preparing financial statements - thomson reuters

PFST10

SELF�STUDY CONTINUING PROFESSIONAL EDUCATION

Companion to PPC's Guide to

Preparing FinancialStatements

Fort Worth, Texas(800) 431�9025trainingcpe.thomson.com

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Interactive Self�study CPE

Companion to PPC's Guide to PREPARING FINANCIAL STATEMENTS

TABLE OF CONTENTS

Page

COURSE 1: PREPARING FINANCIAL STATEMENTS: LIABILITIES AND STOCKHOLDERS' EQUITY

Overview 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 1: Liabilities 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 2: Stockholders' Equity 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 3: Accounting Changes 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Glossary 103. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 105. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COURSE 2: ACCOUNTING FOR CERTAIN TAX TRANSACTIONS

Overview 107. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 1: Selected Topics Part 1 109. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 2: Selected Topics Part 2 159. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Glossary 199. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 201. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COURSE 3: STATEMENT OF CASH FLOWS AND NOTES TO FINANCIAL STATEMENTS

Overview 203. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 1: The Statement of Cash Flows 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 2: Notes to Financial Statements 253. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Glossary 343. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 345. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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COURSE 4: PREPARING FINANCIAL STATEMENTS: ASSETS

Overview 349. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 1: Current Assets 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 2: Long�term Investments 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 3: Property and Equipment 411. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 4: Intangible Assets, Other Deferred Costs, and Long�lived Assets 437. . . . . . . . . . . . . . . . . .

Glossary 461. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 463. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To enhance your learning experience, the examination questions are located throughoutthe course reading materials. Please look for the exam questions following each lesson.

EXAMINATION INSTRUCTIONS, ANSWER SHEETS, AND EVALUATIONS

Course 1: Testing Instructions for Examination for CPE Credit 465. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 1: Examination for CPE Credit Answer Sheet 467. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 1: Self�study Course Evaluation 468. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 2: Testing Instructions for Examination for CPE Credit 469. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 2: Examination for CPE Credit Answer Sheet 471. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 2: Self�study Course Evaluation 472. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 3: Testing Instructions for Examination for CPE Credit 473. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 3: Examination for CPE Credit Answer Sheet 475. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 3: Self�study Course Evaluation 476. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 4: Testing Instructions for Examination for CPE Credit 477. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 4: Examination for CPE Credit Answer Sheet 479. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 4: Self�study Course Evaluation 480. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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INTRODUCTION

Companion to PPC's Guide to Preparing Financial Statements consists of four interactive self�study CPE courses.These are companion courses to PPC's Guide to Preparing Financial Statements designed by our editors toenhance your understanding of the latest issues in the field. To obtain credit, you must complete the learningprocess by logging on to our Online Grading System at cl.thomsonreuters.com or by mailing or faxing yourcompleted Examination for CPE Credit Answer Sheet for print grading by November 30, 2011. Completeinstructions are included below and in the Test Instructions preceding the Examination for CPE Credit AnswerSheet.

Taking the Courses

Each course is divided into lessons. Each lesson addresses an aspect of financial statement preparation. You areasked to read the material and, during the course, to test your comprehension of each of the learning objectives byanswering self�study quiz questions. After completing each quiz, you can evaluate your progress by comparingyour answers to both the correct and incorrect answers and the reason for each. References are also cited so youcan go back to the text where the topic is discussed in detail. Once you are satisfied that you understand thematerial, answer the examination questions which follow each lesson. You may either record your answerchoices on the printed Examination for CPE Credit Answer Sheet or by logging on to our Online Grading System.

Qualifying Credit HoursQAS or Registry

PPC is registered with the National Association of State Boards of Accountancy as a sponsor of continuingprofessional education on the National Registry of CPE Sponsors (Registry) and as a Quality Assurance Service(QAS) sponsor. Part of the requirements for both Registry and QAS membership include conforming to theStatement on Standards of Continuing Professional Education (CPE) Programs (the standards). The standards weredeveloped jointly by NASBA and the AICPA. As of this date, not all boards of public accountancy have adopted thestandards. Each course is designed to comply with the standards. For states adopting the standards, recognizingQAS hours or Registry hours, credit hours are measured in 50�minute contact hours. Some states, however, require100�minute contact hours for self study. Your state licensing board has final authority on accepting Registry hours,QAS hours, or hours under the standards. Check with the state board of accountancy in the state in which you arelicensed to determine if they participate in the QAS program or have adopted the standards and allow QAS CPEcredit hours. Alternatively, you may visit the NASBA website at www.nasba.org for a listing of states that acceptQAS hours or have adopted the standards. Credit hours for CPE courses vary in length. Credit hours for eachcourse are listed on the �Overview" page before each course.

CPE requirements are established by each state. You should check with your state board of accountancy todetermine the acceptability of this course. We have been informed by the North Carolina State Board of CertifiedPublic Accountant Examiners and the Mississippi State Board of Public Accountancy that they will not allow creditfor courses included in books or periodicals.

Obtaining CPE Credit

Online Grading. Log onto our Online Grading Center at cl.thomsonreuters.com to receive instant CPE credit.Click the purchase link and a list of exams will appear. You may search for the exam using wildcards. Payment forthe exam is accepted over a secure site using your credit card. For further instructions regarding the Online GradingCenter, please refer to the Test Instructions preceding the Examination for CPE Credit Answer Sheet. A certificatedocumenting the CPE credits will be issued for each examination score of 70% or higher.

Print Grading. You can receive CPE credit by mailing or faxing your completed Examination for CPE Credit AnswerSheet to the Tax & Accounting business of Thomson Reuters for grading. Answer sheets are located at the end ofall course materials. Answer sheets may be printed from electronic products. The answer sheet is identified with thecourse acronym. Please ensure you use the correct answer sheet for each course. Payment of $79 (by check orcredit card) must accompany each answer sheet submitted. We cannot process answer sheets that do not includepayment. Please take a few minutes to complete the Course Evaluation so that we can provide you with the bestpossible CPE.

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You may fax your completed Examination for CPE Credit Answer Sheet to the Tax & Accounting business ofThomson Reuters at (817) 252�4021, along with your credit card information.

If more than one person wants to complete this self�study course, each person should complete a separateExamination for CPE Credit Answer Sheet. Payment of $79 must accompany each answer sheet submitted. Wewould also appreciate a separate Course Evaluation from each person who completes an examination.

Express Grading. An express grading service is available for an additional $24.95 per examination. Courseresults will be faxed to you by 5 p.m. CST of the business day following receipt of your Examination for CPE CreditAnswer Sheet. Expedited grading requests will be accepted by fax only if accompanied with credit cardinformation. Please fax express grading to the Tax & Accounting business of Thomson Reuters at (817) 252�4021.

Retaining CPE Records

For all scores of 70% or higher, you will receive a Certificate of Completion. You should retain it and a copy of thesematerials for at least five years.

PPC In�House Training

A number of in�house training classes are available that provide up to eight hours of CPE credit. Please call ourSales Department at (800) 431�9025 for more information.

PFST10 Companion to PPC's Guide to Preparing Financial Statements

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COMPANION TO PPC'S GUIDE TO PREPARING FINANCIAL STATEMENTS

COURSE 1

PREPARING FINANCIAL STATEMENTS: LIABILITIES ANDSTOCKHOLDERS' EQUITY (PFSTG101)

OVERVIEW

COURSE DESCRIPTION: This interactive self�study course provides guidance for reporting liabilities andstockholders' equity on financial statements. Lesson 1 discusses current andnoncurrent liabilities, income taxes payable, and other liabilities as reported on thebalance sheet. Lesson 2 discusses the reporting of stockholders' equity. Lesson 3discussed how accounting changes affect the balance sheet.

PUBLICATION/REVISIONDATE:

November 2010

RECOMMENDED FOR: Users of PPC's Guide to Preparing Financial Statements

PREREQUISITE/ADVANCEPREPARATION:

Basic knowledge of financial statements.

CPE CREDIT: 8 QAS Hours, 8 Registry Hours

Check with the state board of accountancy in the state in which you are licensed todetermine if they participate in the QAS program and allow QAS CPE credit hours.This course is based on one CPE credit for each 50 minutes of study time inaccordance with standards issued by NASBA. Note that some states require100�minute contact hours for self study. You may also visit the NASBA website atwww.nasba.org for a listing of states that accept QAS hours.

FIELD OF STUDY: Accounting

EXPIRATION DATE: Postmark by November 30, 2011

KNOWLEDGE LEVEL: Basic

Learning Objectives:

Lesson 1Liabilities

Completion of this lesson will enable you to:� Identify and present current and noncurrent liabilities.� Classify and report income taxes payable.� Identify other liabilities, ownership agreements and provisions that affect balance sheet reporting.

Lesson 2Stockholders' Equity

Completion of this lesson will enable you to:� Identify and correctly report stockholders' equity on the balance sheet.

Lesson 3Accounting Changes

Completion of this lesson will enable you to:� Identify and report accounting changes on the balance sheet.

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TO COMPLETE THIS LEARNING PROCESS:

Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to:

Thomson ReutersTax & AccountingR&GPFSTG101 Self�study CPE36786 Treasury CenterChicago, IL 60694�6700

See the test instructions included with the course materials for more information.

ADMINISTRATIVE POLICIES:

For information regarding refunds and complaint resolutions, dial (800) 431�9025 for Customer Service and yourquestions or concerns will be promptly addressed.


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Lesson 1:�Liabilities

INTRODUCTION

SAS No. 29 lists the balance sheet as one of the basic financial statements. The balance sheet (or statement offinancial position) generally presents three major categories: (a) assets, (b) liabilities, and (c)�stockholders' equity.The balance sheet (together with certain disclosures made in the notes to the financial statements) is the vehiclecompanies use to present their financial position.

Criteria for Classification. The criteria for separating current and noncurrent items are specified by FASB ASC210�10�45�1 through 45�12; 310�10�45�9 (formerly ARB No. 43, Ch. 3A), and are summarized as follows:

� Current Assets. Cash and other assets that are reasonably expected to be realized in cash or sold orconsumed during one year or within the company's normal operating cycle if it is longer than a year.(Current assets normally include cash, marketable securities, receivables, inventories, and prepaidexpenses.) [FASB ASC 715�20�45�3 (formerly SFAS No. 106) requires an asset representing theoverfunded status of a defined benefit plan to be classified as a noncurrent asset as discussed in theRetirement Plan Considerations section.]

� Current Liabilities. Obligations whose liquidation is reasonably expected to require the use of current assetsor the creation of other current liabilities. (Current liabilities include short�term obligations such as payablesfor materials and supplies, wages, taxes, amounts collected in advance of delivery of goods or services,the current portion of long�term obligations, and any other obligations expected to be liquidated within ayear.) [FASB ASC 470�10�45 (formerly EITF Issue No. 86�5 and SFAS No. 6) and FASB ASC 715�20�45�3(formerly SFAS No. 106) address the appropriate classification of liabilities in certain situations asdiscussed in the Refinancing of Short�term Debt and Retirement Plan Considerations sections.]

� Operating Cycle. The time needed to convert cash first into materials and services, then into products, thenby sale into receivables, and finally by collection back into cash. In some industries, products have tomature or age or otherwise undergo an extended conversion period (for example, distilleries, tobacco,forest products, and shipbuilding), and the cycle goes beyond a year. However, most companies haveseveral cycles per year or no recognizable cycle.

If the operating cycle is shorter than a year or is not determinable, a one�year period is used for both assets andliabilities. If the operating cycle exceeds a one�year period, common practice is to use the operating cycle forclassifying assets as current, but to apply a one�year period for classifying liabilities.


Completion of this lesson will enable you to:� Identify and present current and noncurrent liabilities.� Classify and report income taxes payable.� Identify other liabilities, ownership agreements and provisions that affect balance sheet reporting.

CLASSIFYING AND REPORTING CURRENT LIABILITIES

The primary balance sheet caption �CURRENT LIABILITIES" may include the following secondary captions:

� Short�term debt (notes and loans)

� Current portion of long�term debt

� Accounts payable

� Accrued liabilities

� Income taxes payable�current and deferred


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This section discusses short�term debt, accounts payable, accrued liabilities, and other current liabilities. It alsodiscusses short�term debt refinancing and whether the debt should be classified as current or long�term. The twoother common current liabilities, income taxes and current portion of long�term debt, are also discussed in thislesson.

Short�term Debt

Short�term debt includes both notes (when there is a written document) and loans (when there is no writtendocument). Short�term notes customarily require payment in a period shorter than one year, for example, 90 daysor on demand. In selecting captions for short�term debt and considering the order of presentation, the followingguidelines are suggested:

a. The caption should distinguish between loans (when there is no written document) and notes (when thereis a written document).

b. Material loans from related parties should be disclosed.

c. There is no need to name the lender, for example, First National Bank of Fort Worth.

d. The order of presentation should be as follows:

(1) Notes payable to third parties

(2) Notes payable to related parties

(3) Loans

The preceding guidelines are illustrated by the following balance sheet presentation:

20X2 20X1

CURRENT LIABILITIES

Short�term notes $ 50,000 $ 75,000

Loans payable to stockholders � 25,000

Accounts Payable

The balance sheet caption �Accounts payable" or �Trade accounts payable" includes costs and expenses that arecustomarily billed through a third party invoice. They should normally be recorded at the invoice amount. Concep�tually, the amount should be reported net of vendor discounts if the company normally takes cash discounts andis financially capable of continuing to take the discounts, although in practice, vendor discounts may not bematerial. (Since some note holders send periodic �billings" for current debt service payable, preparers should besure that listings of accounts payable exclude them.) Material debit balances in accounts payable should bereclassified as accounts receivable (if collectible in cash) or inventory (if they will be applied to future purchases).

Cutoff Problems. It is not uncommon for nonpublic companies to �hold open" cash disbursements for a few daysafter year end. As a result, both cash and accounts payable are understated in the balance sheet. Although thereis no effect on working capital, the understatements may be material to cash, accounts payable, current assets, andcurrent liabilities and do affect the current ratio. Preparers should be alert for cutoff problems.

Unrecorded Liabilities. Many nonpublic companies do not have voucher systems and, accordingly, mustconstruct accounts payable. Possible sources include all disbursements subsequent to the balance sheet date,vendor statements dated as of the balance sheet date, and vendor invoices on hand. Preparers should be alert tothe possibility of unrecorded liabilities. Many preparers set a minimum dollar amount for items that will be consid�ered, such as all subsequent disbursements over $500 during the first month after the balance sheet date and over$750 during the second month.


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Accrued Liabilities

Accrued liabilities are estimates of the obligation for expenses that have been incurred but for which no billing hasbeen received. In some cases, such as product warranties, the specific person to whom payment will be madecannot be determined. Some of the expenses that may require accrual are as follows:

� Compensation

� Income taxes

� Interest

� Payroll taxes

� Retirement plan contributions

� Royalties

� Damages under lawsuits

� Vacation pay

� Warranty claims

GAAP MeasurementGeneral. The accounting requirements for recording accrued expenses and the relatedliability are specified by SFAS No. 5, Accounting for Contingencies (FASB ASC 450�20�25�2), which requires anaccrual when both of the following conditions exist at the balance sheet date:

a. It is probable that a liability has been incurred.

b. The amount can be reasonably estimated.

In June 2008, the FASB issued an exposure draft of a proposed standard, Disclosure of Certain Loss Contingen�

cies, which would expand disclosures about certain loss contingencies. It would not change the recognition andmeasurement guidance for loss contingencies. Practitioners should monitor the FASB website at www.fasb.org forfuture developments related to this project.

For most accrued expenses, the fact that a liability has been incurred at the balance sheet date is clear, and thedifficulty arises in making a reasonable estimate of the amount. When the estimate is a range rather than a specificamount, FASB ASC 450�20�30�1 (formerly FASB Interpretation No. 14) provides the following guidelines:

� If one amount within the range is considered to be the best estimate, it should be used as the accrual.

� If no amount within the range is considered to be the best estimate, the lowest amount in the range shouldbe used as the accrual.

Accrued Vacation Pay. FASB ASC 710�10�25�1 (formerly SFAS No. 43, Accounting for Compensated Absences),requires accruing a liability for employees' compensation for future absences if all of the following conditions aremet:

a. The employer's obligation relating to employees' rights to receive compensation for future absences isattributable to employees' services already rendered.

b. The obligation relates to rights that vest or accumulate.

(1) Vested rights are those that the employer has an obligation to pay even if an employee terminates.


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(2) �Accumulate" means that the employee may carry unused vacation forward to subsequent periods,even though there may be a limit to the amount that can be carried forward. [FASB ASC 710�10�25�5(formerly EITF Issue No. 06�2, �Accounting for Sabbatical and Other Similar Benefits Pursuant to FASBStatement No. 43") considers whether the right to a compensated absence under certain sabbaticalor other similar benefit arrangements should be considered to accumulate. In an arrangement inwhich during the compensated absence the individual continues to be a compensated employee andis not required to perform services for the entity, the right to the compensated absence is consideredto accumulate if (a) the arrangement requires the completion of a minimum service period and (b) thebenefit does not increase with additional years of service.]

c. Payment of the compensation is probable.

d. The amount can be reasonably estimated.

If compensated absences are not accrued because the amounts cannot be reasonably estimated, employersshould disclose that fact in their financial statements. GAAP does not require accrual of nonvesting rights to sickpay; thus, it applies primarily to vacation pay.

Although many nonpublic companies do not have a formal vacation policy, most allow employees to take vacationsunder an informal arrangement. The arrangements often provide for the following:

a. The number of days varies with the length of service.

b. The vacation days must be used by a certain time (typically December 31) or they are lost.

c. Whether an employee that quits will be paid for unused vacation is at the employer's discretion.

d. If the employer lays off or fires the employee, the employee will normally be paid for unused vacation, butpayment is at the employer's discretion.

Informal arrangements also should be evaluated to determine if a liability for vacation pay should be accrued. If acompany does not have formal (written) policies, factors such as the following should be considered in determiningthe need to accrue unused vacation pay:

a. If the company reports on a fiscal year and the vacation year is on a calendar year, the vacation rightsaccumulate at the balance sheet date.

b. If the employer customarily pays for unused vacation pay on termination, the vacation rights are vested.

c. If the employee may carry forward some unused days to the next year, the vacation rights accumulate.

Vacation pay to be accrued generally is calculated by preparing a schedule showing unused vacation days andsalary per day for each employee as of the balance sheet date. Although GAAP does not specify the rate to use, itimplies that the accrual should be based on compensation that will actually be paid. Accordingly, the computationbecomes more complicated when employees are paid a combination of salary and commissions. (Benefits such asretirement plans, insurance, and FICA taxes do not have to be considered in the accrual.) In evaluating the need foran accrual, the materiality of not providing the accrual should be determined based on the effect on currentliabilities and on expenses. The effect sometimes may be estimated using a technique such as the following,particularly when vacation pay does not accumulate:

a. Determine total salaries and wages for the year.

b. Compute the cost per week.

c. Multiply that amount by the estimated average number of vacation weeks allowed. As an example, ifemployees start with two weeks' vacation and move to three weeks after five years, an appropriate estimateof the average may be 2.5 weeks.


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d. The result should be the maximum understatement, because it does not consider that some vacation dayshave been used.

e. The amount should be compared with total current liabilities.

f. A similar estimate also should be made at the beginning of the year. The change in the estimate should becompared with total costs and expenses.

g. If the estimate is not material to either the balance sheet (step e.) or the income statement (step f.), the actualunderstatement would not be material.

Postemployment Benefits. Employers often provide postemployment benefits to former or inactive employeesafter employment but before retirement. Such benefits include the following (the list is not all�inclusive):

� Salary continuation

� Supplemental unemployment benefits

� Severance benefits

� Disability�related benefits

� Job training and counseling

� Continuation of health care benefits and life insurance coverage

FASB ASC 712�10�05�5 and 05�6; 712�10�15�3 and 15�4; 712�10�25�4 and 25�5; 712�10�35�1; 712�10�50�2 (formerlySFAS No. 112, Employers' Accounting for Postemployment Benefits), establishes accounting standards foremployers that provide postemployment benefits. Employers are required to accrue an obligation to providepostemployment benefits if all of the following conditions are met:

� The obligation is attributable to employees' services already rendered.

� Employees' rights to those benefits accumulate or vest.

� Payment of the benefits is probable.

� The amount of the benefits can be reasonably estimated.

If all of the preceding conditions are not met, employers should follow the contingency guidance and accruepostemployment benefits when it is probable that a liability has been incurred and the amount can be reasonablyestimated. (If obligations are not accrued because the amounts cannot be reasonably estimated, employersshould disclose that fact in their financial statements.)

Compensation and Payroll Taxes. Accruals for compensation and payroll taxes generally include the following:

a. Gross compensation for the expired portion of a pay period that straddles the balance sheet date

b. Bonuses

c. Amounts that were withheld from employees' compensation in prior pay periods but have not beenremitted to the appropriate third party

d. Employer's taxes on compensation charged to earnings, for example, FICA and federal and stateunemployment taxes

Practice varies on whether separate captions are used for each of the preceding components. This courserecommends grouping all of them into a single amount with a caption such as �Compensation" or �Compensation


8

and related taxes," however. Since withholdings arise through compensation expense and are normally due atapproximately the same time, there is no need to disclose them separately.

Retirement Plan Considerations. Measurement and presentation considerations for retirement plans are asfollows:

� Pension expense charged to earnings for defined contribution plans usually will be the same ascontributions related to the period. Therefore, the accrual at the balance sheet date usually represents theremaining contributions due. Accordingly, the captions �Retirement plan contribution" or �Contribution toretirement plan" are normally appropriate for the accrual. A caption such as �Prepaid retirement plancontributions" could be used for an excess of contributions over expense related to the defined contributionplan.

� Companies sometimes maintain a variety of plans, such as a defined benefit plan, a defined contributionplan, and a profit sharing plan. There is no need to use different accrual captions for each plan. They shouldbe combined into a single caption such as �Contributions to retirement plans" or �Retirement plancontributions." Generally, the reader would not be helped by having separate accruals for each plan.

