
Quantitative disclosures ❑ ❑
◼
Significance of entity’s financial instruments Nature and extent of risks
Credit, liquidity and market risk Concentration of risk
Risk-based disclosures ❑ ❑ ❑
Maturity analysis Description of entity’s approach to risk management Sensitivity analysis
FASB Exposure Draft – May, 2010 ◼ Fair Value Option for Financial
Liabilities ◼ Presentation of gains and losses on liabilities ◼ Limited – focuses only on 2 areas: ❑
❑
Effects of changes in entity’s own credit risk Elimination of cost exception of derivative liabilities to be settled by delivery of unquoted equity instruments
End of Chapter 11 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 12 ACCOUNTING FOR INCOME TAXES
Introduction ◼ Income taxes are an
expense ❑
Consistent with ◼ ◼
the proprietary theory definition of comprehensive income
◼ Accounting for income taxes is a controversial
issue
Historical Perspective ◼
◼
◼ ◼
Income taxes first became a significant issue because of the emerging facilities exception during World War II ARB No. 23 ❑ required the allocation of some deferred income taxes ❑ did not provide clear measurement guidelines The allocation of income taxes to the periods impacted is termed interperiod tax allocation APB Opinion No. 11 ❑ extended interperiod tax allocation to all timing differences ❑ criticism because resulting balance sheet items did not reflect future tax consequences ❑ result ◼ ◼
FASB Statement No. 96 later FASB Statement No. 109 (See FASB ASC 740)
The Income Tax Allocation Issue The objective of financial accounting SFAC No. 1
◼ ◼
provide information about the amount and timing of future cash flows
Most economic events have tax cash flow consequences These cash consequences are reported on tax returns in accordance with the Internal Revenue Code (IRC)
The Income Tax Allocation Issue ◼
The goal of the IRC is to raise revenue to run the government and in some cases to regulate the economy
◼
These same economic events are reported for financial accounting purposes under GAAP
The Income Tax Allocation Issue ◼
◼
◼
The goals of the IRC and GAAP sometimes result in reporting revenues and expenses in different accounting periods creating an originating difference In subsequent years these differences will reverse creating a reversing difference This issue is termed the income tax allocation issue
Revenue 2010
Expense 2011
Permanent Differences ◼
Permanent differences are differences between taxable income and financial accounting that will never reverse federal economic policy ❑ or to alleviate a provision of the IRC that falls too heavily on one segment of the economy ❑
Financial income
Taxable income
Permanent Differences ◼ Occur because provisions
of the IRC exempt certain types of revenue from taxation ❑ or prohibit the deduction of certain expenses ❑
Financial income
Taxable income
Types of Permanent Differences ◼
Revenue recognized for financial accounting purposes that is never taxable ❑
◼
Taxable income
interest on municipal bonds
Expenses recognized for financial accounting purposes that are never deductible for tax purposes ❑
◼
Financial income
life insurance premiums
Income tax deductions that do not qualify as expenses under GAAP
Temporary Differences
◼ Temporary differences
will reverse in a subsequent period ❑ some temporary differences are timing differences ❑ others occur because of different measurement bases ❑
Temporary Differences ◼ Create timing differences ◼ Result in assets and liabilities
having differing bases for financial accounting and taxation purposes ◼ Originating differences when they reverse create Taxable amounts ❑ Deductible amounts ❑
Temporary Differences ◼ Categories of timing differences
Current financial accounting income exceeds current taxable income ❑ Current financial accounting income is less than current taxable income ❑
Additional Temporary Differences 1
2 3
4
5
Reduction in the tax basis of depreciable assets because of tax credits The ITC accounted for by the deferred method Foreign operations for which the reporting currency is the functional currency An increase in the tax basis of assets because of indexing for inflation Business combinations accounted for by the purchase method
Net Operating Losses ◼ Occurs when tax deductions are
greater than taxable income in a period ◼ IRC allows for these losses to be carried back two years and forward twenty years ◼ Should the benefits of NOL’s be recognized?
Conceptual Issues ◼ Allocation versus Nonallocation ◼ Comprehensive versus Partial allocation ◼ Discounting deferred taxes
Alternative Interperiod Tax Allocation Methods ◼
Deferred method ❑
◼
Asset/liability method ❑
◼
uses rates in effect when difference originates uses rates expected to be in effect when the difference reverses
Net of tax method use one of the above methods to adjust balance sheet items that caused the temporary difference ❑ e. g. depreciable assets ❑
FASB Dissatisfaction With the Deferred Method ◼ APB Opinion No. 11 required the use of
the deferred method ◼ Did not meet SFAS No. 6 definition of assets and liabilities
Measurement and Reporting Under SFAS No. 96 ◼ Required the asset/liability approach
to allocation Deferred tax liability ❑ Deferred tax asset ❑
◼ SFAS No. 96
limited the recognition of deferred tax assets created by NOLs ❑ zero future income assumption ❑
Business Dissatisfaction With SFAS No. 96 ◼ The cost of scheduling necessary under its
provision ◼ Loss of deferred tax assets under zero future income assumption
SFAS No. 109 Board remained committed to the asset/liability method ◼ Allowed for the separate recognition and measurement of deferred tax assets and liabilities without regard to future income considerations ◼ More likely than not criteria for deferred tax assets rather than zero future income assumption ◼
Determining Deferred Asset and Liability Balances 1 2
3
4 5
Identify temporary differences, NOL carryforwards, and unused tax credits Measure the total deferred tax liability by applying the expected tax rate to the future taxable amount Measure the total deferred tax asset by applying the expected future rate to future deductible amounts and NOL carryforwards Measure deferred tax assets for each type of unused tax credit Measure the valuation allowance based on the more likely than not criterion
The Valuation Allowance ◼ There may be insufficient future
taxable income to derive the benefit from a deferred tax asset ◼ Use allowance to reduce the deferred tax asset to amount expected to be realized under the more likely than not criterion
Do Assets and Liabilities Created by SFAS No. 109 Meet the Definitions in SFAC No. 6?
◼ Deferred tax liability - meets the three
characteristics of liabilities ◼ Deferred tax asset - meets the three characteristics of assets
Financial Statement Disclosures ◼ Income statement ◼ Balance sheet ◼ SEC disclosure requirements
FIN No. 48 (ASC 740): Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Stmt No. 109 ◼ Tax contingencies too flexible
Used to manipulate earnings ❑ Reporting & disclosure of tax positions lacked transparency ❑
◼ FIN 48 establishes proper
accounting treatment for uncertain tax positions.
FIN No. 48: Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Stmt No. 109 ◼ Evaluation of tax position is a 2-step
process Recognition ❑ Measurement ❑
Financial Analysis of Income Taxes ◼ Disclosure requirements allow
financial statement users to make better decisions including: 1 2 3
Assessing the quality of earnings Assessing future cash flows Calculation of actual tax rates
Financial Analysis of Income Taxes ◼ The footnotes provide information on: 1
2
3
Information on the amount of taxes that would be paid at the federal statutory rate and the amount actually paid Changes in the deferred tax asset and liability accounts Information concerning income tax carrybacks and carryforwards
Financial Analysis of Income Taxes ◼
The earnings conservatism ratio Pretax accounting incomea Taxable income
aIn the event a company reports material permanent income tax
differences, the amount of these differences adjusts the numerator.