� A reporting entity that sponsors one or more single�employer defined benefit plans (such as a pension orother postretirement benefit plan) is required to recognize the funded status of the plan in its balance sheet.The funded status of a plan is calculated as the difference between the fair value of a plan's assets and thebenefit obligation. If the fair value of plan assets exceeds the benefit obligation, the plan is overfunded, andthe entity should report an asset in its balance sheet. Alternatively, a liability should be recognized if thebenefit obligation is greater than the fair value of the plan's assets, which results in the plan beingconsidered underfunded.

If an entity sponsors more than one defined benefit plan, the entity is not permitted to aggregate all plansand report a single net asset or net liability. However, the reporting entity should combine all of itsoverfunded plans and recognize the total as an asset in the balance sheet. Likewise, it should combine allof its underfunded plans and recognize that total as a liability in the balance sheet. If the entity presents aclassified balance sheet, the asset for an overfunded plan should always be classified as a noncurrentasset. Nevertheless, the liability for an underfunded plan must be classified as current, noncurrent, or acombination of both. The current portion should be determined individually for each plan and should becalculated as the amount by which the actuarial present value of benefits in the benefit obligation payablein the next 12 months (or, if longer, the entity's operating cycle) is greater than the fair value of plan assets.

Certain of the illustrations in FASB ASC 715�20 (formerly SFAS No. 158, Employers' Accounting for Defined

Benefit Pension and Other Postretirement Plans), use the balance sheet caption �Liability for pensionbenefits" to recognize an underfunded pension plan. Other captions may be used, such as �Liability forother postretirement benefits," �Underfunded pension obligation," or �Excess pension obligations." Anappropriate balance sheet caption for an overfunded plan would be �Overfunded pension obligation,"�Overfunded other postretirement obligation," or �Excess pension assets." Also, reporting entities shouldpresent the funded status of defined benefit pension plans separate from the funded status of definedbenefit other postretirement benefit plans. Thus, if a reporting entity has both an underfunded pension planand an underfunded other postretirement benefit plan, the reporting entity should report each amount asseparate liabilities in the balance sheet.

Claims�made Insurance Policies. An increasing number of liability insurance policies written are claims�madepolicies rather than the typical occurrence policies. The claims�made coverage insures only those claims that arereported to the insurance company during the policy period. (In contrast, occurrence policies insure claims arisingfrom events that occur during the policy period regardless of when the claim is made.) Accordingly, with claims�made coverage, companies have a liability for any losses incurred during the policy period that have not beenreported to the insurance company.

FASB ASC 720�20�25�14 (formerly EITF Issue No. 03�8, �Accounting for Claims�Made Insurance and RetroactiveInsurance Contracts by the Insured Entity") provides that companies should record a liability for probable lossesfrom claims incurred but not reported during the policy period if the losses are both probable and reasonably


9

estimable. The liability should be evaluated in subsequent periods and adjusted, if necessary. For example, if thecompany purchases new coverage that insures events arising during the claims�made policy period but notreported to the insurance company or renews the claims�made coverage, an adjustment to reduce or eliminate theliability might be necessary because incurred but not reported claims would be partially or totally covered byinsurance.

If it is reasonably possible that a loss has been incurred, the appropriate disclosures should be made.

Balance Sheet Presentation of Accrued Liabilities. The following are three basic ways of presenting accruedliabilities in the balance sheet:

� Group all accrued expenses under a heading such as �accrued expenses," as illustrated below:

20X2 20X1

CURRENT LIABILITIES


Accounts payable 90,000 80,000

Accrued expenses

Compensation 10,000 15,000

Retirement plan contributions 7,000 6,000

Other 3,000 4,000

TOTAL CURRENT LIABILITIES 160,000 165,000

� Present the components of accrued expenses as separate line items without using �accrued" in the captionas illustrated below:

20X2 20X1

CURRENT LIABILITIES





Other 3,000 4,000


� Combine all accrued expenses and present as one caption. This presentation is appropriate when noneof the components is individually material to the total or to current liabilities.

20X2 20X1

CURRENT LIABILITIES



Accrued expenses 20,000 25,000


Other Current Liabilities

Agency Obligations. Agency obligations arise from the collection or acceptance of cash or other assets for theaccount of third persons, such as sales taxes. Essentially they are �wash" transactions and should have no effecton a company's assets or operations. Amounts withheld from employees' pay for items such as income taxes,FICA, and insurance are not agency obligations because the employer acts as a disbursing agent for the


10

employee. Those amounts are accrued expenses.) Since agency obligations are �pass through items," distinguishthem from accounts payable and accrued expenses when they are material. The captions should be descriptive asillustrated by the following:

� Sales taxes

� Escrow obligations

� Refundable deposits

If the amounts are not material, the liabilities should be included in accounts payable.

Deferred Revenues. FASB ASC 210�10�45�8 (formerly ARB No. 43, Chapter 3A) defines deferred revenues ascollections received in advance of the delivery of goods or performance of services. The following are examples:

� Membership dues and fees received in advance

� Advance rental payments received from lessees

Classification as current or noncurrent depends on when they will be included in earnings. If the deferral will becredited to earnings over a period longer than one year, for example, membership dues under a three�year plan, itshould be divided into current and noncurrent portions. Refundable deposits, such as damage deposits fromlessees, should normally be treated as agency obligations. Nonrefundable deposits would normally be taken intoearnings when received. Nonpublic companies ordinarily do not have more than one source of deferred revenues.The caption used should describe the source as illustrated by the following alternatives:

� Membership fees received in advance

� Refundable damage deposits

Refinancing of Short�term Debt

Practice Problems in Classification of Short�term Debt. Because lenders and bonding agents tend to empha�size working capital levels, companies sometimes attempt to exclude short�term debt from current liabilities unlessit clearly will be repaid within one year. The following are examples of those situations:

a. Interim construction financing, for example, bridge loans for construction of a building that will be convertedto long�term financing when construction is complete

b. Demand notes that are being repaid in installments over a period longer than one year in either of thefollowing cases:

(1) The note is strictly a demand note, but the lender orally agreed to accept payment in installments.

(2) The note specifies the installments, but also allows the lender to call the note at his option.

c. The company is in default on a long�term obligation because it violated one of the following types ofcovenants of the loan agreement:

(1) Transaction default (For example, the company bought equipment without the prior approval of thelender.)

(2) Condition default (For example, the company's operations are less profitable than levels prescribedby the agreement.)

Criteria for Classification as Current or Noncurrent. FASB ASC 210�10�20 (formerly SFAS No. 6, Classificationof Short�Term Obligations Expected to Be Refinanced) refers to �short�term obligations" as those scheduled to


11

mature within one year after the date of a company's balance sheet. Short�term obligations are normally classifiedas current liabilities. However, FASB ASC 470�10�45�13 and 45�14 (formerly SFAS No. 6) indicates short�termobligations should be included with noncurrent liabilities if both of the following conditions are met:

a. Intent to refinanceThe company intends to refinance the obligation on a long�term basis.

b. Ability to consummate the refinancingAbility may be demonstrated in either of the following ways:

(1) Post Balance Sheet Date Issuance of a Long�term Obligation or Equity Securities. After the balancesheet date but before the balance sheet is available to be issued, a long�term obligation or equitysecurities have been issued for the refinancing.

(2) Financing Agreement. Before the balance sheet is available to be issued, the company has enteredinto a financing agreement that clearly permits refinancing on terms that are readily determinable, andall of the following conditions are met:

(a) the agreement does not expire within one year (or within the operating cycle) from the balancesheet date and the agreement is not cancelable by the lender (or callable) except for violationof a provision with which compliance is objectively determinable or measurable;

(b) no violation of any provision in the agreement exists at the balance sheet date, and no availableinformation indicates that a violation has occurred after that date but prior to the date the balancesheet is available to be issued, or if there has been a violation, a waiver has been obtained; and

(c) the lender is expected to be financially capable of honoring the agreement.

Suggested GuidelinesBridge Loans. Bridge loans are often with a bank, but the borrower intends to refinancewith some other financing institution. In reality, the debt has to be refinanced, and normally negotiations haveprogressed to the point that commitment letters have been obtained for the long�term financing. If letters have beenobtained, the requirements have been met, and the debt should be classified as noncurrent. However, if completionis anticipated within a year, and commitment letters have not been obtained, the preparer has no real basis forexcluding the note from current liabilities. Also, common sense dictates that classification as current is the moreeconomically realistic approach, since the lack of commitment letters may indicate that there is some problemobtaining long�term financing.

Accounting for Demand Loans. FASB ASC 210�10�20 (formerly SFAS No. 6) defines short�term obligation as onescheduled to mature within one year. Should �scheduled" be interpreted based on form (if so, all demand noteswould be classified as current) or on substance (if so, some demand notes would be classified as noncurrent)?Some preparers have attempted to overcome the problem by requesting that the lender waive its right to call thenote during the next year. However, they are normally unsuccessful. Instead, the lender will at best say that the loanwill not be called �provided there are no adverse shifts in operations." Therefore, preparers should be alert for �dueon demand" clauses that are included in many standard commercial bank notes and, at first glance, may appearto be long�term notes. An example of a typical $30,000 note that contains both a due on demand clause and amaturity schedule is as follows:

The note is due on demand, but if no demand is made, is payable as follows:

January 1, 20X1 $ 10,000

January 1, 20X2 10,000

January 1, 20X3 10,000

In FASB ASC 470�10�45�9 and 45�10 (formerly EITF Issue No. 86�5, �Classifying Demand Notes with RepaymentTerms") an obligation that, by its terms, is due on demand should be considered a current liability. Factors such asan assessment of the likelihood that the creditor actually will call the notes do not affect the classification decision.Demand notes that specify or permit installments, lines of credit, and borrowings from stockholders are currentliabilities unless the creditor has specifically waived the right to demand payment for more than one year from the


12

balance sheet date. GAAP requires an unconditional waiver, however, before short�term debt may be classified asnoncurrent. A waiver stating that the loan will not be called provided there are no adverse shifts in operations orusing similar language is not sufficient.

Accounting for Violations of Debt Covenants

If violations of long�term debt agreements exist that make the debt callable within one year from the balance sheetdate (or callable within one year from the balance sheet date if not cured within a specified grace period), thelong�term debt should be classified as a current liability unless:

� the creditor has specifically waived the right to demand payment for more than one year from the balancesheet date,

� the violation is cured after the balance sheet date but before the financial statements are available to beissued, or

� the company demonstrates that it is probable it will be able to cure the violation within the grace period.

The preceding criteria apply to a violation of debt agreements whether they are condition violations, transactionviolations, or other violations that the debtor believes are merely technical. In reaching that conclusion, the FASBbelieved that the debtor would be able to obtain a waiver for violations considered insignificant by the creditor.

A subjective acceleration clause allows a creditor to accelerate the maturity of long�term debt based on subjectivecriteria such as �occurrence of material adverse changes" or �failure to maintain satisfactory operations." However,FASB ASC 470�10�45�2 (formerly FASB Technical Bulletin No. 79�3, Subjective Acceleration Clauses in Long�TermDebt Agreements), indicates that an evaluation of all of the facts and circumstances is necessary in decidingwhether (a) the long�term debt should be classified as current, (b)�the subjective acceleration clause should bedisclosed, or (c) neither disclosure nor reclassification is called for because the company is in good financialcondition.

Subjective Acceleration Clauses. Banks often use a standard note agreement that contains a subjective accel�eration clause. In many cases, the clause is included with boilerplate language about conditions of default and iseasy to overlook. The following is an example of a subjective acceleration clause:

Default, Acceleration and Setoff

Any one of the following shall constitute an event of default under the terms of this Note: . . . (5) adetermination by the Bank that it deems itself insecure or that a material adverse change in thefinancial condition of any Party or decline or depreciation in the value or market value of anyCollateral has occurred since the date of this Note or is reasonably anticipated; . . . If an event ofdefault occurs, .�.�. the entire unpaid balance of this Note, shall, at the option of the Bank, becomeimmediately due and payable, without notice or demand . . . . To the extent permitted by law, upondefault, the Bank will have the right . . . to set off the amount due under this Note or due under anyother obligation of the Bank against any and all accounts . . . or other security . . . held by the Bank. . . to the credit of any party, without notice or consent . . . .

Subjective acceleration clauses often are found in bank commitment letters, too, as the following example illus�trates:

MATERIAL ADVERSE CHANGE:

This commitment may be terminated, at the sole discretion of the Bank, upon the occurrence ofa material adverse change in the financial condition of the Borrower or any other person liable tothe Bank for the repayment of this loan.

In both of the preceding examples, a change in the financial condition of either the debtor or guarantors triggers theclause. The clause in the first example is also triggered by declines in the value of the collateral, whether the debtor,


13

one of its owners, or some other entity owns the collateral. Neither example requires the bank to call the loan; theclause only gives it the option of calling the loan. But the existence of the option raises measurement and disclosurequestions, such as the following:

a. When does a subjective acceleration clause require reporting all of the balance of a long�term note as acurrent liability?

b. What should the financial statements say about such clauses?

Subjective acceleration clauses are addressed by FASB ASC 470�10�45�2 (formerly FASB Technical Bulletin No.79�3) and FASB ASC 470�10�45�12 and 45�13 (formerly SFAS No.�6). FASB ASC 470�10�45�2 addresses such aclause in an existing long�term note. It only requires classifying the outstanding principal as current if default underthe clause within a year of the balance sheet date is probable and the likelihood the bank will call the loan in theevent of such default is probable. FASB ASC 470�10�45�12 and 45�13 addresses a subjective acceleration clausein an agreement to refinance a short�term note on a long�term basis. It prohibits reclassifying the present debt whenthe refinancing agreementeither a new note or a commitment letterhas a subjective acceleration clause. It doesnot allow probability assessments.

FASB ASC 470�10�45�3 through 45�6 (formerly EITF Issue No. 95�22, �Balance Sheet Classification of BorrowingsOutstanding under Revolving Credit Agreements That Include both a Subjective Acceleration Clause and a Lock�Box Arrangement") addresses the effect of subjective acceleration clauses on classifying revolving credit agree�ments that require the use of a lock�box arrangement in which the lender applies payments remitted by theborrower's customers directly to the lock�box as a reduction of the borrower's debt. Debt outstanding under suchagreements should be considered a short�term obligation. Therefore, the debt should be classified as a currentliability because of the subjective acceleration clause, unless the conditions for classification as a noncurrentliability in the �GAAP Criteria for Classification as Current or Noncurrent" section are met based on an agreement(other than the revolving credit agreement) to refinance the obligation on a long�term basis after the balance sheetdate.

Assessing the likelihood that an existing note will be called requires considering the likelihood of a default eventoccurring and the likelihood the bank will call the loan if such an event is probable. This course recommends thefollowing steps:

a. Identify the events that would trigger the clause.

b. Based on information available prior to issuing the financial statements, consider the likelihood of one ofthose events occurring within one year from the balance sheet date. That may require inquiries about thefinancial condition of guarantors and the value of collateral. Some practical considerations in making theassessment follow:

(1) Concluding that an event is probable is often justified only if it is a continuation of an existing condition,such as continuing losses, or an event has occurred, such as a fire or other casualty.

(2) If a significant change in a market condition either has occurred or is probable, such as theintroduction of a competing line, evaluating the likelihood of a material adverse effect requires anassessment of how long it will take the condition to affect the entity and whether the entity will be ableto develop a compensating strategy. Often, a material adverse effect within a year of the balance sheetdate is not probable.

c. If a default condition is probable, consider the likelihood that the bank will call the loan. Best practicesindicate that only if that is probable should the debt be reclassified. Often a loan is called only if the situationrepresents a deterioration of already existing conditions.

The need to disclose the existence of a subjective acceleration clause depends on the likelihood that the bank willcall the loan. Disclosure of subjective acceleration clauses should be addressed in the following ways:

a. If a long�term note is reclassified as current because of a subjective acceleration clause, the financialstatements should disclose the reasons.


14

b. If calling the note is at least reasonably possible and it would have a material effect on the financialstatements within the near term, the provisions of FASB ASC 275�10 (formerly SOP 94�6, Disclosure ofCertain Significant Risks and Uncertainties) apply.

c. If there is only a remote chance the loan will be called, no disclosure is necessary. Disclosing a subjectiveacceleration clause in that circumstance may unnecessarily alarm the reader.

Demand loans can also include subjective acceleration clauses. However, since demand loans are already classi�fied as current liabilities, the clause has no additional effect in those cases.

Questions have arisen about whether the balance sheet classification of debt is affected by (a)�violations that occursubsequent to the balance sheet date or (b) violations that have not occurred but are probable. The followingparagraphs discuss those issues, and Exhibit 1�1 summarizes the accounting for covenant violations.


15

Exhibit 1�1

Accounting for Covenant Violations

Yes

Yes

Did aviolation occur

at the balance sheet date or would one have occurred absent

a loan modification?

Yes

No

Was anunconditional

waivercovering

the next 12 monthsobtained?

Classify ascurrent

Did a violationoccur prior to

the statement being available to be issued?

Does it indicatea condition

existing at thebalance sheet?

No No

No

Yes

NoAre violations

within thenext 12 months

probable?

Classify asnoncurrent

Yes

* * *


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Subsequent Violations. Although GAAP provides guidance on classifying long�term debt when covenant viola�tions have occurred at the balance sheet date, it does not address whether classification is affected when violationsoccur after the balance sheet date but before the financial statements are available to be issued. The issue isparticularly relevant for smaller companies because, although accountants only have a responsibility to considersubsequent events that occur between the balance sheet date and the date financial statements are available to beissued, smaller companies tend to have longer intervals between those dates. (Intervals of 75 days or longer are notuncommon because the financial statements of many smaller companies are issued or are available to be issuednear the date that their federal tax returns are due.)

In deciding how subsequent covenant violations affect the financial statements, the guidance on subsequentevents in FASB ASC 855 (formerly SFAS No. 165, Subsequent Events) applies. GAAP identifies two types ofsubsequent events. The first type is recognized subsequent events (called Type I in prior standards) and the secondtype is nonrecognized subsequent events (called Type II in prior standards). As the names imply, recognizedsubsequent events are recognized in an entity's financial statements and nonrecognized subsequent eventsshould not be recognized in an entity's financial statements. However, some nonrecognized subsequent eventsmay be of such a nature that disclosure would be required to keep the financial statements from being misleading.In most cases, covenant violations may be classified as follows:

CovenantViolation

Subsequent EventClassification

Effect on FinancialStatements

Technical covenants, i.e., those that prohibita borrower from doing something such aspaying dividends or buying equipment overa prescribed dollar limit without priorapproval.

Nonrecognized Possible disclosure

Condition covenants, i.e., those that requirecertain conditions to exist such as pre�scribed debt�to�equity ratio, earnings level,or working capital level.

Recognized or nonrecogni�zed depending on whetherthe violation is indicative ofconditions existing at the bal�ance sheet date

Measurement ordisclosure

Violations of condition covenants generally would be recognized subsequent events. (Such violations could benonrecognized subsequent events, however, if the violation results from a discrete event that occurs after thebalance sheet date, such as failure to meet prescribed earnings levels as a result of a fire or flood.) Thus, if theviolation makes long�term debt callable by the lender, the debt should be classified as a current liability.

Probable Violations. Questions have been raised about whether long�term debt should be classified as currentwhen covenant violations have neither occurred at the balance sheet date nor the date the financial statements areavailable to be issued, but the accountant believes that it is probable that covenant violations will occur within thenext 12 months (or operating cycle, if longer). For example, consider the following scenario:

� A company has a long�term debt that requires compliance with certain condition covenants, such as aminimum level of stockholders' equity on a quarterly or semi�annual basis.

� At the balance sheet date, the company is in violation of the covenant, thus giving the lender the ability tocall the debt, but the lender waives its rights resulting from that violation for a period greater than one year.

� The lender retains the future covenant compliance requirements.

Does the lender's waiver constitute a grace period since the company must meet the same or a similar test at thenext quarterly or semi�annual compliance date? If viewed as a grace period, and it is not probable that the companywill be able to comply with the covenant at the end of the grace period, GAAP would require the debt to be classifiedas current.


17

FASB ASC 470�10�45�1 (formerly EITF Issue No. 86�30, �Classification of Obligations When a Violation Is Waived bythe Creditor") concludes that such long�term obligations should be classified as noncurrent unless both of thefollowing conditions exist:

� A covenant violation has occurred at the balance sheet date or would have occurred absent a modification.

� It is probable that the borrower will not be able to cure the default (or comply with the covenant) atmeasurement dates that are within the next 12 months (or operating cycle, if longer).

A violation must have occurred before classification becomes an issue. However, if a violation would have occurred,but the loan agreement is modified to postpone the compliance requirement, the substance of the situation isconsidered to be the same as a violation occurring.

Some general observations about applying FASB ASC 470�10�55 when a violation has occurred at the balancesheet date are as follows:

� If the covenant requires annual measurement and the lender waives its right to call the loan for the next year,the debt normally should be classified as noncurrent.

� If the covenant requires interim measurement and the lender waives its right to call the loan for the next year,it also generally would be appropriate to classify the debt as noncurrent.

� However, if the covenant requires interim measurement and the lender reserves its rights to reconsidercompliance at any future measurement date within the next 12 months (or operating cycle, if longer), thedebt should be classified as current if noncompliance during the period is probable and noncurrent ifnoncompliance is not probable.

� Even if a waiver is obtained for the proper period, it would be necessary to reconsider the appropriateclassification when the next interim statements are prepared because the new 12�month period will extendbeyond the original waiver period.

Illustrations. To illustrate, assume that a loan agreement requires attaining working capital levels of $150,000 byDecember 31, 20X1, $175,000 by June 30, 20X2, and $200,000 by December 31, 20X2.

a. If working capital at December 31, 20X1 was less than $150,000 but the lender unconditionally waived itsright to call the loan prior to January 1, 20X3 (i.e., 12 months plus one day), the debt should be classifiedas noncurrent even if the company forecasted working capital levels less than $175,000 at June 30, 20X2,and less than $200,000 at December 31, 20X2. However, classification problems might appear in 20X2interim financial statements as follows:

(1) If the March 31, 20X2 financial statements report working capital of at least $150,000, the companyis in compliance since the higher compliance criteria are not yet in effect. Therefore, it would not benecessary to assess probability of compliance at either June 30, 20X2, or December 31, 20X2, andthe debt should be classified as noncurrent.

(2) If the March 31, 20X2 financial statements report working capital of less than $150,000, the companyis in violation of the agreement, and the original waiver expires in less than 12 months. Therefore, theloan should be classified as current unless a new waiver is obtained to prevent the lender from callingthe loan prior to April 1, 20X3.

b. If at December 31, 20X1, working capital was less than $150,000 but the loan agreement was modified toeliminate the December 31 compliance requirement (but all future compliance requirements wereretained), it would be necessary to assess the probability of the company meeting future covenantrequirements. If it were probable that the company could attain required working capital levels at both June30, 20X2, and December 31, 20X2, the debt should be classified as noncurrent. If it were unlikely, however,that the�required working capital levels could be attained at either of those dates, the debt should beconsidered as current unless the lender unconditionally waived its right to call the loan prior to January 1,20X3.


18

If the preceding example were modified so that the loan was obtained in January 20X2 and required an immediateworking capital level of $150,000, debt classification would not be an issue since the debt would not be reported inthe December 31, 20X1 financial statements. Similarly, if the preceding example were modified so that the loan wasobtained in 20X1, but there were no compliance requirements prior to 20X2, it would not be necessary to assess theprobability of compliance within the next 12 months, and the debt would be classified as noncurrent.

The focus of the standard is only on whether long�term debt should be classified as current or noncurrent in thepreceding circumstances. Regardless of how the debt is classified, companies may need to disclose the potentialadverse consequences of its failure to satisfy future covenants.


19

SELF�STUDY QUIZ

Determine the best answer for each question below. Then check your answers against the correct answers in thefollowing section.

1. Which one of the following is a secondary caption that might be listed under the primary caption �CURRENTLIABILITIES" on the balance sheet?

a. Notes payable.

b. Accrued expenses.

c. Deferred income tax benefit.

2. Which of the following guidelines concerning the presentation of short�term debt is suggested by this course?

a. The order of presentation for short�term debt is: notes payable to related parties are reported first, notespayable to third parties are reported second, and then loans are reported last.

b. Notes (when there is a written document) and loans (when there is no written document) should bereported together under the caption �Short�term debt (notes and loans).

c. The short�term debt portion of the balance sheet should include the name of the lender if the note ismaterial.

d. Material loans from related parties should be presented on the balance sheet using a caption such as�Loans payable to stockholders."

3. A compensated absence would not be accrued in which of the following situations?

a. A nonpublic company has an informal vacation policy.

b. The employees have nonvesting rights to sick pay.

c. The employee has vested rights in vacation time.

d. Payment of the compensation is reasonably possible.

4. Which one of the following measurement or presentation considerations accurately describes the accrualreporting for retirement plans?

a. An entity sponsoring more than one defined benefit plan is allowed to aggregate all plans and report asingle net asset or liability.

b. The funding status of a defined benefit plan is determined by comparing the benefit obligation to the fairvalue of the plan's assets.

c. An entity is not required to recognize the funded status of the defined benefit plan if it only sponsors a singleplan.

d. The liability for an underfunded plan should always be classified as a noncurrent asset.

5. Which of the following items is an agency obligation?

a. Sales taxes.

b. Withholding taxes.

c. Health insurance premiums.


20

6. According to the guidance in FASB ASC 470�10�45�13 (formerly SFAS No. 6), which of the following may beincluded with noncurrent liabilities?

a. A demand note, but with an oral agreement with the lender to accept payment in installments.

b. A demand note that specifies the installments, but also allows the lender the option to call the note.

c. A bridge loan that the company intends to refinance and has the ability to consummate the refinancing.

7. A subjective acceleration clause in a note would require disclosure in the financial statements even if there isonly a remote chance the loan will be called.

a. True.

b. False.

8. According to general observations about the guidance in FASB ASC 470�10�45�1 (formerly EITF Issue No.86�30), in which of the following situations would the debt be classified as current?

a. A covenant violation would have occurred at the balance sheet date absent a modification by the lenderand it is probable that the borrower will not be able to cure the default by the quarterly measurement date.

b. A covenant violation occurred at the balance sheet date (The covenant requires annual measurement.),but the lender waived its right to call the loan for the next year.

c. A covenant violation occurred at the balance sheet date (The covenant requires interim measurementwhich the lender reserved its right to reconsider compliance at any future measurement date within theyear.), but compliance is probable during the period.

d. A covenant violation occurred at the balance sheet date (The covenant requires interim measurement.),but the lender waives its right to call the loan for the next year.


21

SELF�STUDY ANSWERS

This section provides the correct answers to the self�study quiz. If you answered a question incorrectly, reread theappropriate material. (References are in parentheses.)

1. Which one of the following is a secondary caption that might be listed under the primary caption �CURRENTLIABILITIES" on the balance sheet? (Pages 3 and 9)

a. Notes payable. [This answer is incorrect. �Notes payable" is not a secondary caption listed under�CURRENT LIABILITIES" on the balance sheet since this section of the balance sheet does not include thelong�term portion of the note. However, the current portion of any notes payable will be listed under thecaption �Current portion of long�term debt."]

b. Accrued expenses. [This answer is correct. Accrued liabilities are reported on the balance sheetunder �CURRENT LIABILITIES." The caption may be presented in one of three basic ways: bycombining all accrued expenses and presenting as one caption �Accrued expenses," by presentingeach type of accrued expense as a sub heading under the heading �Accrued expenses," or bypresenting the components of accrued expenses as separate line items without using �accrued" inthe caption.]

c. Deferred income tax benefit. [This answer is incorrect. A deferred income tax benefit is an asset. Thiscaption would be listed under the �CURRENT ASSETS" caption of the balance sheet.]

2. Which of the following guidelines concerning the presentation of short�term debt is suggested by this course?(Page 4)

a. The order of presentation for short�term debt is: notes payable to related parties are reported first, notespayable to third parties are reported second, and then loans are reported last. [This answer is incorrect.The correct presentation order for short�term debt is: notes payable to third parties, notes payable torelated parties, and then loans.]

b. Notes (when there is a written document) and loans (when there is no written document) should bereported together under the caption �Short�term debt (notes and loans). [This answer is incorrect. Thecaption should distinguish between loans and notes by using captions such as �Short�term notes" or�Short�term loans."]

c. The short�term debt portion of the balance sheet should include the name of the lender if the note ismaterial. [This answer is incorrect. There is no need to name the lender, for example, First National Bankof Fort Worth. The amount would be reported under the caption �Short�term notes."]

d. Material loans from related parties should be presented on the balance sheet using a caption suchas �Loans payable to stockholders." [This answer is correct. Material loans from related partiesshould be disclosed. �Loans payable to stockholders" is a way of presenting this on the balancesheet.]

3. A compensated absence would not be accrued in which of the following situations? (Page 5)

a. A nonpublic company has an informal vacation policy. [This answer is incorrect. Although many nonpubliccompanies do not have a formal vacation policy, most allow employees to take vacations under an informalarrangement. The informal arrangements should be evaluated to determine if a liability for vacation payshould be accrued.]

b. The employees have nonvesting rights to sick pay. [This answer is correct. GAAP does not requireaccrual of nonvesting rights to sick pay.]

c. The employee has vested rights in vacation time. [This answer is incorrect. GAAP requires an accrual forvested rights as long as all of the other conditions of FASB ASC 710�10�25�1 (formerly SFAS No. 43) aremet.]


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d. Payment of the compensation is reasonably possible. [This answer is incorrect. GAAP requires an accrualif the payment of the compensation is probable as long as all of the other conditions of FASB ASC710�10�25�1 (formerly SFAS No. 43) are met.]

4. Which one of the following measurement or presentation considerations accurately describes the accrualreporting for retirement plans? (Page 8)

a. An entity sponsoring more than one defined benefit plan is allowed to aggregate all plans and report asingle net asset or liability. [This answer is incorrect. If an entity sponsors more than one defined benefitplan, the entity is not permitted to aggregate all plans and report a single net asset or net liability. However,the reporting entity should combine all of its overfunded plans and recognize the total as an asset in thebalance sheet. Likewise, it should combine all of its underfunded plans and recognize that total as a liabilityin the balance sheet.]

b. The funding status of a defined benefit plan is determined by comparing the benefit obligation tothe fair value of the plan's assets. [This answer is correct. The funded status of a plan is calculatedas the difference between the fair value of a plan's assets and the benefit obligation. This differenceis described as overfunding or underfunding depending on whether or not the fair value of the planassets is greater or less than the plan's benefit obligation.]

c. An entity is not required to recognize the funded status of the defined benefit plan if it only sponsors a singleplan. [This answer is incorrect. Any single�employer defined benefit plan's funding status must berecognized on the balance sheet. The number of plans sponsored is irrelevant. An asset would be reportedif the plan is overfunded, and a liability would be recorded if the plan is underfunded.]

d. The liability for an underfunded plan should always be classified as a noncurrent asset. [This answer isincorrect. If an entity presents a classified balance sheet, the liability for an underfunded plan must beclassified as current, noncurrent, or a combination of both. The assets for an overfunded plan shouldalways be classified as current.]

5. Which of the following items is an agency obligation? (Page 9)

a. Sales taxes. [This answer is correct. Agency obligations arise from the collection or acceptance ofcash or other assets for the account of third persons, such as sales taxes.]

b. Withholding taxes. [This answer is incorrect. Income taxes withheld from employees' pay are not agencyobligations because the employer acts as a disbursing agent for the employee.]

c. Health insurance premiums. [This answer is incorrect. An employer's withholding of health insurancepremiums from an employee's pay is not an agency obligation. The employer is merely acting as adisbursing agent for the employee.]

6. According to the guidance in FASB ASC 470�10�45�13 (formerly SFAS No. 6), which of the following may beincluded with noncurrent liabilities? (Page 10)

a. A demand note, but with an oral agreement with the lender to accept payment in installments. [This answeris incorrect. FASB ASC 470�10�45�13 does not cover demand notes that are not expected to be refinancedon a long�term basis.]

b. A demand note that specifies the installments, but also allows the lender the option to call the note. [Thisanswer is incorrect. The guidance in FASB ASC 470�10�45�12 (formerly SFAS No. 78, Classification of

Obligations That Are Callable by the Creditor) and FASB ASC 470�10�45�9 and 45�10 (formerly EITF IssueNo. 86�5, �Classifying Demand Notes with Repayment Terms") state that demand notes that specifyinstallments are current liabilities unless the creditor has specifically waived the right to demand paymentfor more than one year from the balance sheet date. GAAP requires an unconditional waiver beforeshort�term debt may be classified as noncurrent.]


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c. A bridge loan that the company intends to refinance and has the ability to consummate therefinancing. [This answer is correct. FASB ASC 470�10�45�13 and 45�14 (formerly SFAS No. 6) statesthat short�term obligations may be included with noncurrent liabilities if both of the followingconditions are met: intent to refinance and ability to consummate the refinancing.]

7. A subjective acceleration clause in a note would require disclosure in the financial statements even if there isonly a remote chance the loan will be called. (Page 13)

a. True. [This answer is incorrect. If a long�term note is reclassified as current because of a subjectiveacceleration clause, then the financial statements should disclose the reasons. Disclosing a subjectiveacceleration clause when there is only a remote chance the loan will be called may unnecessarily alarmthe reader.]

b. False. [This answer is correct. The need to disclose the existence of a subjective acceleration clausedepends on the likelihood that the bank will call the loan. If there is only a remote chance the loanwill be called, no disclosure is necessary.]

8. According to general observations about the guidance in FASB ASC 470�10�45�1 (formerly EITF Issue No.86�30), in which of the following situations would the debt be classified as current? (Page 17)

a. A covenant violation would have occurred at the balance sheet date absent a modification by thelender and it is probable that the borrower will not be able to cure the default by the quarterlymeasurement date. [This answer is correct. FASB ASC 470�10�45�1 (formerly Issue No. 86�30) statesthat if a violation is waived by the creditor, the long�term obligation would be classified as currentif both (1) the covenant violation has occurred at the balance sheet date or would have occurredabsent a modification and (2) it is probable that the borrower will not be able to cure the default (orcomply with the covenant) at measurement dates that are within the next 12 months (or operatingcycle, if longer).]

b. A covenant violation occurred at the balance sheet date (The covenant requires annual measurement.),but the lender waived its right to call the loan for the next year. [This answer is incorrect. When a violationhas occurred at the balance sheet date, if the covenant requires annual measurement and the lenderwaives its right to call the loan for the next year, the debt normally should be classified as noncurrent.]

c. A covenant violation occurred at the balance sheet date (The covenant requires interim measurementwhich the lender reserved its right to reconsider compliance at any future measurement date within theyear.), but compliance is probable during the period. [This answer is incorrect. Since the future complianceis probable, the debt can be classified as noncurrent.]

d. A covenant violation occurred at the balance sheet date (The covenant requires interim measurement.),but the lender waives its right to call the loan for the next year. [This answer is incorrect. If the covenantrequires interim measurement and the lender waives its right to call the loan for the next year, it wouldgenerally be appropriate to classify the debt as noncurrent.]


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CLASSIFYING AND REPORTING INCOME TAXESPAYABLE ANDDEFERRED

Income tax related accounts in the balance sheet include accrued income taxes payable and deferred tax assets orliabilities. The primary presentation issue is classification of deferred tax amounts as current or noncurrent.

Accounting for Uncertainty in Income Taxes

Depending on the facts and circumstances, there may be varying views on the appropriate income tax treatment ofa transaction. Therefore, there may be uncertainty about whether a tax position would be sustained by the taxingauthority if it examined the position.

Nevertheless, most accountants have not viewed FASB ASC 740 (formerly SFAS No. 109) as requiring theconsideration of uncertainty about tax positions in computing current and deferred tax assets and liabilities.Generally, as long as the entity had appropriate support for the tax positions it has taken or intends to take, thepositions would be accepted as the basis for the computations of current and deferred tax assets and liabilities.

FASB ASC 740�10 [formerly FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes], requiresa different approach to income taxes. It requires that computations of current and deferred income tax assets andliabilities only consider tax positions that are more likely than not to be sustained if the taxing authority examined thepositions. For this purpose, the phrase more likely than not means that there is greater than a 50% chance.

Tax Positions. For simplicity, this section of the course only uses as examples positions taken in deciding whetherto claim a deduction for income tax reporting and, if so, when to claim the deduction. However, GAAP also looks atother forms of tax positions, for example

a. Deciding not to file a return, such as deciding not to file in another state because of the position that thereis no nexus.

b. Allocating or shifting income between jurisdictions, such as a position taken for the application of allocationguidelines or transfer pricing between related entities.

c. Characterizing income, such as characterizing gains in a way that enables taxation at a lower rate.

d. Deciding to classify a transaction as tax�exempt, such as a position that prevents a not�for�profitorganization from classifying income as unrelated business income.

Recognition and Measurement of Tax Benefits. GAAP requires a two�step approach to recognizing tax benefits:determining whether a tax benefit should be recognized and determining how to measure a tax benefit that isrecognized.

Determining whether a tax benefit should be recognized depends on whether the benefit is, or will be, derived froma tax position that meets the �more likely than not" criterion. A tax benefit should only be recognized if the taxposition meets the criterion. The entity must assess the likelihood that a tax position would be sustained byassuming that the taxing authority will examine the return in which the position is, or will be, taken, and that thetaxing authority will examine the position. That is, GAAP prohibits considering the possibility that a return may notbe examined and that, even if a return is examined, the position may not be examined.

The recognized tax benefit should be measured as the largest amount of tax benefit for which there is greater thana 50% chance of realization after an assumed examination by a taxing authority with complete knowledge of allrelevant information related to the tax position. The largest amount of tax benefit should be determined using factsand circumstances available and should also consider likely outcomes.

To illustrate, assume that an entity develops a tax position under which it will claim a deduction for an expense. If theentity believes there is no more than a 50% chance the taxing authority would accept the position, the entity shouldrecognize no tax benefit from the deduction in its financial statements.


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However, if the entity believes there is greater than a 50% chance the taxing authority would accept the position, theentity should recognize the tax benefit for which there is greater than a 50% chance of realization upon settlementwith the taxing authority.

If the entity believes there is greater than a 50% chance the full deduction would be allowed, the tax benefit of thefull deduction should be recognized. However, if the entity believes it would likely settle with the taxing authority byagreeing to a deduction for less than the full amount originally deducted, or that the taxing authority would disallowpart of the deduction, the entity should recognize a tax benefit for only the portion of the deduction expected to beultimately accepted. That amount can be determined qualitatively or quantitatively.

a. A qualitative assessment could be made in a variety of ways. For example, it could be made based on theaccountant's experience with comparable situations, or based on the accountant's understanding of therecent trend of rulings by the taxing authority.

b. A quantitative assessment could be made based on different probability scenarios under which the amountrecognized is the largest amount above a cumulative probability greater than 50%.

To help focus discussions on the effects of FASB ASC 740�10 (formerly FIN 48), the illustrations in this section of thecourse use simple facts and circumstances and a 40% tax rate imposed by a single taxing authority. Each of theillustrations assumes that the entity did not make estimated tax payments during the year, and, therefore, thecarrying amount of the current tax liability at year�end equals the amount of tax reported in the return.

In addition, to avoid inferences that a particular tax position always has a certain level of uncertainty, the illustrationsdescribe the uncertainty in income taxes in only general terms. The uncertainty of a tax position and the amount oftax benefit that ultimately will be realized depends on the facts and circumstances.

The Effect on Current Tax Provisions. To illustrate applying this guidance to the computation of current taxprovisions, assume the following:

a. The entity's financial statements report income before income taxes of $200, consisting of revenue of $300and expense of $100.

b. The entity believes the expense is deductible in the current�year return and, therefore, the tax return reportstaxable income of $200, which is the same as pretax income reported in the financial statements, and taxof $80, computed by applying the 40% tax rate to taxable income of $200.

If the entity believes there is greater than a 50% chance that, upon examination, the tax position for deducting the$100 expense in the current�year return would be sustained and that there is greater than a 50% chance the fullamount of the deduction would be allowed, the entity would recognize a current tax provision of $80 and an $80liability for the tax reported in the return as illustrated by the following entry:

Current tax provision $ 80Income tax due currently $ 80

However, if the entity believes there is no greater than a 50% chance the tax position would be sustained, GAAPwould prohibit recognizing any tax benefit from the $100 deduction. Instead, the current provision would becomputed on a pro forma basis ignoring the deduction.

a. Pro forma taxable income would be $300, consisting solely of the revenue because none of the deductionfor the expense could be considered.

b. The pro forma tax would be $120, computed by applying the 40% tax rate to the $300 pro forma taxableincome.

The $120 pro forma tax exceeds by $40 the $80 tax reported in the return. The excess is the tax benefit of thededuction claimed in the return that cannot be considered under FASB ASC 740�10 (formerly FIN 48) (the $100deduction � the 40% tax rate).


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The entity would recognize a $120 current provision for the pro forma tax and an $80 liability for the tax reported inthe return. The $40 difference between those two amounts would be recognized as a liability as illustrated by thefollowing entry:

Current tax provision $ 120Income tax due currently $ 80Liability for unrecognized tax benefit 40

Therefore, even though the tax benefit was realized by claiming the deduction in the current�year return, it was notincluded in earnings but was recorded as a liability.

FASB ASC 740�10�25�16 (formerly Paragraph 17 of FIN 48) describes the liability as the entity's �potential futureobligation to the taxing authority for a tax position that was not recognized" by GAAP. The liability can be viewed asthe entity's obligation to return the realized tax benefit to the taxing authority in the event it disallows the tax position.Therefore, the liability would be the estimated additional tax that would be assessed if the tax position is disallowed.

The liability can also be viewed as a deferral of the tax benefit that was realized by claiming the deduction in thecurrent�year return. Recognition of the realized tax benefit is being deferred until the uncertainty is reduced to nomore than 50% or eliminated. However, the deferral is not a deferred tax liability but a deferral of a current taxbenefit.

GAAP prohibits including the liability for unrecognized tax benefits with deferred tax liabilities or offsetting it againstdeferred tax assets. The Interpretation also requires the liability to be classified based on whether settlement isanticipated within one year (or the operating cycle).

Consistent with the deferral notion, the liability for the unrecognized tax benefit generally would be written off, orderecognized, only when:

a. New information, such as additional authoritative support, causes the entity to change its assessment ofthe likelihood the position would be sustained to more likely than not.

b. The taxing authority examines, but does not accept, the position, and the entity pays the additional taxassessed.

c. The taxing authority examines and accepts the position.

d. The statute of limitations for the taxing authority to examine the position expires.

To illustrate, assume that the taxing authority does not examine the position in the previous illustration before thestatute of limitations expires. In the year the statute expires, the entity would eliminate the $40 liability and recognizean offsetting tax benefit as illustrated by the following entry:

Liability for unrecognized tax benefit $ 40Current tax provision $ 40

Therefore, in this set of facts and circumstances, the $40 tax benefit of the $100 deduction would be recognizedwhen the uncertainty is eliminated rather than when the tax benefit is realized by deducting it in the return.

The Effect on Deferred Tax Provisions. To illustrate applying this guidance to the computation of deferred taxprovisions, assume that:

a. The entity's financial statements report income before income taxes of $200, consisting of revenue of $300and an estimated expense of $100 recorded through the recognition of a liability.

b. The entity believes the $100 estimated expense is not deductible in the current�year return but hasdeveloped a tax position that it believes supports deduction when the obligation is paid next year.

c. The tax return for the current year reports taxable income of $300, consisting solely of the revenue for theyear, and it reports tax of $120 ($300 � 40%).


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A taxable or deductible temporary difference is a difference between the tax basis of an asset or liability and itscarrying amount in the financial statements. However, only tax positions that meet the �more likely than not"criterion should be considered in determining the tax basis of an asset or liability.