Financial Analysis of Income Taxes Earnings conservatism ratios for Hershey and Tootsie 1.20 1.00 1.00 0.80
1.00
1.00 1.00
1.00 1.01
0.60 0.40 0.20 0.00 2006
2007
Hershey
Tootsie Roll
2008
IAS No. 12: Accounting for Taxes on Income ◼ Both similarities and differences between
FASB ASC 740 and IAS No. 12 ◼ Considering other issues: 1
2
Do tax consequences of recovery amounts of assets and liabilities depend on the manner of recovery? Disclosure of reconciliation between income tax expense and accounting profit
◼ March 2009: Exposure draft of revised IAS
No. 12 ◼
Attempt to alleviate differences
End of Chapter 12 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 13 LEASES
Introduction ◼ Property rights are acquired by the
purchase of assets ◼ Rights to use property are acquired by leases ◼ Some leases allow lessees to use offbalance sheet financing of assets
Advantages of Leasing ◼ 100 percent financing ◼ Protection against obsolescence
◼ Frequently less costly than other
forms of financing the cost of the acquisition of fixed assets ◼ Does not add debt to the balance sheet
Management’s Choice Between Purchasing and Leasing ◼ Function of:
Strategic investment and capital structure objectives ❑ Comparative costs ❑ Availability of tax benefits ❑
◼ Question: ❑
When does the acquisition of rights to use property become an in-substance property right?
Types of Leases Capital lease
lease is in substance a longterm purchase of an asset
Operating lease
lease is a rental agreement
◼
What are decision criteria for deciding whether a lease is capital or operating?
Historical Perspective ARB No. 38 ◼ APB Opinion No. 5 ◼ APB Opinion No. 7 ◼ APB Opinion No. 27 ◼ APB Opinion No. 31 ◼
Historical Perspective ◼
Problems: Criteria in these four APB Opinions did not result in the capitalization of many leases ❑ There was a lack of symmetry between lessee and lessor accountings ❑
◼
Result: SFAS No. 13
Conceptual Foundation of SFAS No. 13 ◼
Capital lease ❑
transfers substantially all of the benefits and risks of ownership from the lessor to the lessee
◼
Conclusion Must identify the characteristics that indicate transfer of benefits and risks ❑ Same characteristics should apply to both lessors and lessees ❑ Those leases that do not satisfy the characteristics should be classified as operating leases ❑
Reasons Why Leasing May Be More Attractive Than Buying an Asset Period of use is short relative to the overall life of the asset 2 Lessor has a comparative advantage over the lessee in reselling the asset 3 Corporate bond covenants of the lessee contain restrictions relating to financial policies the firm must follow (maximum to debt to equity ratios) 4 Management compensation contracts contain provisions expressing compensation as a function of return on invested capital 1
Reasons Why Leasing May Be More Attractive Than Buying an Asset Lessee ownership is closely held so that risk reduction is important 6 Lessor (manufacturer) has market power and can thus generate higher profits by leasing the asset (and controlling the terms of the lease) than by selling the asset 5
The asset is not specialized to the firm 8 The asset’s value is not sensitive to use or abuse (owner takes better care of the asset than does the lessee) 7
Criteria for Classifying Leases ◼
For lessees 1
2 3
Lease transfers ownership of the property to the lessee by the end of the lease term Lease contains a bargain purchase option Lease term is equal to 75 percent or more of the estimated remaining economic life of the leased property ➢
unless the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property
Criteria for Classifying Leases 4
Present value of the minimum lease payments at the beginning of the lease term ➢
➢
equals or exceeds 90 percent of the fair value of the leased property less any related investment tax credit retained by the lessor
Recording Capitalized Leases ◼ For lessees ❑
Present value of minimum lease payments is computed and capitalized at lessee’s incremental borrowing rate ◼
❑
Minimum lease payments consist of: 1 2 3 4
❑
unless lessor’s implicit rate is known and lower. Rental payments over the life of the lease Any bargain purchase option Any guaranteed residual value of the property by the lessee Any penalties for failure to renew the lease by the lessee
Periodic expenses are interest expense and depreciation on leased asset
Lease
Disclosures Required by Lessees for Capitalized Leases – SFAS No. 13) 1
Gross amount of assets recorded under capital leases ➢ as of the date of each balance sheet ➢ presented by major classes according to nature or function. 2
Future minimum lease payments ➢ as of the date of the latest balance sheet presented ➢ in the aggregate and for each of the five succeeding fiscal years.
Disclosures Required by Lessees for Capitalized Leases 3
4
Total minimum sublease rentals to be received in the future under noncancelable subleases ➢ as of the date of the latest balance sheet presented. Total contingent rentals ➢ rentals on which the amounts are dependent on some factor other than the passage of time ➢ actually incurred for each period for which an income statement is presented.
Operating Lease ◼ Operating leases ❑
Income Statement
All leases which do not meet any of the four capitalization criteria
◼ Periodic payments are
recorded as rent expense
Rent Expense
Disclosures Required for Operating Leases by Lessees For operating leases having initial or remaining noncancelable lease terms in excess of one year:
1.
a)
b)
Future minimum rental payments required as of the date of the latest balance sheet presented The total of minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented.
For all operating leases
2. a)
b)
Rental expense for each period for which an income statement is presented with separate amounts for minimum rentals, contingent rentals and sublease rentals.
Disclosures Required for Operating Leases by Lessees 3
a b
c
A general description of the lessee's leasing arrangements including, but not limited to the following:
The basis on which contingent rental payments are determined. The existence and terms of renewals or purchase options and escalation clauses. Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and further leasing
Criteria for Classifying Leases ◼ For lessors ❑
previous four criteria plus: 1
2
Collectability of minimum lease payments is reasonably predictable No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease
Sales-Type Leases ◼ Involves manufacturer's or dealer’s profit
◼ Implication
Leased asset is an item of inventory ❑ Seller (lessor) ❑
◼
◼
is earning a profit on the sale of the property as well as interest over the life of the lease
Accounting by Lessors ◼ Concern ❑
Appropriate allocation of revenues and expenses to the lease period
◼ Capital leases are then classified by lessors
as either: Sales-type ❑ Direct financing ❑
Direct Financing Lease ◼ No profit is recorded at the inception of the
lease ◼ Lessor is viewed as a lending institution financing the purchase of an asset ◼ Revenue is interest earned over the life of the lease
Disclosures Required by Lessors for Sales Type and Direct Financing Leases 1.
The components of the net investment in leases as of the date of each balance sheet presented a) b) c)
2.
3.
4.
5.
Future minimum lease payments to be received The unguaranteed residual value Unearned income
Future minimum lease payments to be received for each of the five succeeding fiscal years as of the date of the latest balance sheet presented The amount of unearned income included in income to offset initial direct costs charged against income for each period for which an income statement is presented (For direct financing leases only) Total contingent rentals included in income for each period for which an income statement is presented A general description of the lessor's leasing arrangements
Lessor Operating Leases ◼ Do not meet criteria for
classification as either sales-type ❑ or direct financing leases are recorded as operating leases by lessors ❑
◼ Periodic payments are
recorded as rent revenue and leased asset is depreciated
Disclosures Required by Lessors for Operating Leases 1
The cost and carrying amount, if different, ➢ of property on lease or held for leasing by major classes of property ❖
➢
and the amount of accumulated depreciation in total ❖
2
3
4
according to nature or function, as of the date of the latest balance sheet presented.