The decision of whether recognizing the liability for financial statement reporting creates a deductible differencedepends on whether the tax position for deducting payment of the liability meets the �more likely than not" criterion.The tax basis of the liability is its carrying amount for financial statement reporting less the future deduction from itssettlement that meets the �more likely than not" criterion.

a. If the tax position meets the �more likely than not" criterion and there is greater than a 50% chance the fullamount of the deduction would be allowed, the tax basis of the liability is zero. Thus, there is a deductibledifference equal to the carrying amount of the liability for financial statement reporting.

b. If the tax position does not meet the �more likely than not" criterion, the deduction from settlement of theliability cannot be considered and the tax basis of the liability is the same as its carrying amount for financialstatement reporting. Because there is no difference in basis, there is no temporary difference, and adeferred tax benefit cannot be recognized for the expense.

c. If the tax position meets the �more likely than not" criterion, but there is greater than a 50% chance that lessthan the full amount of the deduction would be allowed upon examination, the tax basis of the liability isits carrying amount for financial statement reporting less the amount of the future deduction that is morethan 50% likely to be accepted. Therefore, there is a deductible difference equal to the amount of the futurededuction from settlement of the liability for which a tax benefit can be recognized.

To illustrate, assume that the entity�s tax position for deducting the $100 expense when it is paid meets the �morelikely than not" criterion and that there is greater than a 50% chance the full amount of the deduction would beallowed.

a. The entity would record a $120 current tax provision and a $120 current tax liability for the tax reported inthe return as illustrated by the following entry:

Current tax provision $ 120Income tax due currently $ 120

b. The tax basis of the liability for the expense would be zero, and there would be a deductible difference of$100 because payment of the liability would yield a $100 deduction for which a tax benefit would berecognized. Thus, the entity would recognize a deferred tax asset of $40 (40% � the $100 deductibledifference), and an equal amount of deferred tax benefit as follows:

Deferred tax asset $ 40Deferred tax provision $ 40

The total tax provision would be $80, consisting of the $120 current tax expense less the $40 deferred tax benefit,which equals the amount that would be obtained by applying the 40% tax rate to the $200 pretax income reportedin the financial statements. The amounts are the same because a tax benefit has been recognized through thedeferred tax provision for the $100 expense recognized in the financial statements.

Now assume that the entity's tax position for deducting the $100 expense when the related liability is paid next yeardoes not meet the �more likely than not" criterion.

a. The entity would record a $120 current tax provision and a $120 liability for the tax reported in the return.

b. The tax basis of the liability would be $100, and there would be no temporary difference and no deferredtax benefit because payment of the liability would not yield a deduction for which FASB ASC 740�10(formerly FIN 48) would permit recognizing a tax benefit.

The tax provision would therefore consist solely of the $120 current tax provision, which is $40 greater than the $80amount that would be obtained by applying the 40% tax rate to the $200 pretax income reported in the financial


28

statements. This difference is due to no tax benefit being recognized for the $100 expense recognized in thefinancial statements.

Assume that next year the entity's financial statements report revenue of $500 and no expense. In the tax return forthat year, the entity reports taxable income of $400, which is the revenue of $500 less the deduction for payment ofthe $100 expense recognized in the prior year's financial statements. The return would report tax of $160 (taxableincome of $400 � 40% tax rate). The following entry would be recorded:

Current tax provision $ 200Income tax due currently $ 160Liability for unrecognized tax benefit 40

The $200 current tax provision is calculated based on taxable income excluding the deduction because no taxbenefit can be recognized for the $100 deduction (40% � $500). The income tax due currently of $160 representsthe tax payable as reported in the tax return. The $200 current provision exceeds the $160 tax payable by $40because no tax benefit can be recognized for the $100 deduction claimed in the return. The $40 excess would berecognized as a liability. There is no temporary difference and no deferred tax asset, and the tax provision consistssolely of the $200 current tax provision. The amount of the tax provision equals the amount that would be obtainedby applying the 40% tax rate to the $500 pretax income reported in the financial statements because no expensewas recognized in the financial statements.

FASB ASC 740�10 (formerly FIN 48) takes the same position with losses and tax credits that are available forcarryforward to future years. A deferred tax asset can only be recognized for a carryforward if the future use of thecarryforward is based on a tax position that meets the �more likely than not" criterion.

a. If use of the carryforward is based on a tax position that meets the �more likely than not" criterion and thereis greater than a 50% chance the full amount of the carryforward would be accepted, the entity shouldrecognize a deferred tax asset for the entire carryforward.

b. If use of the carryforward is based on a tax position that meets the criterion and there is greater than a 50%chance that less than the full amount of the carryforward would be allowed, the entity should recognize adeferred tax asset for the amount of the carryforward that is more than 50% likely to be allowed.

c. If use of the carryforward is based on a tax position that does not meet the �more likely than not" criterion,the entity should not recognize a deferred tax asset for the carryforward.

Other Considerations. GAAP requires providing for the effect of penalties and interest on the liability for taxbenefits that have been realized but have not been recognized. It notes that some entities include penalties andinterest related to income taxes in the tax provision and other entities include them in expenses. Either approach ispermitted but disclosure of the approach used by the entity is required. GAAP also requires disclosure of theamounts of penalties and interest related to income taxes that are recognized in the statement of results ofoperations and in the statement of financial position.

Prior to FASB ASC 740�10 (formerly FIN 48), guidance on disclosures required for uncertainty in income taxes wasprovided primarily by FASB ASC 450 (formerly SFAS No. 5). The Interpretation amends FASB ASC 450 (formerlySFAS No. 5) to remove uncertainty in income taxes from its scope. However, FASB ASC 740�10 (formerly FIN 48)does not modify FASB ASC 275�10 (formerly SOP 94�6). However, FASB ASC 740�10 (formerly Paragraphs B60and B61 of FIN 48) suggest that the FASB believes the disclosures required by the Interpretation provide financialstatement users with sufficient information about uncertainty in income taxes. This provides evidence that separateconsideration of FASB ASC 275�10 (formerly SOP 94�6) is not required for disclosures of uncertainty in incometaxes.

ASU No. 2009�06 exempts nonpublic entities from two of the disclosure requirements of FASB ASC 740�10�50(formerly FIN 48):

a. the requirement to provide a tabular reconciliation of the total amount of unrecognized tax benefits at thebeginning and end of the years presented (FASB ASC 740�10�50�15a), and


29

b. the requirement to disclose the total amount of unrecognized tax benefits that, if recognized, would affectthe effective tax rate (FASB ASC 740�10�50�15b).

The entity's policy for the presentation of penalties and interest related to income taxes can be disclosed in a varietyof ways. For example, the disclosure could be provided in a policy note, such as, �Penalties and interest assessedby income taxing authorities are included in operating expenses." However, disclosure of penalties and interest asline items in the financial statements also discloses the entity's presentation policy.

The amounts of penalties and interest related to income taxes may be disclosed either in the financial statementsor in a note to the financial statements.

GAAP also requires describing tax years that remain subject to examination by major tax jurisdictions, as thefollowing illustrates.

The federal income tax returns of the Company for 20X1, 20X2, and 20X3 are subject toexamination by the IRS, generally for three years after they were filed.

The Impact on Pass�through Entities. The measurement and disclosure principles of FASB ASC 740�10 (formerlyFIN 48) normally cannot affect the financial statements of an entity that is not potentially subject to income taxes. Toillustrate, assume that the IRS examines the Form 1065 of a partnership and disallows certain deductions. Anyadditional income taxes will be imposed on the partners rather than the partnership, and accordingly, there is noeffect on the partnership's financial statements. Similarly, many S corporations do not have the potential to besubject to income taxes.

However, some S corporations have the potential to be subject to income taxes on taxable income generated afterconversion from a regular corporation. In addition, some entities treated as pass�through entities for federal incometax reporting may be subject to state income taxes.

In September 2009, the FASB issued Accounting Standards Update (ASU) No. 2009�06, Implementation Guidance

on Accounting for Uncertainty in Income Taxes and Disclosure Amendments for Nonpublic Entities. The guidance inASU No. 2009�06 appears in the Codification in various parts of FASB ASC 740�10.

ASU No. 2009�06 clarifies that if income taxes paid by the entity are attributable to the

a. entity, they should be accounted for following the provisions of FASB ASC 740 (formerly SFAS No. 109,Accounting for Income Taxes).

b. owners, they should be accounted for as a transaction with owners.

For example, a state that recognizes the Subchapter S election may nevertheless require the entity to pay anamount computed by applying the state income tax rate to the entity's taxable income allocated to an out�of�stateowner. The individual would include the allocated income in his return and recognize a tax credit for the paymentby the entity. The payment should be considered attributable to the owner and shown as a dividend in the entity'sfinancial statements.

ASU No. 2009�06 also clarifies that

a. the determination of attribution should be made for each jurisdiction where the entity is subject to incometaxes and determined on the basis of laws and regulations of the jurisdiction, and

b. management's determination of the taxable status of the entity, including its status as a pass�through entityor tax�exempt not�for�profit entity, is a tax position that is subject to the accounting for uncertainty in incometax requirements.

To illustrate the accounting considerations, assume that a corporation that has elected Subchapter S status takesthe position that it does not have nexus with a state that does not recognize that election. The corporation shouldevaluate whether the position would more likely than not be sustained by the state in an examination. That


30

evaluation should consider the positions taken by the state in applying nexus requirements, such as how manyyears are considered open if tax would be assessed retrospectively, and whether the state has adopted thresholdsof taxable income attributable to the state below which it will not assert nexus.

Consideration of Certain Administrative Practices. GAAP permits considering administrative practices to deter�mine whether a tax position meets the �more likely than not" criterion. To illustrate, assume that an entity haselected to be treated as an S corporation for federal income tax reporting. The states with which the entity believesit has nexus recognize the federal S election and treat the entity as a pass�through entity.

The entity recognizes that there is the possibility a state that does not recognize the S election may assert that theentity has nexus with it and assess income taxes. However, the entity also has found that the possible statestypically only assess taxes for three to five prior years. In addition, the entity has had no notification from thosestates, there is no indication that they are aggressive in asserting nexus, and the entity believes it is more likely thannot that the entity would prevail in the event the states assert that there is nexus. Accordingly, the entity concludesthat its tax position of not filing returns in those states meets the �more likely than not" criterion. (The entity may alsonote that allocation of taxable income to those states would not result in material tax assessments.) Even if the entityconcludes its tax position does not meet the �more likely than not" criterion, consideration of the states' administra�tive practices is permitted in determining that it is not necessary to go back more than three to five years to applythe guidance.

Some Observations. The following observations may be helpful.

a. The guidance will have no effect on an entity's financial statements if there is greater than a 50% chancethat all tax positions would be sustained upon examination, and if there is greater than a 50% chance thefull amount of the tax benefits of those positions would be realized upon settlement.

b. If there are one or more tax positions for which there is no greater than a 50% chance of being sustained,no tax benefit from those tax positions can be recognized.

(1) If the tax benefit has been realized because it has been reflected in a tax return, it should effectivelybe deferred through recognition of a liability.

(2) If the tax benefit has not been realized, no deferred tax benefit should be recognized.

c. If there are one or more tax positions for which there is greater than a 50% chance they would be sustained,only the portion of the benefit from the position for which there is greater than a 50% chance of realizationupon examination should be recognized.

(1) The assessment can be made qualitatively or quantitatively.

(2) If the entity believes there is greater than a 50% chance of realization upon settlement, all of the taxbenefit should be recognized.

d. Depending on the risk in the tax positions, the guidance may have no impact on current and deferredincome taxes and related current and deferred tax assets and liabilities recognized.

PPC's Guide to Accounting for Income Taxes provides additional guidance on accounting for uncertainty in incometaxes.

Information Required by the Internal Revenue Service about Uncertain Tax Positions. The Internal RevenueService has adopted a five�year phase�in of a requirement to provide information about uncertain tax positions.Generally, the requirement will ultimately apply to all corporations that are subject to federal income tax and issueaudited financial statements that

a. are prepared using generally accepted accounting principles, IFRS, or a country�specific accountingstandard and


31

b. reflect a provision for tax benefits that have been realized but not recognized.

The phase�in is based on the entity's size, determined based on total assets:

a. Corporations with total assets of at least $100 million will first need to consider the requirement for yearsbeginning in 2010.

b. Corporations with total assets of at least $50 million, but less than $100 million, will first need to considerthe requirement for years beginning in 2012.

c. Other corporations will first need to consider the requirement for years beginning in 2014.

The Internal Revenue Service has announced that it will consider whether to extend all or a portion of therequirements to pass�through entities and tax�exempt entities for 2011 or later tax years.

The required information is to be presented on Schedule UTP filed as part of the Form 1120. Concise descriptionsare to be provided for each position reflected in the liability. The descriptions are not required to include anassessment of the hazards of the tax position or an analysis of the support for or against the tax position. Thepositions are to be ranked according to their portion of the liability, with identification of which positions compriseat least 10% of the liability. Other quantitative information is not required. For example, there is no requirement todisclose the amount of the liability for all or any of the uncertain tax positions.

Classifying Deferred Income Tax Assets and Liabilities

FASB ASC 740�10�45�4 through 45�10 (formerly SFAS No. 109) requires companies to classify deferred tax assetsand liabilities into a current and noncurrent portion. The basic steps are as follows:

a. Deferred tax assets and liabilities related to each major type of temporary difference are first classified ascurrent and noncurrent dependent on the classification of the related asset or liability.

b. Valuation allowances are allocated to current and noncurrent deferred tax assets on a prorata basis.

c. For each tax jurisdiction, deferred tax assets and deferred tax liabilities classified as current are then netted.If the result is a net deferred asset, it is included with current assets. If the net amount is a deferred liability,it is included with current liabilities.

d. For each tax jurisdiction, noncurrent deferred tax assets and deferred tax liabilities are also netted andincluded with noncurrent assets or noncurrent liabilities.

Criteria for Classification. Classification of deferred taxes as current or noncurrent depends on whether they are�related" to a specific asset or liability.

� If the deferred tax is related to a specific asset or liability, it is classified the same as that asset or liability.

� If the deferred tax is not related to a specific asset or liability, it is classified based on its expected reversaldate. The portion that will reverse within one year of the balance sheet date should be classified as currentand the remainder should be classified as noncurrent.

The determination of whether a temporary difference is related to a specific asset or liability depends on whatcauses the temporary difference to reverse. If reduction of the asset or liability causes the temporary difference toreverse, the two are related. (A reduction of an asset can occur through amortization, sale, or other realization; areduction of a liability can occur through amortization, payment, or other realization.) However, if (a) the asset orliability can be reduced without causing the temporary difference to reverse or (b) there is no associated asset orliability for financial reporting, they are not related.

Examples of Classification. The following examples illustrate classification according to the criteria of FASB ASC740�10�45�7 through 45�10; 740�10�55�77 and 55�78; 740�10�55�205 through 55�211 (formerly SFAS No. 37).

� Depreciation Methods. The use of an accelerated method for tax reporting and the straight�line method forthe financial statements initially causes GAAP earnings to be higher than taxable earnings. The tax effect


32

of the excess earnings is deferred to future periods. During the early years, a deferred tax liabilityaccumulates. The temporary difference reverses as the asset is reduced through depreciation. It also wouldreverse if the asset were sold. Accordingly, the temporary difference is related to property and equipment,and the related deferred tax liability is classified as noncurrent.

� Cash and Accrual Methods. Companies using different bases of accounting typically have higher accrualbasis earnings. The tax effect of GAAP earnings is deferred to future periods. Collection of the accruedassets and payment of the accrued liabilities cause the temporary difference to reverse, and accordingly,the temporary difference is related to the accrued amounts. Since they are classified as current, the relateddeferred tax liability is classified as current.

� Bad Debts. The use of the allowance method for recording bad debts for GAAP financial statements andthe direct charge�off method for the tax return normally causes GAAP earnings to be lower than taxableincome and a deferred tax benefit accumulates. A reduction of the receivable through charge�off causesthe temporary difference to reverse. Accordingly, it is related to the asset and is classified as current.

� Operating Loss and Tax Credit Carryforwards. Deferred tax assets for operating loss and tax creditcarryforwards are not related to specific assets or liabilities for financial reporting. Accordingly, they areclassified as current or noncurrent based on the expected realization of the carryforward.

� Temporary Differences That Cannot Be Identified with Particular Assets or Liabilities. Some temporarydifferences relate to deferred taxable income or deductions and have assets or liabilities only on tax basisbalance sheets; there is no associated asset or liability for financial reporting. FASB ASC 740�10�25�24through 25�26; 740�10�5�10 (formerly Paragraph 15 of SFAS No. 109) cites two examples: (a) revenue fromlong�term contracts that is accounted for using the percentage�of�completion method for financialreporting and the completed�contract method for tax reporting and (b) organization costs that a companyexpenses for financial reporting and capitalizes for tax purposes. Since the deferred tax asset or liabilityis not related to an asset or liability for financial reporting, it is classified as current or noncurrent based onthe expected reversal of the temporary difference.

Valuation Allowance. A valuation allowance should be provided for deferred tax assets if it is more likely than notthat all or a portion of the asset will not be realized. According to FASB ASC 740�10�45�5 (formerly Paragraph 41 ofSFAS No. 109), the valuation allowance for a particular tax jurisdiction should be allocated between current andnoncurrent deferred tax assets for that tax jurisdiction on a prorata basis. If a company has only one deductibledifference, the valuation allowance would be classified the same as the deductible difference. For example, assumea company that is subject to federal income taxes of 34% has a $750,000 operating loss that it may carry forwardfor 20 years. It records a deferred tax asset of $255,000 ($750,000 � 34%) and a valuation allowance of $51,000because, at the end of the year, it estimates that it is more likely than not that $150,000 of the loss carryforward willexpire unused ($150,000 � 34% = $51,000). Since the deferred tax asset for the loss carryforward is not related toa particular asset or liability for financial reporting, the company would classify the net deferred tax asset based onits expected realization. If the company expected to offset $75,000 of the loss carryforward against taxable incomein the next year, it would classify 10% of both the deferred tax asset and the valuation allowance as current andclassify the remainder as noncurrent. Thus, its financial statements would report a net current deferred tax asset of$20,400 (10% of the deferred tax asset of $255,000 less 10% of the $51,000 valuation allowance) and a netnoncurrent deferred tax asset of $183,600.

If a company has more than one deductible difference, GAAP requires a prorata allocation of the valuationallowance; it is not necessary to identify the valuation allowance with specific temporary differences. Thus, assumethe same scenario as in the preceding paragraph except that, in addition to the $750,000 operating loss carryfor�ward, the company also has a $100,000 deductible difference for inventory�related general and administrativecosts that are capitalized for tax purposes and expensed for financial reporting. The valuation allowance would beclassified as current and noncurrent as follows:


33

Total Current NoncurrentBasis for

Classification

Deductible temporary difference:

NOL $ 750,000 $ 75,000 $ 675,000 Expected reversal�

Inventory 100,000 100,000 � Same as inventory

Total $ 850,000 $ 175,000 $ 675,000

Deferred tax asset (34%) $ 289,000 $ 59,500 $ 229,500

100 % 21 % 79 %

Valuation allowance ($150,000 � 34%) $ 51,000 $ 10,710 $ 40,290 Prorata

Balance Sheet Presentation

Noncurrent Deferred Taxes. Noncurrent deferred tax liabilities are generally presented between long�term debtand stockholders' equity with a caption such as �Deferred Income Taxes" as illustrated in the following:

20X2 20X1


LONG�TERM DEBT, less current portion 77,000 93,000

DEFERRED INCOME TAXES 23,000 18,000

TOTAL LIABILITIES 260,000 261,000

or

20X2 20X1



DEFERRED INCOME TAXES 23,000 18,000

STOCKHOLDERS' EQUITY

Common stock 10,000 10,000

Retained earnings 353,800 328,200

363,800 338,200

$ 623,800 $ 599,200

or

20X2 20X1

NONCURRENT LIABILITIES

Long�term debt, less current portion 77,000 93,000

Deferred income taxes 23,000 18,000

TOTAL NONCURRENT LIABILITIES 100,000 111,000


34

The noncurrent portion of deferred tax assets, net of any valuation allowance, should be presented with othernoncurrent assets in the balance sheet as follows:

20X2 20X1

PROPERTY AND EQUIPMENT 320,000 298,000

OTHER ASSETS

Notes receivableofficer 65,000 80,000

Deferred income tax benefit 12,000 18,000

Goodwill 100,000 100,000

177,000 198,000

Current Income Tax Liabilities. The current portion of deferred tax liabilities and income taxes currently payableare both presented under the current liabilities caption of the balance sheet as shown in the following alternativepresentations:

� Group taxes currently payable and deferred taxes under a single heading such as �income taxes" and use�current" and �deferred" for the components as illustrated below:

20X2 20X1

CURRENT LIABILITIES

Accounts payable $ 90,000 $ 80,000


Income taxes

Current 5,000 10,000

Deferred 70,000 65,000



� Present taxes currently payable and deferred taxes as separate line items using captions such as �currentincome taxes" and �deferred income taxes" as illustrated by the following:

20X2 20X1

CURRENT LIABILITIES

Accounts payable $ 90,000 $ 80,000


Current income taxes 5,000 10,000


Deferred income taxes 70,000 65,000


Current Income Tax Assets. If income taxes are refundable at the balance sheet date, the claims for refundsshould be reported as receivables and generally should be classified as current assets. Current deferred tax assetsalso should be included in the current assets section of the balance sheet. The following are illustrative presenta�tions:


35

20X2 20X1

CURRENT ASSETS

Cash $ 16,000 $ 20,000

Accounts receivable 155,000 100,000

Deferred income tax benefit 10,000 �

Inventory 24,000 15,000

TOTAL CURRENT ASSETS 205,000 135,000

or

20X2 20X1

CURRENT ASSETS

Cash $ 16,000 $ 20,000

Accounts receivable

Trade 130,000 90,000

Related parties 20,000 10,000

Tax refund claim 5,000 �

Deferred income tax benefit 10,000 �

Inventory 24,000 15,000


Offsetting Tax Assets and Liabilities

Generally accepted accounting principles preclude offsetting current tax assets and liabilities against noncurrenttax assets and liabilities. Also, tax assets and liabilities should not be offset unless a legal right of setoff exists.However, for each tax jurisdiction, all current deferred tax assets and liabilities should be offset and presented as asingle amount, and all noncurrent deferred tax assets and liabilities should be offset and presented as a singleamount. FASB ASC 740�10�45�6 (formerly Paragraph 42 of SFAS No. 109) explicitly prohibits offsetting deferred taxassets and liabilities of different jurisdictions because a right of setoff usually does not exist. For example, a taxasset for federal income taxes may not be offset against a tax liability for state or local income taxes. Thus, if acompany operates in only one tax jurisdiction, its financial statements could show a current deferred tax asset orliability and a noncurrent deferred tax asset or liability. If a company operates in more than one tax jurisdiction,however, it is possible for its financial statements to show current taxes payable and refundable and four categoriesof deferred income taxes: current and noncurrent deferred tax assets and current and noncurrent deferred taxliabilities.