Minimum future rentals on noncancelable leases ➢ as of the date of the latest balance sheet presented ➢ in the aggregate ➢ and for each of the five succeeding fiscal years. Total contingent rentals included in income ➢ for each period for which an income statement is presented. A general description of the lessor's leasing arrangements.
Sale and Leaseback ◼ Owner sells property and then
immediately leases it back ◼ Usually treated as a single economic event ❑
with the gain or loss on the sale being amortized over the lease term
Leveraged Leases ◼ Three parties
Equity holder
Lessor
Asset user
Lessee
Debt Holder
Long-term financier
Leveraged Leases Lessee periodic payments assigned to debt holders
Finances purchase of assets Financing Company
Transfer use of the asset Lessor
Lessee
FASB Decision on Accounting for Leveraged Leases ◼ Should transaction be recorded as a
single economic event or as separate transactions? Accounted for as a single transaction ❑ Accounted for as a capital lease by the lessee and as a direct financing lease by the lessor ❑
Financial Analysis of Leases ◼ Company employing operating leases as
opposed to capital leases ❑ will report a relatively higher working capital position ❑ and relatively higher current and return on assets ratios ◼ Analyze footnotes to a company’s financial statements ❑ to determine the impact of the use of operating leases its financial position
Current Developments ◼ March 2009: FASB & IASB announced joint
project on accounting for leases ◼ Lessee should initially measure both its right-of-use asset and lease obligations at present value of expected lease payments ❑ Discount estimated lease payments using lessee’s incremental borrowing rate ❑
◼ Lessor accounting wasn’t covered in the original
proposal; however, an exposure draft was released in August 2010 that incorporated lessor accounting.
Current Developments ◼
Lessor - Two different accounting models would apply to lessors: 1. The performance obligation approach and 2. The derecognition approach.
◼
Both models would require a lessor to recognize a lease receivable for estimated future lease payments. ❑
If lessor retains significant risks or benefits associated with the underlying property ◼
❑
continue to recognize the underlying property and recognize a liability to deliver its use to the lessee over the estimated lease term (the performance obligation approach).
If the lessor does not retain significant risks or benefits associated with the underlying property ◼
◼
◼
Derecognize the portion of that property representing the cost of the right-of-use sold to the lessee, Reclassify the remaining portion as a residual asset representing its rights to the underlying property at the end of the lease term, and Recognize an immediate profit or loss on the transaction (the derecognition approach).
IAS No. 17 – Accounting for Leases Added enhanced disclosure requirements ◼ Requirements similar to SFAS No. 13 ◼ Difference in terminology – ◼
❑ ❑
Financing leases rather than capital leases for lessee Terms sales-type and direct financing not used for lessors
IAS No. 40 – Investment Property Defined investment property as property held to earn rentals or for capital appreciation or both ◼ Two models: ◼
Fair value model ❑ Cost model (See IAS No. 16) ❑
End of Chapter 13 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION
RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 14 PENSIONS AND OTHER POSTRETIREMENT BENEFITS
Accounting for the Cost of Pension Plans ◼ Types of plans
Defined contribution ❑ Defined benefit ❑
◼ Actuarial funding methods
for defined benefit plans Cost approach ❑ Benefit approach ❑
1 2
Accumulated benefits approach Benefits/years of service approach
Historical Perspective APB Opinion No. 8 ◼ ◼
◼ ◼
Measuring total cost Allocating cost to proper accounting period Providing cash to fund the pension plan Disclosure
APB Opinion No. 8 Issues ◼ Normal cost ◼ Past service cost ◼ Prior service cost ◼ Actuarial gains and losses
Accounting Method Under APB No. 8 ◼ Minimum
Normal cost ❑ Interest on unfunded prior or post service cost ❑ A provision for any vested benefit ❑
◼ Maximum
Normal cost ❑ 10% of past and prior service cost ❑ Interest equivalent ❑
APB’S Inability to Reach A Conclusion ◼ Two views of pensions 1
A means of promoting efficiency ➢
2
therefore, pension costs are associated with the plan and not specific individuals
A form of supplemental benefits ➢
therefore, they are related to specific employees
The Pension Liability Issue ◼ Issues involved in preliminary views
Period over which to recognize pension costs ❑ How to spread pension cost over periods ❑ Whether to include pension information on balance sheets ❑
The Pension Liability Issue ◼
Position taken was that liability should be recognized on the balance sheet Pension benefit obligation + Actuarial present value of accumulated benefits with salary progression – Less pension assets Balance + Plus or minus valuation allowance
◼
Opposition by AICPA
Sheet
SFAS No. 87 (See FASB ASC 715) Pension information
◼
should be prepared on the accrual basis while retaining three fundamental aspects of previous requirements
❑ ❑
1.
2. 3.
◼
Delayed recognition of certain events Reporting net cost Offsetting assets and liabilities
Changes from APB Opinion No 8: 1.
2.
3.
Standardized method of measuring pension cost Immediate recognition of a pension liability when the accumulated benefit obligation exceeds the fair value of plan assets Expanded disclosure requirements
Pension Cost ◼ Components:
Service cost ❑ Interest cost ❑ Return on plan assets ❑ Amortization of unrecognized prior service cost ❑ Amortization of gains and losses ❑ Amortization of transition amount ❑
◼
Minimum liability recognition ❑
When accumulated benefit obligation exceeds plan assets
Disclosures Required Under FASB ASC 715 ◼
A description of the plan including
Net periodic pension cost by components ◼ A schedule reconciling funding status with the amounts reported on the balance sheet by category. ◼
groups covered ❑ type of benefit formula ❑ funding policy ❑ types of assets held ❑ significant nonbenefit liabilities ❑ any matters affecting comparability of information presented ❑
FASB ASC 715: Theoretical Issues ◼ Projected benefits approach ◼ The settlement rate
◼ Return on plan assets ◼ Reporting the minimum
liability
Accounting for the Pension Fund ◼ Requires information on pension plan
financial statements Net assets available for benefits ❑ Changes in net assets ❑ Actuarial present value of accumulated plan benefits ❑ Effects of certain factors ❑
The Employee Retirement Income Security Act (ERISA) Goals
◼ 1.
2.
◼ ◼
create standards for the operation of pension funds correct abuses in the handling of pension funds
Concerned only with funding policies Does not impact on the determination of periodic pension expense
Other Postretirement Benefits ◼
SFAS No. 106 (See FASB ASC 715) deals with several benefits offered to retired employees ❑ the most important are health insurance and life insurance ❑
◼
These benefits are offered in exchange for current service similar to defined benefit pension plans ❑ should be accounted for as such over the working life of employees ❑
Prior treatment was pay-as-you-go ◼ Economic consequences arguments of SFAS No. 106 ◼
Accounting Treatment Required By SFAS No. 106 (See FASB ASC 715) ◼ Service cost ◼ Interest
◼ Amortization of prior service costs ◼ Amortization of transition amount ◼ Disclosure
◼ Postemployment Benefits
SFAS No. 132 (See FASB ASC 715 -20-50) ◼
New requirements including: 1
2
3
◼
Standardization of the disclosure requirements for pensions and other postretirement benefits Requiring the disclosure of additional information on changes in the benefit obligation and fair value of plan assets Eliminates some other disclosure requirements
The benefit to financial statement users includes disaggregated information on the six components of pension cost
SFAS No. 158 ◼ 2005: FASB, in conjunction with IASB,
added 2-phase review of accounting for pension plans to agenda 1.