Materiality should be considered in applying the preceding presentation principle, as it should in applying allaccounting principles, and tax assets and liabilities of different tax jurisdictions may be offset if doing so does notsignificantly distort the balance of assets or liabilities, working capital, or the current ratio.


36


37

SELF�STUDY QUIZ


9. Which of the following authoritative sources relies on the �more likely than not" approach of classifying incometaxes?

a. FASB ASC 740 (formerly SFAS No. 109).

b. FASB ASC 740�10 (formerly FIN 48).

10. Dino Company develops a tax position under which it will claim a deduction for an expense. Under which ofthe following scenarios should Dino recognize a tax benefit?

a. A tax benefit of $2,000 with a 30% chance of realization.

b. A tax benefit of $1,000 with a 55% chance of realization.

c. A tax benefit of $500 with a 60% chance of realization.

11. Pea Picker Company's financial statements report income before income taxes of $50,000, consisting ofrevenue of $200,000 and expense of $150,000. Pea Picker believes the expense is deductible in thecurrent�year return and, therefore, the tax return reports taxable income of $50,000, which is the same as pretaxincome reported in the financial statements. A single taxing authority imposes a simple 40% tax rate. Pea Pickerdid not make any estimated tax payments during the year. If the entity believes there is greater than a 50%chance that, upon examination, the tax position for deducting the $150,000 expense in the current�year returnwould be sustained and that there is greater than a 50% chance the full amount of the deduction would beallowed, how much will Pea Picker recognize as its current tax provision?

a. $20,000.

b. $40,000.

c. $60,000.

d. $80,000.

12. Assume the same facts as the previous question except that Pea Picker believes there is less than a 50% chancethe tax position would be sustained. How much will Pea Picker recognize as its current tax provision?

a. $20,000.

b. $40,000.

c. $60,000.

d. $80,000.

13. Assume the same facts as the previous question. How much will Pea Picker record as a liability for unrecognizedtax benefit in its financial statements?

a. $20,000.

b. $40,000.

c. $60,000.

d. $80,000.


38

14. What is a liability for unrecognized tax benefit?

a. The entity's obligation to return the realized tax benefit to the taxing authority in the event it disallows thetax position.

b. The estimated additional tax that would be assessed if the tax position is allowed.

c. A deferred tax liability.

d. An offset against deferred tax assets.

15. A taxable or deductible temporary difference is a difference between the tax basis of an asset or liability andits carrying amount in the financial statements. Following the guidance in FASB ASC 740�10 (formerly FIN 48),in which situation below would the tax basis of the liability be zero?

a. The tax position meets the �more likely than not" criterion and there is a greater than 50% chance the fullamount of the deduction would be allowed.

b. The tax position meets the �more likely than not" criterion, but there is greater than a 50% chance that lessthan the full amount of the deduction would be allowed upon examination.

c. The tax position does not meet the �more likely than not" criterion.

16. Which of the following provides primary guidance on disclosures of uncertainty in income taxes?

a. FASB ASC 450 (formerly SFAS No. 5).

b. FASB ASC 740�10 (formerly Paragraphs B60 and B61, FIN 48).

c. FASB ASC 275�10 (formerly SOP 94�6).

d. FASB ASC 740 (formerly SFAS No. 109).

17. When classifying deferred income tax assets and liabilities, which of the following is one of the basic steps?

a. Deferred tax assets and liabilities related to each major type of temporary difference are first classifiedbased on its expected reversal date.

b. Valuation allowances are allocated on a prorata basis to current and noncurrent deferred tax assets.

c. All deferred tax assets and deferred tax liabilities classified as current are netted together.

d. All deferred tax assets and deferred tax liabilities classified as noncurrent are netted together.

18. Which of the following would normally cause GAAP earnings to be lower than taxable income?

a. The entity uses the cash method for filing its income tax return.

b. The entity uses an accelerated depreciation method for tax reporting.

c. The entity uses the direct charge�off method for tax reporting.


39

19. An entity is subject to federal income taxes at the 34% rate. It has a $100,000 operating loss that it may carryforward for 20 years. The deferred tax asset for the loss carryforward is not related to a particular asset or liabilityfor financial reporting. The entity expects to offset $10,000 of the loss carryforward against taxable income inthe next year. The entity expects $40,000 of the loss carryforward will expire unused. How much will it reportas a net current deferred tax asset?

a. $2,040.

b. $10,000.

c. $13,600.

d. $34,000.

20. Assume the same facts as the previous question. How much will the entity report as a net noncurrent deferredtax asset?

a. $10,000.

b. $13,600.

c. $18,360.

d. $20,400.


40



9. Which of the following authoritative sources relies on the �more likely than not" approach of classifying incometaxes? (Page 24)

a. FASB ASC 740 (formerly SFAS No. 109). [This answer is incorrect. According to this approach, as long asthe entity had appropriated support for the tax positions it has taken or intends to take, the positions wouldbe accepted as the basis for the computations of current and deferred tax assets and liabilities.]

b. FASB ASC 740�10 (formerly FIN 48). [This answer is correct. This approach requires thatcomputations of current and deferred income tax assets and liabilities only consider tax positionsthat are more likely than not to be sustained if the taxing authority examined the positions.]

10. Dino Company develops a tax position under which it will claim a deduction for an expense. Under which ofthe following scenarios should Dino recognize a tax benefit? (Page 24)

a. A tax benefit of $2,000 with a 30% chance of realization. [This answer is incorrect. According to GAAP, Dinoshould not accept a position with less than a 50% chance that the taxing authority would accept theposition.]

b. A tax benefit of $1,000 with a 55% chance of realization. [This answer is correct. This choice meetsthe �more likely than not" criterion and recognizes the larger amount of tax benefit.]

c. A tax benefit of $500 with a 60% chance of realization. [This answer is incorrect. Although this choice hasmore than a 50% chance of the taxing authority accepting the position, another answer would be the bestchoice in this situation.]

11. Pea Picker Company's financial statements report income before income taxes of $50,000, consisting ofrevenue of $200,000 and expense of $150,000. Pea Picker believes the expense is deductible in thecurrent�year return and, therefore, the tax return reports taxable income of $50,000, which is the same as pretaxincome reported in the financial statements. A single taxing authority imposes a simple 40% tax rate. Pea Pickerdid not make any estimated tax payments during the year. If the entity believes there is greater than a 50%chance that, upon examination, the tax position for deducting the $150,000 expense in the current�year returnwould be sustained and that there is greater than a 50% chance the full amount of the deduction would beallowed, how much will Pea Picker recognize as its current tax provision? (Pages 25 & 25)

a. $20,000. [This answer is correct. Since Pea Picker believes there is greater than a 50% chance thefull amount of the deduction would be allowed, $50,000 of taxable income is multiplied by the 40%tax rate to arrive at the $20,000 current tax provision.]

b. $40,000. [This answer is incorrect. $40,000 is 40% of $100,000, which is not the taxable income in thisexample.]

c. $60,000. [This answer is incorrect. $60,000 is 40% of the $150,000 expense. This is not the correct wayto compute income tax.]

d. $80,000. [This answer is incorrect. Since Pea Picker believes there is greater than a 50% chance the fullamount of the deduction would be allowed, the entity is allowed to deduct the $150,000 in expenses fromthe revenue amount.]

12. Assume the same facts as the previous question except that Pea Picker believes there is less than a 50% chancethe tax position would be sustained. How much will Pea Picker recognize as its current tax provision? (Page 25)

a. $20,000. [This answer is incorrect. If Pea Picker believes there is greater than a 50% chance the full amountof the deduction would be allowed, $20,000 would be the current tax provision. However, that is not thecase in this example.]


41

b. $40,000. [This answer is incorrect. $40,000 is 40% of $100,000, which is not the taxable income based onthe facts in this example.]

c. $60,000. [This answer is incorrect. $60,000 is 40% of the $150,000 expense. However, GAAP prohibitsrecognizing any tax benefit from the $150,000 deduction. The current provision would be computed ona pro forma basis ignoring the deduction in this example.]

d. $80,000. [This answer is correct. Since the entity believes there is less than a 50% chance that, uponexamination, the tax position for deducting the $150,000 expense in the current�year return wouldbe sustained, GAAP prohibits recognizing any tax benefit from the deduction. Therefore, the currenttax provision would be $200,000 multiplied by the 40% tax rate.]

13. Assume the same facts as the previous question. How much will Pea Picker record as a liability for unrecognizedtax benefit in its financial statements? (Page 26)

a. $20,000. [This answer is incorrect. $20,000 is the amount that the entity will record as income tax duecurrently.]

b. $40,000. [This answer is incorrect. $40,000 is neither the current tax provision, income tax due currently,nor the liability for unrecognized tax benefit.]

c. $60,000. [This answer is correct. The entity would recognize an $80,000 current tax provision for thepro format tax and a $20,000 liability for the tax reported in the return. The excess is the tax benefitof the deduction claimed in the return that cannot be considered under FASB ASC 740�10 (formerlyFIN 48), which is $60,000.]

d. $80,000. [This answer is incorrect. $80,000 is the amount that the entity will record as the current taxprovision.]

14. What is a liability for unrecognized tax benefit? (Page 26)

a. The entity's obligation to return the realized tax benefit to the taxing authority in the event it disallowsthe tax position. [This answer is correct. The liability is the entity's �potential future obligation to thetaxing authority for a tax position that was not recognized" by GAAP according to FASB ASC740�10�25�16 (formerly FIN 48, paragraph 17).]

b. The estimated additional tax that would be assessed if the tax position is allowed. [This answer is incorrect.The liability for unrecognized tax benefit is the estimated additional tax that would be assessed if the taxposition is disallowed.]

c. A deferred tax liability. [This answer is incorrect. The deferral is not a deferred tax liability but a deferral ofa current tax benefit.]

d. An offset against deferred tax assets. [This answer is incorrect. GAAP prohibits including the liability forunrecognized tax benefits with deferred tax liabilities or offsetting it against deferred tax assets.]

15. A taxable or deductible temporary difference is a difference between the tax basis of an asset or liability andits carrying amount in the financial statements. Following the guidance in FASB ASC 740�10 (formerly FIN 48),in which situation below would the tax basis of the liability be zero? (Page 27)

a. The tax position meets the �more likely than not" criterion and there is a greater than 50% chancethe full amount of the deduction would be allowed. [This answer is correct. If the tax position meetsthe �more likely than not" criterion and there is a greater than 50% chance the full amount of thededuction would be allowed, the tax basis of the liability is zero. Thus, there is a deductibledifference equal to the carrying amount of the liability for financial statement reporting.]

b. The tax position meets the �more likely than not" criterion, but there is greater than a 50% chance that lessthan the full amount of the deduction would be allowed upon examination. [This answer is incorrect. In this


42

situation the tax basis of the liability is its carrying amount for financial statement reporting less the amountof the future deduction that is more than 50% likely to be accepted. Therefore, there is a deductibledifference equal to the amount of the future deduction from settlement of the liability for which a tax benefitcan be recognized.]

c. The tax position does not meet the �more likely than not" criterion. [This answer is incorrect. In this situationthe deduction from settlement of the liability cannot be considered and the tax basis of the liability is thesame as its carrying amount for financial statement reporting. Because there is no difference in basis, thereis no temporary difference, and a deferred tax benefit cannot be recognized for the expense.]

16. Which of the following provides primary guidance on disclosures of uncertainty in income taxes? (Page 28)

a. FASB ASC 450 (formerly SFAS No. 5). [This answer is incorrect. Previously, guidance on disclosuresrequired for uncertainty in income taxes was provided primarily by FASB ASC 450 (formerly SFAS No. 5).New guidance amends this to remove uncertainty in income taxes from its scope.]

b. FASB ASC 740�10 (formerly Paragraphs B60 and B61, FIN 48). [This answer is correct. FASB ASC740�10 (formerly FIN 48) provides guidance on disclosures required for uncertainty in income taxes.Included in the disclosures, this guidance requires the financial statements to provide a tabularreconciliation of the carrying amount of the liability for unrecognized tax benefits as of the beginningand end of the year.]

c. FASB ASC 275�10 (formerly SOP 94�6). [This answer is incorrect. The new guidance does not modify FASBASC 275�10 (formerly SOP 94�6), but it does suggest that the FASB believes the disclosures required bythe new guidance provide financial statement users with sufficient information about uncertainty in incometaxes. This provides evidence that separate consideration of FASB ASC 275�10 (formerly SOP 94�6) is notrequired for disclosures of uncertainty in income taxes.]

d. FASB ASC 740 (formerly SFAS No. 109). [This answer is incorrect. Guidance in FASB ASC 740 (formerlySFAS No. 109) generally provides that as long as the entity had appropriate support for the tax positionsit has taken or intends to take, the positions are accepted as the basis for the computations of current anddeferred tax assets and liabilities. It does not provide the primary guidance on disclosures.]

17. When classifying deferred income tax assets and liabilities, which of the following is one of the basic steps?(Page 31)

a. Deferred tax assets and liabilities related to each major type of temporary difference are first classifiedbased on its expected reversal date. [This answer is incorrect. Deferred tax assets and liabilities relatedto each major type of temporary difference are first classified as current and noncurrent dependent on theclassification of the related asset or liability. Only if the deferred tax is not related to a specific asset orliability, is it classified based on its expected reversal date.]

b. Valuation allowances are allocated on a prorata basis to current and noncurrent deferred tax assets.[This answer is correct. This is one of the basic steps. Valuation allowances are allocated to currentand noncurrent deferred tax assets on a prorata basis.]

c. All deferred tax assets and deferred tax liabilities classified as current are netted together. [This answer isincorrect. Only current deferred tax assets and current deferred tax liabilities from the same tax jurisdictionare netted together.]

d. All deferred tax assets and deferred tax liabilities classified as noncurrent are netted together. [This answeris incorrect. Only noncurrent deferred tax assets and noncurrent deferred tax liabilities from the same taxjurisdiction are netted together.]


43

18. Which of the following would normally cause GAAP earnings to be lower than taxable income? (Page 31)

a. The entity uses the cash method for filing its income tax return. [This answer is incorrect. Companies usingdifferent bases of accounting typically have higher accrual basis earnings.]

b. The entity uses an accelerated depreciation method for tax reporting. [This answer is incorrect. The useof an accelerated method for tax reporting and the straight�line method for the financial statements initiallycauses GAAP earnings to be higher than taxable earnings.]

c. The entity uses the direct charge�off method for tax reporting. [This answer is correct. The use ofthe allowance method for recording bad debts for GAAP financial statements and the directcharge�off method for the tax return normally causes GAAP earnings to be lower than taxableincome.]

19. An entity is subject to federal income taxes at the 34% rate. It has a $100,000 operating loss that it may carryforward for 20 years. The deferred tax asset for the loss carryforward is not related to a particular asset or liabilityfor financial reporting. The entity expects to offset $10,000 of the loss carryforward against taxable income inthe next year. The entity expects $40,000 of the loss carryforward will expire unused. How much will it reportas a net current deferred tax asset? (Page 32)

a. $2,040. [This answer is correct. The deferred tax asset is $34,000 ($100,000 � 34%) and thevaluation allowance is $13,600 ($40,000 � 34%). Since the entity expects to offset $10,000 of theloss carryforward against taxable income in the next year, it would classify 10% of both the deferredtax asset ($34,000 � 10% = $3,400) and the valuation allowance ($13,600 � 10% = $1,360) ascurrent. Therefore the net current deferred tax asset is $2,040 ($3,400 � $1,360).]

b. $10,000. [This answer is incorrect. This is the amount of the loss carryforward that the entity expects tooffset against taxable income next year.]

c. $13,600. [This answer is incorrect. This is the valuation allowance. It must be allocated between currentand noncurrent.]

d. $34,000. [This answer is incorrect. This is the deferred tax asset. It must be allocated between current andnoncurrent.]

20. Assume the same facts as the previous question. How much will the entity report as a net noncurrent deferredtax asset? (Page 32)

a. $10,000. [This answer is incorrect. This is the amount of the loss carryforward that the entity expects tooffset against taxable income.]

b. $13,600. [This answer is incorrect. This is the valuation allowance. It must be allocated between currentand noncurrent.]

c. $18,360. [This answer is correct. The remaining 90% of both the deferred tax asset and the valuationallowance are allocated as noncurrent (($34,000 � 90%) � ($13,600 � 90%) = $18,360).]

d. $20,400. [This answer is incorrect. This is the full amount of the deferred tax asset that the entity expectsto realize over the next 20 years.]


44

CLASSIFYING AND REPORTING LONG�TERM DEBT

Long�term debt consists of the following:

a. Notes that provide for repayment over a term longer than one year.

b. Notes or loans whose form is short�term but that are treated as long�term.

c. Obligations under capital leases due over a term longer than one year.

Conceptually, the principal balance of any debt represents the present value of future payments discounted overthe repayment period using the interest rate stated in the agreement. The present value computation varies with thepayment arrangement. Financing arrangements are becoming more creative and in practice some exotic situationsmay be found, even in nonpublic companies. However, the GAAP concept of discounting for the �time value ofmoney" is unaffected.

Current Maturities of Long�term Debt

FASB ASC 210�10�45�9 (formerly ARB No. 43, Chapter 3A) requires that principal reductions of long�term debtscheduled during the next year be classified as a current liability in classified balance sheets. Normally, that amountmay be quickly computed by adding the principal portion of the payments for the next 12 months on the amortiza�tion schedule. However, the computation is complicated somewhat by situations such as the following:

a. There is no amortization schedule.

b. Payments are in arrears.

c. The interest rate floats, for example, prime plus 2%.

Each of those may be solved through present value computations using a computer amortization program or aninexpensive present value calculator, but the preparer will need to know payment amounts (including balloonpayments), interest rates, and the number of payments remaining. Preparers should normally obtain a copy of thedebt agreement because it provides information about payment arrangements as well as collateral arrangements,both of which are necessary for preparation of financial statements.

Current maturities represent the difference between the present value of payments outstanding (including balloonpayments) computed as of the balance sheet date and 12 months after the balance sheet date. If the interest ratefloats, use the rate in effect at the balance sheet date. Predicting fluctuations of interest rates is subjective, and thereis no need to attempt to predict changes during the next 12 months. The current rate may be determined in eitherof the following ways:

a. The lender may provide it.

b. It may be derived through present value computations.

Problems of GAAP Measurement for Debt

Determining the Effective Interest Rate. The interest method is defined in FASB ASC 835�30�20 (formerlyParagraph 16 of APB Opinion No. 12, Omnibus Opinion1967) as a method of arriving �at a periodic interest cost(including amortization) that will represent a level effective rate on the sum of the face amount of the debt and (plusor minus) the unamortized premium or discount and expense at the beginning of each period." In other words,interest cost should include amortization of premium or discount and costs incurred in obtaining the debt. Presentvalue computations should be made using the interest method. GAAP requires that the interest method be used(FASB ASC 835�30�55�2). It is specifically required in the following cases:

� FASB ASC 310�10; 835�30 (formerly APB Opinion No. 21, Interest on Receivables and Payables) requiresits use when interest has been imputed.


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� FASB ASC 840�30�35�6 (formerly SFAS No. 13, Accounting for Leases) requires its use for obligationsunder capital leases.

� FASB ASC 470�60�30�35�1 (formerly SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt

Restructurings) requires its use for certain modifications of terms.

In addition, SFAC No. 6, Elements of Financial Statements, indicates a preference for that method for all debt.

Rule of 78s. Some debt agreements provide for interest amortization using the �Rule of 78s" method, whichamortizes interest using the sum�of�the�years' digits method and therefore, amortizes interest faster in the earlyperiods. (Note that the sum of the numbers 1 through 12 is 78.) The results are normally not materially different fromthe interest method when the term is five years or less. However, a straight�line method normally would varymaterially from the interest method. (Note that IRS revenue procedures basically prohibit the use of the Rule of 78smethod for loans longer than five years.)

Financing Arrangements with Low Stated Interest. Some financing arrangements state a low interest rate, buteffectively require a lump�sum payment at the end of the debt term. For example, some loan agreements providefor terms that appear to yield a low interest rate. However, they also contain an option to purchase the financedasset at a specified amount. At the inception of the loan, the lender requires the borrower to sign an agreement toexercise the option. The �option" then becomes a guaranteed residual payment to the lender. When that isconsidered in the present value computations, the effective rate typically approximates current market rates. Inapplying the interest method to those arrangements, the effective interest rate should be used throughout the debtterm. The effective rate may be determined from present value computations, even if a trial and error method isused to �ballpark" the rate.

Imputing an Interest Rate. When a note is exchanged for property, goods, or services, FASB ASC 835�30�25�6(formerly APB Opinion No. 21) requires consideration of whether the interest rate stated in the agreement isreasonable in comparison with prevailing market conditions. However, this guidance does not apply to transactionsin which interest rates are affected by tax attributes, such as industrial revenue bonds or in parent�subsidiarytransactions. Also, when a note is exchanged solely for cash, this guidance does not apply because the presentvalue of the debt service, i.e., principal and interest, is presumed to equal the cash received. When this guidanceapplies, the following decision process is required:

a. The property, goods, or services received preferably should be recorded at whichever of the following ismore clearly determinable:

(1) Fair value of the items received

(2) Market value of the note

b. In the absence of established exchange prices for the items or evidence of the market value of the note,the items received should be recorded at the present value of future payments under the note discountedusing an �appropriate interest rate."


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The following summarizes the two�step process used to discount a note with a $1,000,000 face value to its presentvalue of $321,425 at December 31, 20X2.

Information required for calculation:

� Payment amount $25,000 per quarter

� Terms No payments for first 3 years$25,000 due on 1/1/X6$25,000 due over next 39 quarters

� Interest rate 16% per annum (or 4% per quarter)

Step No. 1Calculate present value of the $25,000 annuity as of January�1,20X6 (PV of 39 payments of $25,000 at 4% plus $25,000) $ 514,612

Step No. 2Calculate the present value of the $514,612 as of December 31,20X2 (PV of the $514,612 future value at 4% for 12 quarters) $ 321,425

The calculation results in a discount of $678,575 ($1,000,000 � $321,425).

An �appropriate interest rate" should be determined at the inception of the note, and subsequent changes inmarket conditions should not be considered. FASB ASC 835�30�25�12; 835�30�10�1 (formerly APB Opinion No. 21,Paragraph 13) offers the following guidance on determining an appropriate interest rate:

� Prevailing rates for similar instruments of issuers (borrowers) with similar credit ratings will normally helpdetermine the appropriate discount rate.

� The discount rate used should be the rate at which the borrower could obtain financing of a similar naturefrom other sources at the date of the transaction. (This is the same as the �incremental borrowing rate.")

� The objective is to approximate the rate that would have resulted if an independent borrower and anindependent lender had negotiated a similar transaction under comparable terms and conditions, with theoption to pay the cash price upon purchase or to give a note for the amount of the purchase that bears theprevailing rate of interest to maturity.

This guidance should be followed when considering the need to impute interest when notes are exchanged forcash. FASB ASC 835�30�25�4 (formerly Paragraph 11 of APB Opinion No. 21) states that:

When a note is received or issued solely for cash and no other right or privilege is exchanged[emphasis added], it is presumed to have a present value at issuance measured by the cashproceeds exchanged. If cash and some other rights or privileges are exchanged for a note, thevalue of the rights or privileges should be given accounting recognition.

Based on the preceding guidance, imputing interest on a loan for cash is necessary only when a future benefit isexchanged. Otherwise, the creditor would recognize a loss equal to the amount of the discount and the debtorwould recognize a gain at the time the loan is made. For example, imputing interest is not necessary in the followingsituations:

� Related Party Loans. Loans are often made to related parties either interest�free or at below�market ratesto help with temporary cash flow problems or so the related party will not have to borrow from others. Theonly right or privilege is the loan, and therefore imputing interest is unnecessary.

� Split Dollar Life Insurance. Payment of premiums under a collateral assignment split dollar arrangementare recoverable through death benefits. There is no right or privilege other than payment of the premiums,and therefore imputing interest is unnecessary.


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Obligations under Buy�out Agreements. Buy�out agreements between a company and a former stockholdersometimes cause problems in deciding whether GAAP requires an interest rate to be imputed. The agreementssometimes provide for payments with interest at rates lower than prevailing rates for long�term bank financing.Typically, the negotiations between the two parties are difficult, and the price of the stock is based on an appraisalof the company's current value. Discounting at a higher rate would reduce the principal and as a result, the cost ofthe treasury stock would be lower than its market value. Accordingly, GAAP would permit recording the treasurystock and interest at the agreed�upon amounts.

Changes in Debt Terms. Debt terms may be changed in the following ways:

a. Forgiveness of principal

b. Transfer of assets in full settlement

c. Transfer of an equity interest in full settlement

d. Modification of terms

Accounting for changes in debt terms is prescribed by the following:

� FASB ASC 470�60 (formerly SFAS No. 15, Accounting by Debtors and Creditors for Troubled DebtRestructurings) applies if the creditor grants a concession to the debtor, for economic or legal reasonsrelated to the debtor's financial difficulties, that it would not otherwise consider.

� FASB ASC 470�50�40�2 and 40�4 (formerly APB Opinion No. 26, Early Extinguishment of Debt) deals withall other situations. [Practice Alert 2000�1, Accounting for Certain Equity Transactions, issued by theAICPA's Professional Issues Task Force, addresses extinguishment of related party debt. The Practice Alertstates that a debtor should record forgiveness of an outstanding loan by a related party as a credit to equity.The Practice Alert cites FASB ASC 470�50�40�2 (formerly Paragraph 20 of APB Opinion No. 26), which notesthat debt extinguishments between related parties essentially may be capital transactions. Although thePractice Alert is nonauthoritative and intended for auditors, it may help financial statement preparers betterunderstand various types of equity transactions.

When assets or equity interests are transferred in settlement of debt, the borrower should recognize a gain equal tothe excess of the debt's carrying amount over the fair value of assets or equity interests transferred to the creditor.Any difference between the fair value and the carrying amount of assets or equity interests transferred is an ordinarygain or loss on transfer of assets. If the debt is forgiven and no consideration is required, the entire principalreduction is included in earnings as a gain. (However, forgiveness of related party debt ordinarily should berecorded as an increase in paid�in capital.) FASB ASC 470�50�45�1 (formerly SFAS No. 145, Rescission of FASB

Statements No. 4, 44, and 64, Amendment of FASB Statement No.�13, and Technical Corrections) permits therecognition of an extraordinary gain or loss from debt extinguishment only when it meets the criteria of FASB ASC225�20 (formerly APB Opinion No. 30, Reporting the Results of OperationsReporting the Effects of Disposal of a

Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions).

Normally, a modification of terms should be accounted for prospectively and does not affect the borrower'searnings in the year of modification. If the carrying amount of the debt exceeds the total future cash paymentsspecified by the new terms, however, the borrower should reduce the debt's carrying amount to the total futurecash payments (Total future cash payments include any related accrued interest at the date of the restructuring thatcontinues to be payable under the new terms.) specified by the new terms and recognize a gain on debt restructur�ing for the amount of the reduction. Subsequently, all cash payments under the terms of the debt should beaccounted for as principal reductions, and no interest expense should be recognized on the debt.

FASB ASC 470�60 (formerly SFAS No. 15) only applies to changes in debt terms associated with a troubled debtrestructuring. A substantial modification in terms of existing debt other than in a troubled debt restructuring or anexchange of existing debt for new debt with substantially different terms should be accounted for in accordance


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with FASB ASC 470�50 (formerly EITF Issue No. 96�19, �Debtor's Accounting for a Modification or Exchange of DebtInstruments"). FASB ASC 470�60�55�4 through 55�14 (formerly Issue No. 02�4, �Determining Whether a Debtor'sModification or Exchange of Debt Instruments Is within the Scope of FASB Statement No.�15, Accounting by

Debtors and Creditors for Troubled Debt Restructurings") clarifies that if a debtor is experiencing financial difficultyand the creditor grants the debtor a concession, FASB ASC 470�60 (formerly SFAS No. 15) applies. However, if thedebtor is not experiencing financial difficulty or the creditor has not extended any concession in response to thedebtor's financial difficulty, FASB ASC 470�50 (formerly EITF Issue No. 96�19) applies. FASB ASC 470�60�55(formerly EITF Issue No.�02�4) provides guidance for determining whether a debtor is experiencing financialdifficulty and whether a creditor has granted a concession.

FASB ASC 470�50�40�6 through 40�10 (formerly EITF Issue No. 96�19, �Debtor's Accounting for a Modification orExchange of Debt Instruments") address how a debtor should account for (a) an exchange of existing debt for newdebt with substantially different terms and (b) a substantial modification in terms of existing debt other than in a

troubled debt restructuring. The guidance concludes that

a. An exchange of debt with substantially different terms is a debt extinguishment and should be accountedfor in accordance with FASB ASC 405�20�40�1 (formerly SFAS No. 140, Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities) as discussed in the �Extinguishments ofLiabilities" section of this course.

b. A substantial modification of terms also should be accounted for as an extinguishment.

c. An exchange of debt or modification of debt terms is considered �substantial" if the present value of thecash flows under the terms of the new debt differs by at least 10% from the present value of the remainingcash flows under the terms of the original debt. Otherwise, the exchange of debt or modification of termsis not considered to be substantially different.

d. The following guidance should be used when applying the 10% cash flows test:

(1) The new cash flows include all cash flows specified by the new debt agreement plus amounts paidby the debtor to the creditor and less amounts received by the debtor from the creditor.

(2) The present value calculations should use the effective interest rate, for accounting purposes, of theoriginal debt instrument.

(3) The rate in effect at the date of the debt exchange or modification should be used to calculate cashflows if the old or new debt has a floating interest rate.

(4) If there is a call or put option related to either the old or the new debt, cash flows should be calculatedseparately assuming exercise and nonexercise of the options. The assumption that results in thesmaller change in cash flows should be used to determine whether the 10% test is met.

(5) Judgment should be used in calculating cash flows based on contingent payment terms or unusualinterest rate terms.

(6) If the debt was exchanged or modified within a year of the current debt exchange or modificationwithout being deemed to be substantially different, then the debt terms that existed a year earliershould be used to determine whether the current exchange or modification is substantially different.

To illustrate application of the 10% test, assume that the entity refinances a note with a principal balance of$4,575,000 that was payable to a bank in 165 monthly installments of $47,763, including interest at 8.75%. Inconnection with the refinancing, the bank loaned the entity an additional $1,750,000 (thereby increasing theprincipal balance to $6,325,000) and lengthened the repayment period to 240 months. The entity paid the bank$25,000 to refinance the debt. The following shows the application of the 10% test using two interest rate assump�tions for the refinancing. The first calculation assumes the bank decreases the rate to 7.75% and the secondcalculation assumes the bank decreases the rate to 7.25%.


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7.75% 7.25%

New monthly payment $ 51,925 $ 49,991

Cash flows to use for the 10% test:

Present value of the new amount and number of monthlypayments at the old 8.75% rate $ 5,875,792 $ 5,656,942

Cash received from the refinancing (1,750,000 ) (1,750,000 )

Cash paid for the refinancing 25,000 25,000

$ 4,150,792 $ 3,931,942

Change from the old terms:

Reduction from the present value of $4,575,000 $ 424,208 $ 643,058

Present value of old debt 4,575,000 4,575,000

% change 9.3 % 14.1 %

The refinancing should be accounted for as an extinguishment if the new interest rate is 7.25% since the change inthe present value of cash flows using the 10% test is 14.1%. However, the refinancing should not be accounted foras an extinguishment if the new rate is 7.75% since the 10% test yields a change in cash flows of only 9.3%.

If the original debt is considered extinguished (because of substantially different terms), the new debt should berecorded at fair value and that amount should be used to measure the gain or loss on debt extinguishment and theeffective interest rate of the new debt. (The cash flows computation should not be used to record the new debt ormeasure the gain or loss on debt extinguishment. Cash flows are used only to determine whether the debt shouldbe accounted for as an extinguishment.) Any fees paid by the debtor to the creditor should be associated with theextinguishment of the original debt and included in determining the gain or loss on debt extinguishment. Any costspaid to third parties (such as legal fees) should be associated with the new debt and amortized over the term of thenew debt using the interest method.

If the original debt is not considered extinguished, a new effective interest rate should be determined based on thecarrying amount of the existing debt and the revised cash flows. Any fees paid by the debtor to the creditor shouldbe associated with the replacement or modified debt and amortized as an adjustment of interest expense (alongwith any existing unamortized premium or discount) over the remaining term of the replacement or modified debtusing the interest method. Any costs paid to third parties (such as legal fees) should be expensed as incurred.

The implementation guidelines note the following:

a. If a debtor pays a creditor cash to settle debt, the transaction should be accounted for as an extinguishmentof debt rather than as a debt exchange or modification and the transaction should be accounted forfollowing the guidance of FASB ASC 405�20�40�1 (formerly SFAS No. 140). However, if cash is exchangedin connection with issuance of new debt and satisfaction of old debt, the transaction should be accountedfor following the guidance in FASB ASC 470�50 (formerly EITF Issue No. 96�19).

b. If a third�party intermediary (such as an investment banker) acts as the debtor's agent, the intermediaryshould be treated as the debtor to determine whether debt has been exchanged or modified.

c. If a third�party intermediary acts as a principal, the intermediary should be treated as a third�party creditorto determine whether debt has been exchanged or modified.

d. Transactions between creditors should not be treated as a modification or exchange of debt between thedebtor and creditor and should not affect the debtor's accounting for the debt.

e. Transactions between a debtor and a third�party creditor should be assessed using the guidance in FASBASC 405�20 (formerly SFAS No. 140) for extinguishments of liabilities and in FASB ASC 470�50 (formerlyEITF Issue No. 96�19) to determine whether a gain or loss should be recognized. Transactions between


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the debtor and a third party that is not the creditor are not covered by FASB ASC 470�50 (formerly EITF IssueNo. 96�19).

FASB ASC 470�50�55�7 (formerly EITF Issue No. 96�19) provides guidance for determining whether a third�partyintermediary is acting as an agent or as a principal. The guidance also includes examples that illustrate applicationof the preceding guidelines.

FASB ASC 470�50�40�12; 470�50�40�15 and 40�16 [formerly EITF Issue No. 06�6, �Debtor's Accounting for aModification (or Exchange) of Convertible Debt Instruments"] apply to modifications of debt instruments orexchanges of debt instruments that (a) affect an existing embedded conversion option's fair value or (b) add oreliminate an embedded conversion option. It does not apply in situations where the embedded conversion optionis separately accounted for as a derivative prior to, subsequent to, or both prior to and subsequent to themodification. As a practical matter, conversion options of small and midsize nonpublic entities generally are notaccounted for separately.

FASB ASC 470�50�40�12; 470�50�40�15 and 40�16 (formerly EITF Issue No. 06�6) provides the following guidance:

a. An entity should not include the change in the fair value of an embedded conversion option caused by anexchange of debt instruments or a modification of the terms of an existing debt instrument when applyingthe cash flows test in FASB ASC 470�50�40�10A (formerly EITF Issue No. 96�19) for determining if the termsof the new debt instrument are substantially different from the original debt.

b. If the cash flows test does not indicate that a substantial modification or exchange has occurred, themodification or exchange will be considered substantial if the change in the fair value of the embeddedconversion option is 10% or more of the carrying amount of the original debt immediately before themodification or exchange.

c. If a modification or exchange adds a substantive conversion option or eliminates a conversion optiondeemed substantive at the date of the exchange or modification, the modification or exchange would beconsidered substantial and debt extinguishment accounting would be required.

d. If the modification or exchange of a convertible debt instrument is not accounted for as an extinguishment,the carrying amount of the debt instrument should be reduced by any increase in the fair value of theembedded conversion option with a related increase in additional paid�in capital. An entity should notrecognize a decrease in the fair value of the embedded conversion option.

e. The issuer should not recognize a beneficial conversion feature or reassess an existing beneficialconversion feature when convertible debt instruments are modified or exchanged if the transaction is notaccounted for as an extinguishment.

Income Tax Considerations. Income tax regulations prescribe the conditions when interest must be imputed, andalso prescribe rates. Accordingly, applying FASB ASC 835�30 (formerly APB Opinion No. 21) may cause atemporary difference between GAAP earnings and taxable income. In addition, the requirements for debt extin�guishment differ from those for tax reporting. Under IRC Reg. Section 1.1001�3, debt modifications should beaccounted for as an extinguishment of debt if they are �significant." Otherwise, they should be treated as acontinuation of the original debt. The tax regulations describe various modifications deemed to be �significant." Forexample, a modification of interest rates is significant if it exceeds the greater of .25% or 5% of the original rate.Since the criteria for �significant" modifications under the tax regulations differ from the 10% test for �substantial"modifications, deferred taxes should be recognized if a modification of debt terms results in debt being consideredextinguished for tax reporting but not for financial reporting (or vice versa).

Credit Line or Revolving Debt Arrangements. A credit line or revolving debt arrangement allows the borrower tomake multiple borrowings up to a specified maximum amount, repay portions of prior borrowings, and thenreborrow under the same contract. The arrangements may include both amounts drawn by the debtor and loancommitments. The debtor generally defers and amortizes the costs incurred to establish the arrangement over theterm of the arrangement.


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FASB ASC 470�50�40�21 (formerly EITF Issue No. 98�14, �Debtor's Accounting for Changes in Line�of�Credit orRevolving�Debt Arrangements") states that credit line or revolving debt modifications or exchanges that result ineither a new credit line or revolving debt arrangement or in traditional term debt should be assessed as follows:

a. The debtor should compare the borrowing capacity of the old arrangement to that of the new arrangement.Borrowing capacity is calculated by multiplying the remaining term by the maximum available credit. (Forexample, the borrowing capacity of a $100,000 loan commitment with two years remaining equals$200,000.)

b. If the new arrangement's borrowing capacity is at least equal to that of the old arrangement, the debtorshould defer and amortize any unamortized deferred costs relating to the old arrangement, any fees paidto the creditor, and any third�party costs over the term of the new arrangement.

To illustrate, assume that a $1,000,000 loan commitment with two years remaining and unamortized loancosts of $40,000 is refinanced as a $1,200,000 commitment for three years at a cost of $60,000. Theborrowing capacity is $2,000,000 ($1,000,000 commitment � 2 years remaining) under the oldarrangement and $3,600,000 ($1,200,000 commitment � 3 years) under the new arrangement. Since thenew arrangement's borrowing capacity exceeds that of the old arrangement, the $100,000 total of the$40,000 loan costs remaining under the old commitment and the $60,000 cost of obtaining the newcommitment should be amortized over the three�year term of the new commitment.

c. If the new arrangement's borrowing capacity is less than that of the old arrangement, the debtor shoulddefer and amortize any fees paid to the creditor and any third�party costs over the term of the newarrangement. Any unamortized deferred costs relating to the old arrangement should be written off inproportion to the decrease in borrowing capacity. The remaining unamortized deferred costs should bedeferred and amortized over the term of the new arrangement.

To illustrate, assume that a $2,000,000 loan commitment with three years remaining and unamortized loancosts of $90,000 is refinanced as a two�year $1,800,000 commitment at a cost of $70,000. The borrowingcapacity is $6,000,000 ($2,000,000 commitment � 3 years remaining) under the old arrangement and$3,600,000 ($1,800,000 commitment � 2 years) under the new arrangement. The borrowing capacity hastherefore been reduced by $2,400,000, which is 40% of the $6,000,000 capacity under the oldarrangement. Accordingly, 40% ($36,000) of the $90,000 unamortized loan costs remaining under the oldcommitment should be written off. The $54,000 remaining balance ($90,000�$36,000) should be addedto the $70,000 cost of obtaining the new commitment, and the $124,000 total should be amortized over thetwo�year term of the new commitment.

Any write off of unamortized deferred costs relating to the old arrangement should not be classified as extraordinaryin the income statement.

Classification of revolving debt agreements can also be an issue. FASB ASC 470�10�45�3 through 45�6 (formerlyEITF Issue No. 95�22, �Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agree�ments that Include both a Subjective Acceleration Clause and a Lock�Box Arrangement") applies to any revolvingline of credit that (a) contains a subjective acceleration clause and (b) requires customer payments to be madedirectly to a lock�box account which is then applied directly to the outstanding balance of the line of credit.According to the guidance, if a line of credit includes these features, it must be classified as a current liability eventhough the agreement may not expire until more than one year after the balance sheet date. Thus, these agree�ments appear to be fairly common and the classification issues may be easily overlooked by basing the classifica�tion on the expiration date of the agreement.

Installment Loans. Installment loans are sometimes recorded on a gross basis by charging an �asset" account forthe interest portion of installments outstanding and crediting a �liability" account for the total of installments(principal and interest) outstanding. That method arose when the �Rule of 78s" method was more prevalent, and itwas necessary to keep track of unamortized interest charges. The unamortized amount is not an asset, and insteadshould be offset against total installments outstanding. The net amount would be reported as a liability.

Costs of Obtaining Financing or Refinancing. Companies incur costs in obtaining financing or refinancing. Forsmall to medium�sized companies, those costs include bank fees, accounting fees to prepare prospective presen�


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tations, and legal fees to draft the necessary documents. FASB ASC 310�20 (formerly SFAS No. 91, Accounting for

Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases)generally requires lenders to account for their fees as an adjustment of yield. FASB ASC 310�20�15�3 (formerlySFAS No. 91, as amended) excludes costs related to commitments to originate, sell, or purchase loans accountedfor as derivatives from the scope of FASB ASC 310�20 (formerly SFAS No. 91). Therefore, the bank fees are, insubstance, discount on the debt. The other costs of obtaining financing, which usually are not material to significantsubtotals in the balance sheet, are similar in concept to bank fees. Accordingly, those costs also should be offsetagainst the debt and amortized to interest expense using the interest method described in the �Determining theEffective Interest Rate" section unless, as discussed below, the loan is payable on demand or under a revolving lineof credit or similar arrangement with no scheduled payments. That method is also appropriate for income taxreporting.

SFAC No. 6, Elements of Financial Statements, views discount and debt issue costs the same. Neither hassubstance apart from the debt, and neither is an asset. Both should be offset against the debt and amortized tointerest expense using the interest method. The interest method produces a periodic interest cost that reflects alevel effective rate on the net loan proceeds. By offsetting discounts and debt issue costs against the debt, interestexpense relates directly to the amount reported as a liability.

This course's recommendation differs from GAAP in one respect: the costs that are not in substance discountshould be reported as a deferred charge. FASB ASC 835�30�45 (formerly APB Opinion No. 21, Interest on Receiv�

ables and Payables), requires offsetting discount against the face amount of the debt, but it requires reporting debtissue costs as a deferred charge. SFACs, are not authoritative so the conclusion in FASB ASC 835�30�45 (formerlyAPB Opinion No. 21) takes precedence over the conclusion in SFAC No. 6. [However, the position in FASB ASC835�30�45 (formerly APB Opinion No. 21) is inconsistent with the definition of carrying amount of debt in FASB ASC470�50�20 (formerly APB Opinion No. 26, Early Extinguishment of Debt), and FASB ASC 470�60�20 (formerly SFASNo. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings). Each defines the carrying amountof the debt as the face amount adjusted for unamortized premium, discount, and cost of issuance.] However, theeffect of the GAAP departure is limited to the balance sheet (that is, it understates noncurrent assets and long�termdebt) and is rarely material.