2.
Address info about DBPP & OPBP – in Notes, but not in financial statements Other financial accounting and reporting issues
SFAS No. 158 ◼ Requires recognition of: 1.
2.
3.
4.
Overfunding or underfunded DBPP or OPBP on statement of financial position Gains and losses, net of tax, and prior service costs and components DBPP and OPBP assets and obligations on fiscal year-end Disclose certain items in notes
SFAS No. 158 ◼ Completed phase one
◼ No income statement affect ◼ Phase two will reconsider
All aspects of accounting for DBPPS or OPBPs ❑ Possibly requiring companies to disclose gross pension assets and liabilities on balance sheets ❑
Financial Analysis of Retirement Benefits Individual components of pension cost have been found to convey different information to financial statement users ◼ Economic consequences of SFAS No. 106 ◼ Hershey ◼
has a defined benefit pension plan ❑ offers other postretirement benefits ❑
◼
Tootsie has a defined benefit pension plan ❑ offers postretirement health care and life insurance benefit plans ❑
International Accounting Standards The IASC has issued two standards affecting accounting for retirement benefits
◼
1.
2.
A revised IAS No. 19, “Retirement Costs and Expenses” IAS No. 26, “Accounting and Reporting by Retirement Benefit Plans”
IAS No. 19: Retirement Costs and Expenses Major provisions are:
◼
For defined contribution plans:
1. ➢
periodic contributions are recognized as expenses
For defined benefit plans:
2. a)
b)
c)
Current service cost should be recognized as an expense Past service costs, experience adjustments and changes in assumptions are to be recognized as expenses in a systematic manner over the working life of current employees. Preferred method is the accrued benefit valuation method but projected benefit valuation method is acceptable
IAS No. 19: Retirement Costs and Expenses IASB currently engaged in project to amend March 2008: discussion paper issued IASB to issue 3 disclosure drafts
◼ ◼ ◼ 1.
2.
3.
Appropriate discount rate for measuring employee benefits Recognition and presentation of changes in defined benefit obligations and plan assets, disclosures, and other issues Accounting for contribution-based promises
IAS No. 26: Accounting and Reporting by Retirement Benefit Plans ◼
Separate reporting standards for defined benefit and defined contribution pension plans Objectives Defined Contribution
Defined Benefit
provide information about the plan and the performance of investments provide information that is useful in assessing the relationship between plan resources and future benefits
End of Chapter 14 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION
RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 15 EQUITY
Introduction ◼ Equity is risk capital
no guaranteed return ❑ no repayment of the investment ❑
◼ The mix of debt and equity is
called a company’s capital structure
Theories of Equity ◼ Proprietary ◼ Entity ◼ Fund
◼ Commander ◼ Enterprise ◼ Residual equity
Definition of Equity ◼ SFAC No. 6 = residual interest ◼ Definition of equity rests on definition of
assets and liabilities ◼ Assets – liabilities ◼ Liabilities vs Equity Liabilities require transfer of resources ❑ Equity has no transfer requirement ❑
◼ FASB ASC 480-10 ❑
Requires that certain obligations that could be satisfied by issuance of equity securities be classified as liabilities
Distinction between Debt and Equity FASB financial instruments project Concerns about how to classify financial instruments in financial statements:
◼
◼ 1.
2.
3.
Financial instruments that have characteristics of liabilities, but are reported as equity or between liabilities and equity Financial instruments that have characteristics of equity, but are presented between liabilities and equity Financial instruments that have characteristics of both liabilities and equity, but are classified either as liabilities or equity.
Distinction between Debt and Equity SFAS No. 150 (FASB ASC 480). limited its scope to three classes of freestanding financial instruments that embody obligations for the issuer:
◼
1.
2.
3.
◼
Manditorily redeemable preferred stock unless the redemption is required to occur only upon liquidation or termination of the issuer, Obligations to repurchase the issuer’s equity shares by transferring assets, and Certain obligations to issue a variable number of shares.
The Board determined that financial instruments that fall into all three classes should be classified as liabilities
Reporting Equity ◼ Forms of business organization
Sole proprietorship ❑ Partnership ❑ Corporation ❑
◼ Most companies are sole
proprietorships but the largest amount of business activity is carried out by corporations
Why? ◼ Limited liability ◼ Continuity ◼ Investment liquidity
◼ Variety of ownership interests
Components of the Capital Section of a Corporation OTHER Paid-In Capital COMPREHENSIVE INCOME
Earned Capital
Paid-in Capital ◼ Common stock vs preferred stock ◼ Features of preferred stock
Conversion ❑ Call ❑ Cumulative ❑ Participating ❑ Redemption ❑
Paid-in Capital
Stock Options Compensatory
VS Noncompensatory
◼
◼
When do you measure compensation in a compensatory plan? APB Opinion No. 25
Recording Stock Options under FASB ASC 718 Many accountants believe that the provisions of APB No. 25 result in understated financial statement values ◼ Exposure draft ◼ SFAS No 123 issued 1995 ◼
❑
Encouraged recognition of estimated value of stock options as expense.
Recommends, but does not require fair value approach (Black-Scholes) ◼ If APB Opinion No. 25 approach is used must show proforma net income and EPS effects ◼
SFAS No. 123R (See FASB ASC 718) ◼
Concern of deceptive accounting practices ❑
◼
Stock options used to avoid paying taxes
Requires companies to estimate compensation expense Fair market value ❑ Disclose estimated expense on Income Statement ❑ Binomial lattice method ❑
◼
Opposition to provisions
Stock Warrants ◼ Types ◼ Valuation ◼ The equity-liability question
Retained Earnings ◼ Accumulated net profits ◼ Have not been distributed as dividends
◼ May be divided into appropriated and
unappropriated
Other Stockholders’ Equity Issues ◼ Stock dividends vs. stock
splits ◼ Treasury stock ◼ Other comprehensive income ◼ Quasi reorganizations
Financial Analysis of Stockholders’ Equity ◼ Return on common shareholders’
equity (ROCSE) reports on a company’s performance from the point of view of its common stockholders ❑ Based on proprietary theory ❑
◼
borrowing costs are considered expenses rather than a return on investment
Net income available to common shareholders Average common stockholders’ equity
Return on Common Stockholders’ Equity ROCSE 100.0%
89.2%
76.9%
80.0% 60.0% 40.0% 20.0%
8.1%
6.1%
0.0% 2007 Hershey
2008 Tootsie
Financial Analysis of Stockholders’ Equity
◼ Financial structure ratio (FSR) ❑
proportion of the company’s assets that are being financed by the stockholders Average assets Average common stockholders’ equity
Financial Structure Ratio FSR 8.65
10.00 8.00
6.59
6.00 4.00 2.00
1.26
1.28
0.00 2007 Hershey
2008 Tootsie
International Accounting Standards ◼ “Framework for the Preparation of
Financial Statements” indicated a preference for the proprietary theory. ◼ Also indicated that equity may be sub classified into: Contributed capital ❑ Retained earnings ❑ Capital maintenance adjustments ❑
IFRS No. 2: Share-Based Payment ◼ Specify financial reporting by entity for effects of
share-based payment transactions ◼ Broader than concept of employee share options ◼ Measurement principles and specific requirements for 3 types of share-based payment transactions: 1.
2. 3.
Equity-settled share-based payment transactions Cash-settled share-based payment transactions Transactions involving receipt of goods or services
End of Chapter 15 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION
RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 16 ACCOUNTING FOR MULTIPLE ENTITIES
Introduction ◼ Businesses find it useful to combine
operations for efficiencies of scale ◼ Accounting issues for multiple entities: Business combinations ❑ Consolidations and segment reporting ❑ Foreign currency translation ❑
Business Combinations Wyatt’s classifications
◼
1. 2.
3.
Classical era Second wave Third era
Why do businesses combine?
◼
1. 2. 3. 4. 5.
Tax consequences Growth and diversification Financial considerations Competitive pressure Profit and retirement
Business Combinations Two methods of acquisition
◼ 1. 2.
cash exchange of stock
Accounting Method
Accounting Treatment
Purchase
Fair Market Value & Goodwill
Pooling of Interests
Book Value
Criticisms of the Pooling of Interests Method ◼ Accounting is distorted
Investment is not disclosed ❑ Assets undervalued ❑ Income overstated in subsequent years ❑
◼ FASB decision
Economic consequences arguments ❑ 2001: SFAS 141 (FASB ASC 805) abolished further use ❑
The Fresh Start Method ◼ Some combinations are a merger of
equals in which none of the combined companies survive ◼ Revalue all assets as if it were a newly formed entity
The Purchase Method ◼
Must be used when one company acquires the net assets of a business ❑ and also obtains control over that business ❑
SFAS No. 141 applies to both incorporated and unincorporated businesses ◼ 2007: Revised standard SFAS No. 141(R) (FASB ASC 805) ◼
The Acquisition Method SFAS No. 141(R): broadened scope of purchases Changed name to acquisition method When a business combination is created by an exchange of stock, requires that the following “pertinent facts and circumstances” be taken into consideration (FASB ASC 805-10-55-12) :
◼ ◼ ◼
a. b. c. d. e.
◼
The relative voting rights The existence of a large minority voting interest The composition of the governing body The composition of senior management The terms of exchange of equity securities.
Subsequently allocate cost to all identifiable assets with remainder to goodwill
Steps in The Acquisition Method Identify acquiring entity Determine cost of acquisition
◼ ◼ ❑
◼
Historical cost prior to SFAS No. 141
Revised standard: acquirer must recognize all assets acquired, liabilities assumed, and any noncontrolling interest at fair value (exit value)
Business Combinations II ◼
FASB – IASB project on business combinations Phase 1- Valuation of intangibles (IFRS No. 3 and SFAS No. 141) ❑ Phase 2 – Develop a common set of principles intended to improve the completeness, relevance and comparability of financial information about business combinations. ❑
◼
2007: FASB determined business combinations should be recorded at fair value as defined is SFAS ASC 820 ❑
Now used under guidelines in FASB ASC 805
Consolidation When one business organization has control over another they should report as a unified whole ◼ Now required by FASB ASC 810-10-25 ◼ ARB No. 51 criteria ◼
❑ ❑ ❑ ❑ ❑
◼
Parent-subsidiary relationship Control Maintenance of control Operate as integrated unit Approximate fiscal years
Principles ❑ ❑
Cannot own or owe itself Cannot make a profit by selling to itself
The Concept of Control ◼
The power of one entity to direct or cause the direction of the management and operating and financing policies of another entity
Should control be presumed in cases of less than 50% ownership? ◼
Control is presumed when the parent ❑ Owns the majority of the subsidiary’s outstanding common stock ❑ Has the ability to dominate the subsidiary’s board of directors ❑ Has the ability to dissolve the entity
The Modified Approach to Control FASB Exposure Draft Asks the question: Is consolidation required?
◼ ◼
Is the entity a special purpose entity and is it a transferor or its affiliate?
1. ➢
Are the permitted activities and powers of the entity significantly linked?
2. ➢
If not the presumption of control exists
Are powers limited? Can the party change the entity’s purpose?
3. ➢
➢
4.
(Use SFAS No 140 – see FASB ASC 860 – criteria)
If so consolidate Also consolidate if no new cash outlay or benefits exceed new cash outlay
If step 3 does not require consolidation, assess whether variable interests are significant
Theories of Consolidation Entity theory
Emphasis is on control of a group of legal entities operating as a single unit
Parent company theory
Purpose of consolidated statements is to provide information for parent company stockholders
Noncontrolling Interest ◼ Definition ◼ Placement
Liability ❑ Separately presented ❑ Stockholder equity ❑
◼ Noncontrolling interest and theories of
consolidation Doesn’t meet SFAC definition of liability ❑ FASB ED suggests “non-controlling interest in subsidiaries” ❑ Report as separate component of stockholders’ equity ❑
Additional Issues ◼ Proportionate consolidation ❑
ignore minority interest
◼ Goodwill
Should it be attributed to minority interest? ◼ Drawbacks to consolidation ❑
loss of information
Special Purpose Entities Partnership, corporation, trust, or joint venture ❑ created for a limited purpose ❑ limited life and limited activities ❑ designed to benefit a single company ◼ Primary motive for most SPEs ❑ off-balance sheet financing ❑ often to avoid reporting capital leases under SFAS No. 13 (See FASB ASC 840) ◼ Companies are able to avoid consolidation of SPEs in which they do not have a majority voting interest ◼ SPE is created by an asset transfer ❑ The assets are sold to the SPE ◼ To achieve off-balance sheet treatment ❑ minimum (previously 3%, now 10%) investment from an independent third party investor is required ◼
Special Purpose Entities ◼
SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” Outlines requirements to qualify an SPE for non-consolidation
❑
◼
Transferor company, has surrendered control over the transferred assets (and thus has a sale) when all of the following conditions are met: The transferred assets have been put beyond the reach of the transferor and its creditors Each transferee (SPE) has the right to pledge or exchange the assets and no conditions constrain the transferee from taking advantage of its right to pledge or exchange The transferor does not maintain effective control over the transferred assets through either
a.
b.
c.
1.