FASB ASC 310�20�20; 310�20�35�18 through 35�24 (formerly SFAS No. 91) provide guidance on how lendersshould calculate the yield adjustment. Although that guidance does not specifically apply to a borrower, its view ofbank fees as yield adjustments of interest provides useful guidance for borrowers. The following definitions areprovided:

� Origination Fees. Fees charged to the borrower in connection with the process of originating, refinancing,or restructuring a loan. This term includes, but is not limited to, points, management, arrangement,placement, application, underwriting, and other fees pursuant to a lending or leasing transaction and alsoincludes syndication and participation fees to the extent they are associated with the portion of the loanretained by the lender.

� Commitment Fees. Fees charged for entering into an agreement that obligates the entity to make or acquirea loan or to satisfy an obligation of the other party under a specified condition. Commitment fees includefees for letters of credit and obligations to purchase a loan or group of loans and pass�through certificates.

This course relies on these provisions to develop the following guidance for borrowers to use in amortizing feescharged by lending institutions:

� If the loan is payable on demand, the fees should be amortized using the straight�line method over a periodconsistent with the understanding between the borrower and lender. If no such understanding exists, thefees should be amortized over the borrower's estimate of the period that the loan will be outstanding. Anyunamortized amount should be charged to interest expense when the loan is paid in full.

� If the loan is a revolving line of credit or similar arrangement with no scheduled payments, the fees shouldbe amortized using the straight�line method over the period the line is active, assuming that borrowingsare outstanding for the maximum term provided in the loan contract. Any unamortized amount should becharged to interest expense when the line is paid.


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� If a loan commitment expires unexercised, fees should be charged to interest expense in the period ofexpiration.

� Fees for all other arrangements should be charged to interest expense using the interest method. If theloan's stated interest rate varies based on future changes in an independent factor (for example, prime plusone percent), the calculation of the constant effective yield should be based either on the factor that is ineffect at the inception of the loan or on the factor as it changes over the life of the loan.

This course also relies on these provisions to provide the following guidance on how borrowers should account fordebt issue costs when the issue is subsequently refinanced or restructured.

� If the refinancing or restructuring is a troubled debt restructuring so that the lender is economically or legallycompelled to grant concessions, FASB ASC 470�60 (formerly SFAS No. 15, Accounting by Debtors and

Creditors for Troubled Debt Restructurings) applies.

� If only minor modifications are made to the original loan contract, the unamortized issue costs should becarried forward and amortized over the term of the new loan following the guidance in the previousparagraph.

� If the terms of the refinanced or restructured loan are comparable to those of other companies with similarcollection risks, unamortized issue costs associated with the original loan should be charged to interestexpense when the new loan is granted.

� If the terms are not comparable, the unamortized costs associated with the original issue should beamortized over the term of the new loan following the guidance in the previous paragraph.

The guidance in FASB ASC 470�50�40�21 through 40�23 (formerly EITF Issue No. 98�14) should be followed fordebt issue costs related to changes in credit line or revolving debt arrangements.

Extinguishments of Liabilities. FASB ASC 405�20�40�1 (formerly SFAS No. 140, Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities) specifies that a liability is considered extinguishedif either of the following conditions is met:

a. The debtor pays the creditor and is relieved of its obligation for the liability.

b. The debtor is legally released from primary obligation under the liability.

A liability that is considered extinguished should be removed from the debtor's balance sheet.

If a creditor releases a debtor from primary obligation on the condition that a third party assumes the debt and theoriginal debtor becomes secondarily liable, the release extinguishes the original debtor's liability. However, in thatcase, the original debtor becomes a guarantor, and should recognize a guarantee obligation at fair value if it is likelythat the third party will not pay the debt. The guarantee obligation reduces the debtor's gain (or increases the loss)recognized on extinguishment of the debt.

FASB ASC 405�20�55 [formerly the FASB Implementation Guide (Q&A) titled A Guide to Implementation of State�ment 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities] providesthe following guidance on debt extinguishment issues:

a. A legal defeasance generally is accounted for as an extinguishment since the creditor legally releases thedebtor from being the primary obligor. In contrast, an �in�substance" defeasance in which the debtor placesassets in a trust to satisfy the debt is not accounted for as an extinguishment.

b. If old debt is exchanged for new debt with substantially different terms or if existing debt terms aresubstantially modified, the guidance in FASB ASC 470�50�40; 470�50�55 (formerly EITF Issue No. 96�19,�Debtor's Accounting for a Modification or Exchange of Debt Instruments") should be followed.


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c. If an entity is released from being the primary obligor but becomes a secondary obligor through aguarantee, the guarantee obligation should be recognized at its fair value through a charge that reducesthe gain, or increases the loss, on extinguishment.

In�substance Defeasance of Debt. In certain �in�substance" defeasances of debt, the debtor irrevocably placescash or other risk�free monetary assets in a trust solely for satisfying the debt; however, the creditor does not relievethe debtor of primary obligation under the debt (although the possibility that the debtor will be required to makefurther payments may be remote). The debtor's liability in such an �in�substance" defeasance is not consideredextinguished because it would not meet either criteria in the �Extinguishments of Liabilities" section. Therefore, thedebtor could not remove the liability from its balance sheet. (If the assets are set aside in an irrevocable trust, theportion used to satisfy the current debt should be classified as current, and the remainder should be classified asnoncurrent. If the assets are set aside in a revocable trust, the entire amount may be classified as current, butnoncurrent classification would be acceptable since it is more conservative.)

Secured Borrowings. A debtor may grant a security interest in assets to a lender to serve as collateral for its debt,and the lender may be allowed to sell or repledge the collateral [FASB ASC 860�30�20 (formerly SFAS No. 140)defines a security interest as �a form of interest in property that provides that upon default of the obligation for whichthe security interest is given, the property may be sold to satisfy that obligation"]. The accounting for noncashcollateral depends on whether the lender has the right to sell or repledge the collateral and if the debtor hasdefaulted on the loan, (Cash �collateral," sometimes used in securities lending transactions, should be removedfrom the debtor's balance sheet and be recognized by the lender as proceeds of either a sale or borrowing, not ascollateral.) as follows:

a. If the lender is allowed (by contract or custom) to sell or repledge the collateral,

(1) the debtor should report the collateral as a restricted asset in its balance sheet, and

(2) the lender should not recognize the pledged collateral on its balance sheet.

b. If the lender sells the collateral, the lender should recognize the proceeds from the sale of the collateral andits liability for returning the collateral.

c. If the debtor defaults under the terms of the secured borrowing and is no longer entitled to redeem thecollateral, the debtor should remove the collateral from its balance sheet. The lender should

(1) record the collateral as an asset at fair value or

(2) if it has already sold the collateral, remove the liability to return the collateral.

FASB ASC 405�20�55; 860 (formerly the FASB Q&A on SFAS No. 140) includes several questions and answersrelated to secured borrowings and collateral. As a practical matter, small and medium�sized entities rarely encoun�ter most of the transactions (such as repurchase and resale agreements) addressed by those questions. However,FASB ASC 860�30�35�2 (formerly Question 117 of the FASB Q&A on SFAS No. 140) addresses how a debtor shouldmeasure transferred collateral that must be reported as a restricted asset in accordance with requirement a.discusses in the paragraph above. In that case, the transfer should not change how the debtor measures fair valuewith changes in fair value reported in other comprehensive income, even if the securities are transferred to a brokeras collateral and reported as restricted assets.


The current portion of long�term debt should be presented immediately after short�term notes and loans and thenoncurrent portion should be presented immediately after total current liabilities as follows:


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20X2 20X1

CURRENT LIABILITIES


Loans payable to stockholders � 25,000

Current portion of long�term debt 10,000 9,000


Accrued expenses 15,000 10,000



It generally would not be appropriate to combine short�term notes and the current portion of long�term debt into asingle caption because they have different characteristics.

REPORTING OTHER LIABILITIES

Environmental Cleanup Costs and Liabilities

Companies often encounter properties that require environmental cleanup. Federal and state laws impose legalobligations on owners of environmentally damaged properties, and those obligations can be very costly. Thefollowing paragraphs discuss general accounting and reporting principles for environmental cleanup costs andrelated liabilities that are applicable to any industry.

Federal Environmental Laws. The following are the environmental laws that most environmental cleanup obliga�tions are based on:

� Superfund Laws. The Comprehensive Environmental Response, Compensation, and Liability Act(CERCLA) and Superfund Amendments and Reauthorization Act established the Superfund, which is usedprimarily to clean up facilities that are abandoned or inactive or whose owners are insolvent. TheEnvironmental Protection Agency (EPA) has the authority to order responsible parties to remediatecontaminated sites or to use Superfund money to remediate the sites and then seek reimbursement forcleanup costs from potentially responsible parties (PRPs). There are four classes of PRPs:

a. Current owners or operators of sites at which hazardous substances have been disposed of orabandoned

b. Previous owners or operators of sites at the time of disposal of hazardous substances

c. Parties that arranged for disposal of hazardous substances found at the sites

d. Parties that transported hazardous substances to a site, having selected the site for treatment ordisposal

� Resource Conservation and Recovery Act of 1976 (RCRA). RCRA provides for comprehensive regulationof hazardous wastes from origination to final disposal. It imposes cleanup obligations on any party that has�contributed to" the disposal of waste that is causing an imminent and substantial endangerment.

Authoritative Literature. The authoritative literature listed below provides the primary guidance in accounting forenvironmental cleanup costs and liabilities:

� FASB ASC 450�20 (formerly SFAS No. 5, Accounting for Contingencies) provides general guidance onaccruing liabilities for loss contingencies.

� FASB ASC 410�20 (formerly SFAS No. 143, Accounting for Asset Retirement Obligations) providesaccounting and reporting guidance that applies to environmental remediation obligations arising from thenormal operation of a long�lived asset and that is associated with the retirement of that long�lived asset.


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� FASB ASC 410�30 (formerly SOP 96�1, Environmental Remediation Liabilities) provides specific guidancefor recognizing, measuring, and disclosing environmental remediation liabilities. (Remediation refers tosteps taken to restore natural resources or to investigate, mitigate, or eliminate environmentalcontamination or the threat of contamination. The term normally is used in connection with Superfundremediation or RCRA actions.)

� FASB ASC 410�30�25�16 through 25�19 (formerly EITF Issue No. 90�8, �Capitalization of Costs to TreatEnvironmental Contamination") provide guidance for determining whether environmental cleanup costsshould be capitalized.

� FASB ASC 360�10�55 (formerly EITF Issue No. 95�23, �The Treatment of Certain Site Restoration/Environ�mental Exit Costs When Testing a Long�Lived Asset for Impairment") addresses whether future cash flowsfor environmental exit costs associated with a long�lived asset should be included in the undiscountedexpected future cash flows used to test property for recoverability.

Accruing Environmental Remediation Liabilities. Environmental remediation liabilities can be challenging toaccount for. First, it is difficult to determine when a liability has been incurred because it often cannot be easilyassociated with a single event. Second, the amount of the liability often is difficult to reasonably estimate until longafter the problem has been identified. Engineers may be able to estimate some costs, but significant uncertaintiessurround the full cleanup costs. Because of those difficulties, FASB ASC 410�30 (formerly SOP 96�1) was issued toprovide more specific guidance for recognizing, measuring, and disclosing liabilities for legally required environ�mental remediation. (GAAP does not provide guidance on accounting for costs associated with voluntary environ�mental remediation activities undertaken at the sole discretion of the company and not as a result of threatenedlitigation, claims, or assessments. However, FASB ASC 410�30 (formerly SOP 96�1) is the most applicable guidancefor accounting for internally identified environmental remediation costs.) In summary, this guidance provides thatenvironmental remediation liabilities should:

� be accrued on a site�by�site basis when the criteria of FASB ASC 450�20�25�2 (formerly SFAS No. 5) aremet, using the benchmarks in FASB ASC 410�30 for determining when those criteria are met.

� include incremental direct costs, as well as compensation and benefit costs for employees who devotesignificant time to remediation activities.

� include costs for the company's specific share of the liability for the site, as well as the company's shareof costs that will not be paid by the government or other PRPs.

� be estimated based on enacted laws and regulations.

� be estimated based on expected improvements in remediation technology.

� be based on the company's estimated costs to perform all phases of the remediation activities when theyare expected to be performed.

� consider discounting when appropriate.

In addition, GAAP points out that environmental remediation obligations are not unusual in nature and do not meetthe criteria for classification as extraordinary items.

Determining When to Accrue a Liability. GAAP indicates that it is probable that an environmental remediationliability has been incurred when the following two elements are met on or before the date the financial statementsare available to be issued:

a. It has been asserted or it is probable that it will be asserted (through litigation, claim, or regulatoryassessment) that the company is responsible for participating in an environmental remediation process asa result of a past event (which occurred on or before the balance sheet date).

b. It is probable that the result of the litigation, claim, or assessment will be unfavorable and the company willbe held responsible.


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This guidance concludes that (a) if an assertion has been made or is probable of being made and (b)�if thecompany is associated with the site (as an owner, previous owner, operator, or was responsible for disposing of ortransporting the hazardous substances at the site), there is a presumption that the outcome of the litigation, claim,or assessment will be unfavorable.

The fact that particular components of the overall environmental remediation liability may not be reasonablyestimated during the early stages of the remediation process should not preclude recognizing a liability. In addition,uncertainties regarding the company's share of an environmental remediation liability should not preclude thecompany from recognizing its best estimate of its share of the liability. Therefore, the following benchmarks areprovided for determining when an environmental remediation liability meets the accrual criteria:

� Identification and Verification of the Company as a PRP. If the company determines that it is associated witha Superfund or RCRA site, it is probable a liability has been incurred, and the liability should be accruedwhen all or a portion of it is reasonably estimable. (Although the term PRP specifically relates to federalSuperfund law, the same accrual benchmarks could be used by smaller companies that are not involvedwith Superfund sites to establish liability under other federal and state environmental laws.)

� Receipt of Order or Mandates to Take Interim Corrective Measures. For example, the company mightreceive a unilateral administrative order from the EPA requiring it to take a �response action" or risksubstantial penalties. In those situations, the cost of performing the required work generally is estimablewithin a range, and the company should not delay accruing a liability for costs of removal actions beyondthis point.

� Participation as a PRP in a Remedial Investigation or Feasibility Study. At this stage, the company generallyhas agreed to pay the costs of a study to investigate the environmental impact of the contamination andidentify remediation alternatives for the site. The cost of the investigation generally can be estimated withina reasonable range. As the investigation proceeds, the company's estimate of its share of the total cost ofthe investigation can be refined.

� Completion of Feasibility or Corrective Measures Study. When the feasibility or corrective measures studyis substantially complete, the company generally will be able to reasonably estimate both a minimumremediation liability and the company's allocated share of the liability.

� Issuance of Record of Decision (ROD) or Approval for Corrective Measures Study. At this stage, the EPAhas issued its decision specifying a preferred remedy, and the company can refine its estimated liabilitybased on the specified remedy and a preliminary allocation of total remediation costs.

� Remedial Design and Implementation of Corrective Measures. During the design phase of the remediation,engineers develop a better estimate of the work to be performed and can provide more precise estimatesof the total remediation costs. The company should continue to refine and recognize its best estimate ofits share of the liability as additional information becomes available throughout the operation andmaintenance of the remedial action plan.

The preceding benchmarks should be considered when evaluating the probability that a loss has been incurredand the extent to which the loss is reasonably estimable. However, these benchmarks should not be applied in away that would delay recognizing an environmental remediation liability beyond the point at which a liability wouldbe recognized.

If the company cannot estimate a single loss amount, the guidance in FASB ASC 450�20�30�1 (formerly FASBInterpretation No. 14, �Reasonable Estimation of the Amount of a Loss") is cited, which allows companies to definea range of estimated losses and record the amount in the range that is the best estimate. (If no amount in the rangeis a better estimate than any other amount, the lowest amount in the range should be used.) Thus, in practice, thecompany generally should define the range of an estimated environmental remediation liability and refine theestimate as activities in the remediation process occur. Subsequent changes in estimates of the company's liability(e.g., changes in the company's share of the liability due to identification of other PRPs) should be accounted foras changes in estimates. Consideration also should be given to the need for additional disclosures related to risksand uncertainties.


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Estimating Environmental Remediation Costs. Environmental remediation liabilities should provide for thefollowing costs:

a. Incremental direct costs, including:

� Legal fees paid to outside law firms for work related to determining the extent of remedial actionsrequired, the type of remedial actions to be used, or the allocation of costs among PRPs

� Costs related to the remedial investigation or feasibility study

� Engineering and consulting fees paid to outside firms for site investigations and development ofremedial action plans and designs

� Contractors' costs for performing remedial actions (such as, soil removal and disposal)

� Government oversight costs (such as, fines)

� Costs of machinery and equipment dedicated to remedial actions

� PRP group assessments to cover costs incurred by the group in dealing with a contaminated site

� Costs for operation and maintenance of the remedial action, including postremediation monitoring

b. Costs of compensation and benefits for employees who devote significant time to remediation activities,including:

� Technical employees involved with remediation activities

� Costs of internal legal staff involved with determining the extent of remediation actions required, thetype of remedial action to be used, or the allocation of costs among PRPs

Costs of compensation and benefits should be allocated based on time spent on the previous activities.

GAAP points out that costs related to routine environmental compliance matters and legal costs associated withpotential recoveries should not be included in remediation costs. However, GAAP does not provide guidance onwhether the costs of defending against liability claims and assertions should be included in the measurement of theenvironmental remediation liability. This course recommends such costs should be included in the measurementof the liability to the extent they are probable and reasonably estimable.

Allocating Shared Costs among Responsible Parties. To record an environmental remediation liability, thecompany must determine its share of the total remediation liability. That is a subjective estimate based on manyfactors, including the following:

� Who Are the PRPs for the Site? Generally, the EPA notifies the company that it is a PRP, along with other PRPsidentified by the EPA. However, depending on the available information, the EPA may not be aware of allPRPs. In that case, the company, along with other identified PRPs, should consider investigating to findother parties who may be liable for a portion of the remediation costs.

� What Is the Percentage of the Total Liability That Will Be Allocated to the Company? Several factors can beconsidered in allocating liability among PRPs, such as volume measures, the type of waste, whether thePRP was a site operator or owner, the degree of care exercised by the PRP, and any statutory or regulatorylimitations on contributions from some PRPs. As a practical matter, the allocation often is determined byagreement among the parties, by hiring an allocation consultant, or by requesting that the EPA determinean allocation. The percentage for the entire remediation effort, not just a portion, should be used todetermine the company's allocable share of the total remediation liability.

� What Is the Likelihood the Other PRPs Will Pay Their Full Share of the Liability? The company should assessthe likelihood that the other PRPs will pay their allocable portion of the total remediation liability. That


59

assessment generally is based on the financial condition of the other PRPs and must be monitored as theremediation progresses. Any amounts that will not be paid by other PRPs must be allocated among theremaining PRPs and included in the remaining PRPs' liabilities.

As previously mentioned, uncertainties in determining the company's share of the remediation liability should notpreclude the company from recognizing its best estimate of its share of the liability, or at least the minimum estimateof its share of the liability if a best estimate cannot be made.

Effect of Changes in Laws and Regulations. The accrual of environmental remediation liabilities should be basedon enacted laws and adopted regulations, not on anticipated changes in those laws and regulations. The companyshould recognize the impact of changes in laws and regulations when those changes are enacted or adopted.

Technology Improvements. The accrual also should be based on remediation technology and methods expectedto be approved to clean up the site. Therefore, when measuring its liability, the company should consider antici�pated advances in technology only to the extent that the company has a reasonable basis to expect a remediationtechnology will be approved. The uncertainty regarding the technology is removed when the regulatory agencyissues its ROD or approved remediation order. At that point, the remediation technology to be used is consideredto be defined.

Productivity Improvements. The accrual of the environmental remediation liability also should be based on thecompany's estimated costs to perform each phase of the remediation effort at the time the phase is expected to beperformed, considering such factors as productivity improvements due to experience with similar sites and similarremedial action plans.

Use of Discounting. An environmental remediation liability, or a component of the liability, may be discounted toreflect the time value of money only if both of the following are fixed or reliably determinable:

a. The company's share of the aggregate liability amount, or component thereof

b. The amount and timing of cash payments for the liability or component

If the company can estimate only a range of possible loss from an environmental liability or other uncertainties existabout the timing of expenditures, discounting is not appropriate.

Claims for Recovery. Companies may be able to pursue recoveries of amounts expended for environmentalremediation from a variety of sources, including insurers, nonparticipating PRPs, the government, or other thirdparties. GAAP requires the amount of an environmental remediation liability to be determined independently fromany potential claim for recovery. Furthermore, an asset related to a potential claim for recovery should be recog�nized only when realization of the claim is considered probable. (If a claim for recovery is being litigated, realizationof the claim generally is not considered probable.) A�potential claim for recovery should be measured at its fairvalue, considering both the costs related to the recovery and the time value of money. However, GAAP states thatthe time value of money should not be considered if the related liability is not discounted and timing of the recoverydepends on the timing of paying the liability. In addition, the guidance from FASB ASC 210�20�45 (formerly FIN 39,Offsetting of Amounts Related to Certain Contracts), is cited, which states that liabilities should not be presented netof related receivables unless there is a legal right of offset. GAAP indicates that environmental remediation liabilitiesand related claims for recovery rarely, if ever, meet the requirements for offsetting. Thus, presentation of the grossliability and related claim for recovery in the balance sheet generally is appropriate.

Effect on Property Impairment. In addition to recognizing a liability for the costs of curing violations of environ�mental regulations, companies should consider whether environmental regulations impose restrictions on thefuture use of the property. Significant restrictions on the property's future use could reduce the property's fair valueor its ability to generate future cash flows. In that case, the property's carrying amount may not be recoverable andthe company may need to recognize an impairment loss. GAAP does not address whether the recognition ofenvironmental remediation liabilities should be considered in assessing asset impairment. FASB ASC360�10�35�18 (formerly SFAS No. 143, Accounting for Asset Retirement Obligations), provides the following guid�


60

ance on the treatment of certain environmental exit costs recognized when testing a long�lived asset for impair�ment:

� Capitalized asset retirement costs should be included in the carrying amount of the asset being tested forimpairment.

� The cash flows used to test the recoverability of the asset and to assess its fair value should excludeestimated future cash flows related to the liability for an asset retirement obligation already recognized inthe financial statements.