2.
an agreement that entitles and obligates the transferor to repurchase or redeem the transferred assets before maturity or the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call
Special Purpose Entities FIN No. 46, 2003, “Consolidation of Certain Special Purpose Entities”
◼
❑
Later amended by FIN 46R
Company may have controlling financial interest but no voting interest
◼ ❑
Variable interest entities (VIEs)
Intent: require consolidation only if VIE did not effectively disperse risks and benefits SFAS No. 167, Dec. 2009, “Amendments fo FASB Interpretation No. 46(R)
◼ ◼ ❑ ❑
Required analysis of controlling financial interest in VIE Assess whether a company has implicit financial responsibility
Segmental Reporting Required under SFAS No. 131 (FASB ASC 280) ◼ How it became a factor ◼
❑ ❑
◼
Why important? ❑
❑
◼
SEC line-of-business reporting NYSE recommendations Various operations may have differing prospects for growth rate of profitability and degrees of risk Assessment of decentralized management
What to disclose ❑ ❑ ❑
Operations in different industries Foreign operations Major customers
SFAS No 14 (1976, since superseded) Criteria ◼ Definition
Identity segment ❑ Reportable segment ❑ Revenue ❑ Operating profit or loss ❑ Identifiable assets ❑
◼ Reporting guidelines
Reportable segments ❑ Information to be disclosed ❑ Where to disclose ❑
SFAS No. 131(FASB ASC 280-10-50-20 to 25) ◼ Operating segment
◼ Report balance sheet
and income statement information about each operating segment ◼ Include other specified information ❑
if it is included in the measurement of segment profit
◼ Include other geographic information
◼ Include reliance on major customers
FASB ASC 280 ◼ Goal: use enterprise’s internal organization so
reportable operating segments will be readily evident ◼ Definition of operating segment ◼ Major problems: Determination of reportable segments ❑ Allocation of joint costs ❑ Transfer pricing ❑
Reportable Segments ◼ Meet any of following quantitative thresholds 1. 2. 3.
Reported revenue is >= 10% of combined revenue Reported profit (loss) >= 10% of combined profit (loss) Assets >= 10% of combined assets
◼ Some segments can be aggregated ◼ FASB ASC 280-10-50 requires
specific disclosures
Foreign Currency Translation ◼ Foreign currency translation issues
Increase of foreign operations ❑ Allowing dollar to float on world market ◼ Necessary to state financial statements in a common measuring unit ◼ Problems: ❑
When do you measure difference? ❑ How do you translate specific assets and liabilities ❑
◼ Methods of translation
Current – Noncurrent ❑ Monetary – Nonmonetary ❑ Current Rate Method ❑ Temporal Method ❑
FASB and Foreign Currency Translation ◼ SFAS No. 8 (since superseded)
Closely follows the temporal method ❑ Measure in conformity with US GAAP ❑ Record transactions at initial exchange rate ❑ Use balance sheet date or measurement date as basis for translation of balance sheet items ❑ Use transaction date for revenues and expenses ❑ Exchange gains and losses in income ❑ Gains and losses from foreign exchange contracts in income ❑
FASB and Foreign Currency Translation ◼ SFAS No. 52 (FASB ASC 830)
SFAS No. 8 produced distortions ❑ SFAS No. 52 adopted functional currency approach ❑ Record transactions in functional currency ❑ Adjust, if necessary to comply with GAAP ❑ Translate into currency of reporting company ❑ Transaction gains and losses reported in OCI ❑ If local currency is not functional currency - gains and losses in income ❑
Foreign Currency Translation – Additional Issues ◼ Translation vs. Remeasurement
Translation – expressing amounts denominated or measured in a different currency ❑ Remeasurement – measuring transactions originally denominated in a different unit of currency (use temporal method ❑
◼ Foreign currency hedges
Fair value hedge ❑ Cash flow hedge ❑ Hedge of net investment in foreign operations ❑
International Accounting Standards ◼
The IASC has issued standards dealing with the following issues:
Revised IAS No. 27 (2008): Consolidated Financial Statements and Accounting for Investments in Subsidiaries More in line with U. S. GAAP ◼ Standard to be applied ◼
1. 2.
◼
For group of entities under control of a parent, and Accounting for investments when entity presents separate financial statements
Consolidation required Ownership of > 50% of voting rights ❑ Ability to govern ❑ Ability to appoint or remove majority of board of directors ❑ Ability to cast majority votes at board of directors meetings ❑
IAS No. 27: Consolidated Financial Statements and Accounting for Investments in Subsidiaries ◼
Parent companies should present consolidated financial statements ❑ when it has the ability to control its subsidiaries
Major Revisions to IAS No. 27 IAS No. 27 permits wholly owned (and virtually wholly-owned) subsidiaries to be excluded from consolidation If the exemption is applied, an entity should disclose:
1.
2.
a.
b.
the reason for not publishing consolidated financial statements the name of the parent that publishes consolidated financial statements that comply with IFRS.
3.
4.
Minority interests should be presented in equity, separately from parent shareholders' equity. The exemptions from consolidation are tightened
IAS No 21: The Effects of Changes in Foreign Exchange Rates
◼ ◼
Initially record transactions at historical cost Use monetary - nonmonetary method for subsequent transactions ❑ Translate monetary items at current rate ❑ Translate nonmonetary items at either historical or current rate depending upon when they were measured ❑ Exchange gains and losses reported as a component of stockholders’ equity
IFRS No 3: Business Combinations ◼
Requires all business combinations to be accounted for using the purchase method ❑
◼
The pooling of interests method is prohibited
Acquirer must be identified for all business combinations
IFRS No 3: Business Combinations ◼
The acquirer measures the cost of a business combination ❑
at the sum of the fair values, at the date of exchange, of ◼ ◼
◼
assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer
◼
The acquirer recognizes separately, at the acquisition date, ❑ the acquiree's identifiable assets, ❑ liabilities ❑ and contingent liabilities ❑ that satisfy specified recognition criteria
ISRS No. 8: Operating Segments ◼ Adopts requirements of SFRS
No. 131 except for some terminology ◼ “Management Approach” ❑
Operating segments become reportable based on threshold tests related to Revenues ◼ Results ◼ Assets ◼
◼ Requires disclosure of
“measure” of profit or loss and total assets
End of Chapter 16 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION
RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY
CHAPTER 17 FINANCIAL REPORTING DISCLOSURE REQUIREMENTS AND ETHICAL RESPONSIBILITIES
Financial Statement Disclosure Chapter focuses on the special importance of disclosure in financial reporting. Disclosure requirements issued by:
◼
◼
1. 2.
FASB SEC
SFAC No. 5 outlines the various methods of disclosure that corporations should utilize in published financial statements
Relationship of SFAC No. 5 to Other Method of Financial Reporting (Adapted) All information useful for investment, credit, and similar decisions Financial Reporting Area directly affected by existing FASB standards Basic Financial Statements Scope of Recognition & Measurements Concepts Stmts Financial Stmts Stmt of Earnings & Comprensive Income Stmt of Financial Position Stmt of Cash Flows Stmt of Investments by & Distributions to Owners
Notes to Financial Stmts
Supplementary Information
Examples:
Examples:
Accounting Policies General Information about the company
Other Means of Financial Reporting
Other Information
Segment Information
Examples:
Analysts’ Reports
MD&A
Auditor’s Report
Notes
Discussion of competition
Examples:
SFAC No. 5 Summarizes the building blocks to disclosure as:
◼
1.
2. 3.
4. 5.
The scope of recognition and measurement Basic financial statements Areas directly affected by existing FASB standards Financial reporting All information useful for investment, credit and similar decisions
The Scope of Recognition and Measurement ◼ Discussed earlier throughout the text.
Financial Statements ◼
◼
The financial statements described in SFAC No. 5 were discussed previously in chapters 6 and 7. In addition to the four basic statements, a full set of financial statements also includes
supplementary schedules
Footnotes The most common examples of footnotes are:
◼
Accounting policies Schedules and exhibits
1. 2. ◼
Explanations of financial statement items
3. ◼
4.
Example: schedules or exhibits concerning long-term debt and income tax Example: Pensions and post-retirement benefits
General information about the company
Accounting Policies APB Opinion No. 22 (FASB ASC 235) ◼
requires all companies to disclose ❑
◼
Typically, companies disclose this information in a Summary of Significant Accounting Policies preceding the footnotes.
❑
the accounting policies the firm follows and the methods it uses in applying these policies.
Accounting Policies APB Opinion No. 22 ◼
requires that the accounting methods and procedures involving the following be disclosed: 1. A selection from existing acceptable alternatives. 2. Principles and methods peculiar to the industry in which the reporting entity operates. 3. Unusual or innovative applications of generally accepted accounting principles.
◼
The APB‘s principal objective in issuing Opinion No. 22: ❑ to provide information that helps investors compare firms across and between industries.
Subsequent Events ◼ During the period between the end of a
company’s fiscal year and the issuance of its financial statements, events might occur that aren’t reflected in its accounting records. ◼ May be either ❑
Events that provide further evidence of conditions that existed on the balance sheet date ◼
❑
GAAP requires these to be reported in financials
Events that provide evidence of conditions that did not exist at the balance sheet date ◼
GAAP requires no adjustment to financials
Areas Directly Affected by Existing FASB Standards: Supplementary Information Supplementary information may be mandated by the FASB or the SEC. ◼ Examples of supplementary information include: 1. Segment information (Chapter 16) 2. The effects of price-level changes 3. The auditor’s report 4. Interim financial reports ◼
Price Level Information ◼ High level of inflation experienced in the
United States during the 1970s caused concerns that financial statements were being distorted. ◼ Result SEC ASR No. 190 ❑ FASB SFAS No. 33 ❑ Both pronouncements required the disclosure of supplemental information on the effects of changing prices in the 10-K and annual report to stockholders. ❑ Disclosures generally made in separate schedules. ❑ Later, after inflation subsided in the 1980s, these requirements were suspended ❑
Auditor’s Report Informs users of the reliability of the financial statements ◼ The following guidelines for preparing the auditor’s report were developed by the AICPA: ❑ Should state whether the financial statements are presented in accordance with generally accepted accounting principles. ❑ Must identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period. ❑ Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report. ❑ The report shall either contain an expression of opinion regarding the financial statements taken as a whole, or an assertion to the effect than an opinion cannot be expressed. ◼
Auditor’s Report ◼ Types of opinions:
Unqualified ❑ Qualified ❑ Disclaimer ❑ Adverse ❑
Interim Financial Statements ◼
Two views 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.
◼
Discrete view ➢
➢
➢
Each interim period is a separate accounting period Income should be determined in the same manner as for the annual period Thus revenues and expenses should be reported as they occur.
APB conclusion - adopted integral view
Financial Reporting: Other Means of Financial Reporting Other relevant information
◼ ❑
❑
can assist in understanding the financial report presented in narrative form
Examples: 1.
2.
Management’s discussion and analysis Letter to stockholders
Management’s Discussion and Analysis ◼ Required by the SEC ◼ Explains the reasons for a company’s
performance during the preceding annual period, including: Liquidity, capital resources and results of operations ❑ Favorable and unfavorable trends ❑ Significant events and uncertainties ❑
Management’s Discussion and Analysis ◼ Designed to allow financial
statement users to assess the likelihood that past performance is indicative of future performance ◼ Contains estimates that are protected by “safe harbor” clause
Management’s Discussion and Analysis SEC also requires disclosure of qualitative and quantitative information about market risk by all companies registered with the SEC ◼ Market risk: the risk of loss arising from adverse changes in market rates and prices from such items as: 1. Interest rates 2. Currency exchange rates 3. Commodity prices 4. Equity prices ◼
Management’s Discussion and Analysis ◼
The quantitative information about market risk sensitive instruments is to be disclosed by using one or more of the following alternatives: 1. Tabular presentation of fair value information and contract terms relevant to determining future cash flows, categorized by expected maturity dates 2. Sensitivity analysis expressing the potential loss in future earnings, fair values, or cash flows from selected hypothetical changes in market rates and prices 3. Value at risk disclosures expressing the potential loss in future earnings, fair values, or cash flows from market movements over a selected period of time and with a selected likelihood of occurrence
Management’s Discussion and Analysis Objective of the quantitative disclosure requirements ❑ provide investors with forward looking information about a registrant's potential exposures to market risk ◼ Registrants are required to categorize market risk sensitive instruments into ❑ instruments entered into for trading purposes, and ❑ instruments entered into for purposes other than trading ◼
Management’s Discussion and Analysis ◼
Specifically, companies must disclose: 1. Their primary market risk exposures at the end of the current reporting period 2. How they manage those exposures ◼ ◼ ◼
such as a description of the objectives general strategies and instruments, if any, used to manage those exposures
Changes in
3.
either the primary market risk exposures b) or how those exposures are managed …when compared to the most recent reporting period and what is known or expected in future periods a)
Management’s Discussion and Analysis Hershey and Tootsie Roll
◼ ❑
Both companies use derivative financial instruments
2003: SEC published new interpretive guidelines
◼ ❑ ❑
❑ ❑
Overall presentation of MD&A Focus and content Disclosure of liquidity and capital resources Disclosure of critical accounting estimates
Letter To Stockholders Four main purposes. It indicates that management:
◼
1.
2.
3.
4.
Is responsible for preparation and integrity of statements Has prepared statements in accordance with GAAP Has used their best estimates and judgment States that the company maintains a system of internal controls
All Information Useful for Investment, Credit and Similar Decisions: Other Information Includes information about companies Also available outside the company’s annual report and 10-K. Examples of these types of information include
◼ ◼
◼
1. 2.
Analysts’ reports News articles about the company.
Analysts’ Reports ◼
Individual investors make essentially three investment decisions
Buy Hold Sell ◼
Potential investor decides to purchase a particular security on the basis of all available disclosed information Investor decides to retain a particular security basis of all available disclosed information Investor decides to dispose of a particular security basis of all available disclosed information
Usually accomplished by fundamental analysis as discussed in Chapter 4
Analysts’ Reports ◼
◼
Investment analysis may also be made by professional security analysts ❑ frequently specialize in certain industries ❑ use their training and experience to process and disseminate information more accurately and economically than individual investors 3 categories of financial analysts: 1. Sell side - Work for full-service broker dealer and make recommendations on securities they cover 2. Buy side -Work for institutional money managers such as mutual funds that purchase securities for their own accounts. Counsel their companies to buy, hold and sell 3. Independent - Not associated with firms that underwrite the securities they cover. Often sell their recommendations on a subscription basis
Analysts’ Reports ◼ Many analysts work in a world of
built-in conflicts of interest and competing pressures ◼ Sell-side firms want their individual investor clients to be successful over time because satisfied longterm investors are the key to the firm’s reputation and success
Analysts’ Reports ◼
Several factors can create pressure on an analyst’s independence and objectivity ❑ An analysts’ firm may be underwriting a company’s securities offering and client firms prefer favorable research reports ❑ Positive reports can generate additional clients and revenues ❑ Arrangements frequently tie compensation to continuation of clients ❑ Analysts may own securities individually or they may be owned by the analyst’s firm
SEC Disclosure Requirements ◼
The Securities Act of 1933 (Going Public) ❑ ❑
◼
Registration statement Prospectus
The Securities Exchange Act of 1934 (Being Public) ❑
Form 10, 10K and 10Q
The Foreign Corrupt Practices Act 0f 1977 ◼ The Sarbanes-Oxley Act of 2002 ◼
Foreign Corrupt Practices Act of 1977 ◼ Provisions:
Makes it a criminal offense to offer bribes to foreign officials 2 Requires detailed financial records and a system of internal control 1
The Sarbanes-Oxley Act of 2002 Early 2000s: dozens of major corporations either went bankrupt or faced extreme financial difficulties ◼ Included ❑ Enron ❑ WorldCom ❑ Xerox ❑ Global Crossing ❑ Arthur Andersen ❑ Merrill Lynch ❑ Tyco International ❑ Halliburton Oil Services. ◼
Result: ❑ Americans lost billions of their investment dollars ❑ jobs vanished ❑ thousands of people lost their entire retirement savings ◼ Subsequently, corporate reform became a watchword ◼
The Sarbanes-Oxley Act of 2002 Congress passed in 2002 ◼ Major provisions are: 1. The creation of a Public Company Accounting Oversight Board (PCAOB) 2. The Establishment of Auditing, Quality Control, and Independence Standards 3. The Inspection of CPA Firms 4. The Establishment of Accounting Standards 5. The Delineation of Prohibited Services 6. Prohibition of Acts that Influence the Conduct of an Audit 7. Requiring Specified Disclosures 8. Requiring CEO and CFO Certification ◼
The Sarbanes-Oxley Act of 2002: Sec. 404 Controversial ◼ 404(a) ❑ Management’s responsibilities ❑ Internal control report by management ◼
◼ ◼
Establishing and maintaining Assessment
404(b)
◼
Independent auditor’s responsibility
❑ ◼ ◼
◼
Report on management’s internal control assessment Assessment of company’s internal controls on financial reporting
2 separate opinions required
The Sarbanes-Oxley Act of 2002: Sec. 404 Higher audit fees for accelerated filers June 2007: PCAOB released Auditing Standard No. 5
◼ ◼ ❑
◼
◼
Integrated top-down, risk-based, materiality-focused approach to audit
One opinion: whether management has maintained internal control over financial reporting Compliance date extended for non-accelerated filers
Recent Developments July 2007: SEC chartered Advisory Committee on Improvements to Financial Reporting August 2008: final committee report included following recommendations
◼
◼ 1.
2.
3.
4.
5.
Usefulness of information in SEC reports should be increased Accounting standards-setting process should be enhanced Substantive design of new accounting standards should be improved Authoritative interpretive guidance should be delineated Guidance on financial restatements and accounting judgments should be clarified
Ethical Responsibilities ◼ What is ethics? ◼ Difference between morals
and ethics ◼ Professions are different ◼ Western ethics is based on the concept of utilitarianism ◼ Professional ethics proscribes a duty that goes beyond the ordinary citizen
Ethical Conduct of Accountants ◼ Ethical issues for accountants
Independence 2 Scope of service 3 Confidentiality 4 Practice development 5 Differences on accounting issues 1
Framework for Analysis of Ethical Issues ◼ Obtain the relevant facts ◼ Identify the ethical issues ◼ Determine the individuals
or groups affected ◼ Identify possible alternative solutions ◼ Determine how various individuals or groups are affected by alternative decisions ◼ Decide on appropriate action
The Ethical-Legal Question ◼ Just because something is
legal it is not necessarily ethical
AICPA Code of Professional Conduct 1 2
The AICPA represents itself as an ethical professional body practicing an art rather than a science Accounting should be viewed as practicing a service function rather than as a profit-making function 3
4
As an art, accounting requires judgment which encompasses ethical conduct To assist in satisfying its responsibilities to society, the accounting profession has developed a code of professional conduct
AICPA Code of Professional Conduct Society viewed accounting favorably until the late 1960s ◼ Watergate ◼ Accountants argued they shouldn’t be held responsible because ◼
these activities were difficult if not impossible to discover during a normal audit ❑ and not material in many cases anyway ❑
◼
Also concern over audit failures for such companies as Penn Central, National Student Marketing and Equity Funding
AICPA Code of Professional Conduct ◼ The role of Congress and Congressmen
Moss and Dingle Were the rules deficient? 2 Were the qualifications to be a CPA sufficient? 3 Was self-policing working? 1
◼ In response the Cohen Commission ❑
The Expectations Gap
AICPA Code of Professional Conduct ◼
The Anderson Report indicated that efficient performance should meet six criteria: 1 Safeguard public interest 2 Recognize CPA’s paramount role in the financial reporting process 3 Help assure quality performance and eliminate substandard performance 4 Help assure objectivity and integrity in public service 5 Enhance CPA’s prestige and creditability 6 Provide guidance as to proper conduct
AICPA Code of Professional Conduct ◼ As a result new ethical standards were
developed in response to the expectations gap
◼ The effect was: 1
2
3
Broader auditor responsibility to consider reliability of internal control system in planning an audit Delineate audit responsibility for reporting errors, irregularities and illegal acts by clients Evaluate ability of a firm to continue as a going concern
AICPA Code of Professional Conduct ◼ The new Code of Professional Conduct
contains four sections: 1
Principles ➢ ➢ ➢ ➢ ➢ ➢
2 3 4
Responsibility The public interest Integrity Objectivity and independence Due care Scope and nature of services
Rules of conduct Interpretations Ethical rulings
AICPA Code of Professional Conduct ◼
Overall the goal of the Anderson Report and the revised Code of Professional Conduct was to be more responsive to the public’s concern by providing 1
2 3 4 5 6
◼
Ethical guidance Broad positive statements Specific behavioral rules Proactive monitoring Broader rules application Guidance on dealing with the changing environment
The profession’s image by the public has suffered but has recently recovered.
International Accounting Standards
IAS No. 1: Presentation of Financial Statements ◼
Requires ❑
companies to present a statement disclosing each item of ◼ ◼ ◼ ◼
◼
income expense gain or loss …required by other standards to be presented directly in equity and the total of these items
◼
Notes to the financial statements must present information about the basis of preparation of the financial statements ❑ and the specific accounting policies selected ❑ must disclose all other information required by IASC standards not presented elsewhere in the financial statements ❑ must provide all other information necessary for a fair presentation ❑
IAS No 34: Interim Financial Reporting ◼
◼
◼
◼
Does not specify which enterprises should present interim financial reports ❑ left to be decided by laws or regulations Adopts the discrete view ❑ U. S. GAAP which requires the integral view The minimum content of an interim financial report is ❑ a condensed balance sheet ❑ condensed income statement ❑ condensed cash flow statement ❑ condensed statement of changes in equity ❑ explanatory notes. Also requires disclosure of unusual events
End of Chapter 17 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.