Costs to Retire Long�lived Assets

FASB ASC 410�20 (formerly SFAS No. 143, Accounting for Asset Retirement Obligations), and FASB ASC410�20�25; 410�20�55 (formerly FIN 47, �Accounting for Conditional Asset Retirement Obligations"), provide guid�ance on accounting for obligations associated with the retirement of tangible long�lived assets. This guidanceapplies to retirements due to acquisition, construction, development, or the normal operation of assets. [Thisguidance does not apply to a lessee's obligations that meet the criteria for minimum lease payments or contingentrentals as as defined in FASB ASC 840�10�25�4 through 25�7 (formerly SFAS No. 13) and that are accounted for inaccordance with FASB ASC 840�10 (formerly SFAS No. 13). In addition, obligations that arise solely from a plan tosell or otherwise dispose of a long�lived asset in accordance with FASB ASC 360�10 (formerly SFAS No. 144,Accounting for the Impairment or Disposal of Long�Lived Assets), are not covered by these provisions.] GAAPrequires asset retirement obligations to be recognized at fair value when (a) an obligation is incurred and (b) areasonable estimate of fair value can be determined. The liability should be recorded in the period that theobligation is incurred, even if it is incurred over more than one reporting period. If an obligation has been incurred,but a fair value can not be determined, the liability does not have to be recognized. However, GAAP requiresdisclosure of that fact and the reasons for it.

FASB ASC 820�10 (formerly SFAS No. 157) generally applies to fair value measurements performed for assetretirement obligations. An asset retirement obligation may be incurred over multiple reporting periods. In that case,the estimation of the obligation's fair value should be determined as the obligation is incurred. Subsequentliabilities, when measured at fair value, should then be added to any obligation previously recognized. In addition,the carrying amount of the liability should be adjusted if in subsequent periods the fair value of the obligationchanges due to the passage of time or revisions to the estimated cash flows.

Once the fair value of an asset retirement obligation has been determined, that value should be capitalized byincreasing the carrying value of the related long�lived asset by the amount of the liability. The capitalized amountshould be allocated to expense over its useful life using a rational and systematic method.

The following disclosures are required:

� General description of the obligation

� The long�lived asset associated with the obligation

� If any assets are legally restricted to settle the obligation, the fair value of such assets

� If the carrying amount of the obligation has changed, a reconciliation between the beginning and endingobligation

� If an obligation has been incurred, but a fair value can not be determined, that fact and the reasons for it

Accounting for a Guarantee by the Entity

According to FASB ASC 460�10�50�2 (formerly Paragraph 12 of SFAS No. 5, Accounting for Contingencies), in thetypical guarantee

a. The possibility of a loss is remote and therefore, since the possibility is less than probable, liabilityrecognition is not required.


61

b. Even though the possibility of a loss is remote, the financial statements should disclose the nature andamount of the guarantee.

FASB ASC 460�10 (formerly FIN 45, �Guarantor's Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others"), changes the conclusion that liability recognition is notrequired just because a loss under the guarantee is not probable and expands somewhat the required disclosures.(Guarantees by the entity are the only guarantees subject to the requirements of FASB ASC 450 (formerly SFAS No.5) and therefore FASB ASC 460�10 (formerly FIN 45). Therefore, for example, they do not apply to another party'sguarantee of the entity's debt or to another party's guarantee of amounts due to the entity. FASB ASC 460�10�15�4;460�10�55�2 (formerly FIN 45) list the basic types of guarantee contracts that, with certain exceptions, are subjectto the requirements of GAAP for guarantees.

FASB ASC 460�10�25�3 (formerly Paragraph 9 of FIN 45) clarifies that FASB ASC 450�20�25 (formerly SFAS No. 5)does not prohibit a guarantor from recognizing a liability when it issues a guarantee, even if the likelihood of theevent that would trigger performance under the guarantee is less than probable. That conclusion is generally basedon the view described in FASB ASC 460�10�25�2 (formerly Paragraph 8 of FIN 45), that the issuance of a guaranteeobligates the entity in two respects, in that the entity undertakes

a. An obligation to stand ready to perform over the term of the guarantee in the event that the specifiedtriggering events or conditions occur (the noncontingent aspect) and

b. A contingent obligation to make future payments if those triggering events or conditions occur (thecontingent aspect).

While FASB ASC 450 and 460 (formerly SFAS No. 5) remain the primary sources of authoritative guidance onaccounting for a guarantee, FASB ASC 460�10 (formerly FIN 45) interprets this guidance to

a. Require measuring the entity's obligation under the guarantee at its fair value.

b. Specify the disclosures for guarantees. However, depending on the facts and circumstances, GAAP mayor may not require entities to add to the information they were already disclosing about the nature andamount of the guarantee.

In considering the measurement provisions, it is important to remember that

a. The overriding objective of those provisions is to record a liability for the fair value of the guarantee. Eventhough the FASB views the guarantee as imposing two obligations, the entity only needs to estimate thefair value of the guarantee in total. FASB ASC 460�10�25�2 (formerly Paragraph�A45 of FIN 45) states thatbifurcation of the contingent and noncontingent aspects of the guarantee is not required. Those twoaspects of the guarantor's obligation are mentioned only to emphasize that the guidance in FASB ASC450�20 (formerly SFAS No. 5) regarding loss contingencies does not control or prohibit the recognition ofa liability arising from the issuance of a guarantee.

b. As with all accounting pronouncements, these provisions need not be applied to immaterial items.

Considering the Applicability to Common Guarantees by Small and Midsize Nonpublic Entities. GAAPexcludes a number of types of guarantees either from its scope entirely or from its measurement, but not itsdisclosure, provisions. The most common guarantees by small and midsize nonpublic entities are guarantees ofrelated party debt and product warranties. The measurement provisions do not apply to many of the related partydebt guarantees or to product warranties, but its disclosure provisions apply to both types of guarantees.

Guarantees of Related Party Debt. While GAAP does not exempt all related party debt guarantees from itsmeasurement provisions, best practices indicate that the related party debt guarantees most commonly enteredinto by small and midsize nonpublic entities will be exempted. For example, following the guidance in FASB ASC460�10�30�1 (formerly Paragraph 7 of FIN 45), the measurement provisions would not apply to the entity's guaran�tee of debt of a sister corporation, a subsidiary, or the entity's parent. In addition, an entity's guarantee of debt of a


62

major stockholder is analogous to guarantee of debt of its parent and therefore would also be exempt from themeasurement provisions. However, disclosure of those guarantees is required, which would ordinarily

a. Consist of the nature of the guarantee and the maximum undiscounted amount of payments the entitycould be required to make.

b. Require little additional disclosure beyond that previously disclosed for the guarantees.

Product Warranties. Product warranties are not considered to be guarantees for purposes of applying thesemeasurement provisions. However, recording a liability for the estimated amount of payments for probable claimsunder outstanding warranties is still required, discounted if the period is long enough.

In addition to information about product warranty arrangements, disclosure of information about a related liabilityrecorded is required. That information generally consists of

a. The carrying amount of the liability.

b. The entity's accounting policy and methodology used in determining its liability for product warranties.

c. The components of the change in the liability during the year.

As a practical matter, if the entity has reinsured its warranty obligation, the liability recognition requirements of FASBASC 460�10�25�5 through 25�7 (formerly SFAS No. 5) are not applicable. (Note that the liability recognized by adealership for warranty premiums received from a customer is a deferral of gross profit, not a liability for warrantyclaims.) Best practices indicate that the disclosure required for those types of arrangements ordinarily wouldconsist of a description of the warranty and reinsurance arrangements. If the entity only acts as a broker for awarranty insurer, this guidance is not applicable.

Estimating the Fair Value of the Obligation under the Guarantee. When initially measuring the liability related toa guarantee, the objective is the fair value of the guarantee at its inception. Fair value measurements performed forguarantees should follow the guidance in FASB ASC 820�10 (formerly SFAS No. 157).

FASB ASC 460�10 (formerly FIN 45) generally establishes a rebuttable presumption that the amount of a feecharged by the entity for entering into a guarantee in an arm's length transaction with an unrelated party is the fairvalue of the entity's obligation under the guarantee. However, FASB ASC 460�10�55�21 (formerly Paragraph A38 ofFIN 45) states that if a guarantee �is issued in conjunction with another transaction (such as the sale of assets by theguarantor), the specified [fee received] may not be an appropriate initial measurement of the guarantor's liabilitybecause the amount specified as being applicable to the guarantee may or may not be its fair value."

The absence of a fee does not eliminate the need to recognize the obligation. For example, FASB ASC460�10�55�21 and 55�22 (formerly Paragraph A31 of FIN 45) notes that the entity would most likely be required topay a fee to get out of the guarantee. In addition, FASB 460�10�55�22 (formerly Paragraph A32 of FIN 45) says, �Ifan entity guaranteed a customer's bank loan purely as an accommodation to an important longstanding customer,unrelated to a specific transaction, the liability for the entity's obligations under the guarantee should be recog�nized."

Accordingly, if a fee is not charged, the fair value of the liability can be estimated either

a. Based on Fees Charged by the Entity or Other Entities for Similar Guarantees. The fee charged by the entityfor guaranteeing the debt or the fee charged by the entity or others for similar guarantees is ordinarily areasonable measure of the fair value of a guarantee. For example, if a fee of no more than 1% of themaximum exposure has been charged for similar guarantees, the fair value of a guarantee of debt withprincipal outstanding that will not exceed $1,000,000 would be no more than $10,000, which is 1% of$1,000,000.


63

b. Computing the Present Value of the Payment the Entity Expects to Make under the Guarantee. FASB ASC460�10�30�3 through 30�4 (formerly Paragraph 9 of FIN 45) refers to this as a �probability�weighted" presentvalue calculation. Best practices indicate that the present value calculation should

(1) Consider the probability of a payment under the guarantee.

(2) Offset the proceeds the entity would likely receive from exercising collateral rights under theguarantee.

(3) Use a rate commensurate with the risk assumed to discount the net payment expected.

Small and midsize nonpublic entities rarely enter into a guarantee of third party debt unless management believesthere is only a remote possibility that settlement would be required. As a result, the present value calculation for aguarantee of debt of a third party often will result in an amount that is not material to the financial statements.Furthermore, if the estimated fair value of the obligation is not likely to be material, liability recognition is notrequired.

Initial and Subsequent Measurement Considerations. Best practices indicate that

a. The initial liability ordinarily should be recorded through a debit to earnings. However, if there is a fee forthe guarantee, the debit would be to cash or receivables

b. Changes in the liability in subsequent years should be recorded through a debit or credit to earnings. Forexample, the fair value of a guarantee ordinarily would decline as principal outstanding under theguaranteed debt declines, and reduction of the liability under the guarantee should be recorded througha credit to earnings. Three alternatives for recognizing the decline are providedupon expiration orsettlement of the guarantee, by a systematic and rational amortization method, or as the fair value of theguarantee changes. However, as clarified by FASB ASC 460�10�35�2 (formerly (FSP) FIN 45�2, �WhetherFASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees,

Including Indirect Guarantees of Indebtedness of Others, Provides Support for Subsequently Accountingfor a Guarantor's Liability at Fair Value"), FASB ASC 460�10�35 (formerly FIN 45) intentionally does notprovide guidance regarding when each of those methods would be appropriate. For example, thisguidance should not be cited as support in justifying the use of fair value in accounting for the guarantor'sliability for its obligations subsequent to the issuance of a guarantee.

REPORTING BUY�SELL AGREEMENTS AND OTHER OWNERSHIPINTEREST REDEMPTION PROVISIONS

FASB ASC 480�10�30 (formerly SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity) requires accounting for a financial instrument within its scope as a liability measured atfair value. For example, entities are required to account for mandatorily redeemable preferred stock as a liabilityrather than equity. Many agreements to purchase, or redeem, an equity interest upon death are also included in thisscope. For those agreements, the guidance would essentially require treasury stock accounting when the entityenters into the agreement, with subsequent fair value adjustments recorded in earnings.

FASB ASC 480�10�65�1 [formerly (FSP) FAS 150�3, �Effective Date, Disclosures, and Transition for MandatorilyRedeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrol�ling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity"], indicates that the provisions of FASB ASC 480�10 (formerly SFAS No. 150) are deferredindefinitely for mandatorily redeemable financial instruments of nonpublic entities unless they are redeemable onfixed dates for amounts that either are fixed or determined by reference to an index. Therefore, the equity redemp�tion agreements of most small and midsize nonpublic entities are exempt from the requirements of FASB ASC480�10 (formerly SFAS No. 150) indefinitely.

FASB ASC 480�10�65�1 (formerly FSP FAS 150�3) says, �During that indefinite deferral, the FASB plans to recon�sider implementation issues and, perhaps, classification or measurement guidance for those instruments in con�


64

junction with the FASBs ongoing project on liabilities and equity." The FASB has announced that thereconsideration will be part of its joint project with the IASB to develop a comprehensive standard of accountingand reporting for financial instruments with characteristics of equity. The FASB expects to issue an exposure draftof a proposed ASU in the first quarter of 2011 followed by a final ASU in the fourth quarter of 2011. Accountants canmonitor this project by visiting the FASB website at www.fasb.org.


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SELF�STUDY QUIZ


21. Meeks Company has a $50,000 note payable providing for payments over a 5 year term. How will the note beclassified on the company's balance sheet?

a. $50,000 will be classified as a current liability.

b. $50,000 will be classified as a noncurrent liability.

c. The principal will be divided between current and long�term.

22. What interest rate should be used to calculate current maturities if the interest rate of the note floats?

a. Use the rate in effect at the date the debt arrangement was made.

b. Predict the fluctuations of interest rates over the next 12 months.

c. Use the rate in effect at the balance sheet date.

d. Use the current prime rate.

23. Which of the following is correct concerning the �Rule of 78s" method for interest amortization?

a. If the term of the debt is five years or less, the results are not materially different than the interest method.

b. The �Rule of 78s" method is required to be used when computing obligations under capital leases.

c. The �Rule of 78s" method amortizes interest slower in the early periods.

d. The �Rule of 78s" method is required to be used when interest has been imputed.

24. In which of the following situations should the interest rate stated in the financing agreement be considered todetermine if it is reasonable in comparison with prevailing market conditions?

a. A note is exchanged solely for cash.

b. A note is exchanged for property.

c. When industrial revenue bonds are involved.

d. In parent�subsidiary transactions.

25. In which of the following scenarios does FASB ASC 470�60 (formerly SFAS No. 15) apply?

a. The Loan Company changes the debt terms on Company A's note due to Company A's financialdifficulties.

b. The Loan Company substantially changes the debt terms on Company B's note. Company B is notexperiencing financial difficulties.

c. The Loan Company exchanged debt with substantially different terms for Company C.

d. Company D transferred assets to The Loan Company to satisfy a debt. This arrangement was a changein debt terms.


66

26. Which of the following correctly accounts for a change in debt terms?

a. A borrower transfers an asset with a fair value of $50 and a carrying amount of $40. The borrower recordsa gain on the transfer.

b. The lender forgives a related party debt and records an expense.

c. An asset with a fair value of $50 is transferred to the creditor in settlement of a $75 debt. The creditorrecognizes a gain of $25.

d. The borrower transfers $100 equity interest in settlement of a $150 debt. The borrower would recognizea $50 loss on the transfer.

27. Which of the following is an implementation guideline for accounting for a modification or exchange in debtterms?

a. If a third�party intermediary acts as the debtor's agent, the transaction does not qualify as a modificationor exchange.

b. If cash is paid to settle a debt, the transaction is accounted for as a debt exchange or modification.

c. If a third�party intermediary acts as a principal, the intermediary is not treated as a third�party creditor.

d. Transactions between creditors do not affect the debtor's accounting for the debt.

28. Imagine That, a book store, has an existing credit line of $100,000 with a 3 year term remaining. What is theborrowing capacity of this arrangement?

a. $0.

b. $100,000.

c. $300,000.

29. Star Company has a $500,000 loan commitment with two years remaining and unamortized loan costs of$20,000. The debt arrangement is refinanced as a $600,000 commitment for three years at a cost of $30,000.How much of the loan costs will be amortized over the three�year term of the new commitment?

a. $0.

b. $20,000.

c. $30,000.

d. $50,000.

30. Edgar Company has a $400,000 loan commitment with three years remaining and unamortized loan costs of$20,000. The debt arrangement is refinanced as a $390,000 commitment for two years at a cost of $25,000.How much of the loan costs will be amortized over the two�year term of the new commitment?

a. $20,000.

b. $25,000.

c. $38,000.

d. $45,000.


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31. Which of the following is an extinguishment of debt?

a. A legal defeasance.

b. An in�substance defeasance.

32. Which of the following authoritative literature was issued to provide specific guidance for accruing legallyrequired environmental remediation?

a. FASB ASC 450�20 (formerly SFAS No. 5).

b. FASB ASC 410�30 (formerly SOP 96�1).

c. FASB ASC 410�20 (formerly SFAS No. 143).

d. FASB ASC 410�30�25�16 through 25�19 (formerly EITF Issue No. 90�8).

33. How is the typical guarantee reported according to FASB ASC 460�10�50�2 and 50�3 (formerly SFAS No. 5)?

a. Disclosure of the nature is not required.

b. Liability recognition is required.

c. Disclosure of the amount is not required.

d. Disclosure of the nature and amount is advised.


68



21. Meeks Company has a $50,000 note payable providing for payments over a 5 year term. How will the note beclassified on the company's balance sheet? (Page 44)

a. $50,000 will be classified as a current liability. [This answer is incorrect. Only if the full $50,000 were duewithin the next 12 months, would the entire $50,000 be classified as a current liability.]

b. $50,000 will be classified as a noncurrent liability. [This answer is incorrect. Only if the payments beganat a date over one year in the future, could the entire $50,000 be classified as a noncurrent liability.]

c. The principal will be divided between current and long�term. [This answer is correct. The principalreductions of long�term debt scheduled during the next year will be classified as a current liability.The remainder will be classified as a noncurrent liability.]

22. What interest rate should be used to calculate current maturities if the interest rate of the note floats? (Page 44)

a. Use the rate in effect at the date the debt arrangement was made. [This answer is incorrect. The rate mayhave been adjusted between the date the debt agreement was signed and the current balance sheet date.]

b. Predict the fluctuations of interest rates over the next 12 months. [This answer is incorrect. Predictingfluctuations of interest rates is subjective, and there is no need to attempt to predict changes during thenext 12 months.]

c. Use the rate in effect at the balance sheet date. [This answer is correct. If the rate floats, use the ratein effect at the balance sheet date. The rate can be provided by the lender or derived through presentvalue computations.]

d. Use the current prime rate. [This answer is incorrect. Floating interest rates are usually tied to the primerate. However, the rate is usually the prime rate plus a percentage such as prime plus 2%.]

23. Which of the following is correct concerning the �Rule of 78s" method for interest amortization? (Page 45)

a. If the term of the debt is five years or less, the results are not materially different than the interestmethod. [This answer is correct. The results are normally not materially different using the �Rule of78s" method than the interest method when the term is five years or less. The IRS prohibits the useof the Rule of 78s method for loans longer than five years.]

b. The �Rule of 78s" method is required to be used when computing obligations under capital leases. [Thisanswer is incorrect. FASB ASC 840�30�35�6 (formerly SFAS No. 13, Accounting for Leases) requires thatthe interest method be used in calculating obligations under capital leases.]

c. The �Rule of 78s" method amortizes interest slower in the early periods. [This answer is incorrect. The �Ruleof 78s" method amortizes interest faster in the early periods, because it amortizes interest using thesum�of�the�years' digits method.]

d. The �Rule of 78s" method is required to be used when interest has been imputed. [This answer is incorrect.FASB ASC 310�10; 835�30 (formerly APB Opinion No. 21, Interest on Receivables and Payables) requiresthe use of the interest method when interest has been imputed.]

24. In which of the following situations should the interest rate stated in the financing agreement be considered todetermine if it is reasonable in comparison with prevailing market conditions? (Page 45)

a. A note is exchanged solely for cash. [This answer is incorrect. When a note is exchanged solely for cash(no other right or privilege is exchanged), the present value of the debt service is presumed to equal thecash received.]


69

b. A note is exchanged for property. [This answer is correct. When a note is exchanged for property,goods, or services, FASB ASC 835�30�25�6 (formerly APB Opinion No. 21) requires considerationof whether the interest rate stated in the agreement is reasonable in comparison with prevailingmarket conditions.]

c. When industrial revenue bonds are involved. [This answer is incorrect. Transactions where interest ratesare affected by the tax attributes or legal restrictions prescribed by a governmental agency, such asindustrial revenue bonds, do not follow the guidance in FASB ASC 835�30�25�6 (formerly APB Opinion No.21).]

d. In parent�subsidiary transactions. [This answer is incorrect. Transactions between parent and subsidiarycompanies do not follow the guidance in FASB ASC 835�30�25�6 (formerly APB Opinion No. 21).]

25. In which of the following scenarios does FASB ASC 470�60 (formerly SFAS No. 15 ) apply? (Page 47)

a. The Loan Company changes the debt terms on Company A's note due to Company A's financialdifficulties. [This is correct. FASB ASC 470�60 (as amended) (formerly SFAS No. 15 Accounting by

Debtors and Creditors for Troubled Debt Restructurings), applies if the creditor grants a concessionto the debtor, for economic or legal reasons related to the debtor's financial difficulties, that it wouldnot otherwise consider.]

b. The Loan Company substantially changes the debt terms on Company B's note. Company B is notexperiencing financial difficulties. [This answer is incorrect. When a substantial modification in termsoccurs on an existing debt other than a troubled debt restructuring, the guidance in FASB ASC 470�50(formerly EITF Issue No. 96�19) applies.]

c. The Loan Company exchanged debt with substantially different terms for Company C. [This answer isincorrect. An exchange of existing debt for new debt with substantially different terms should be accountedfor in accordance with FASB ASC 470�50 (formerly EITF Issue No. 96�19, �Debtor's accounting for aModification or Exchange of Debt Instruments").]

d. Company D transferred assets to The Loan Company to satisfy a debt. This arrangement was a changein debt terms. [This answer is incorrect. FASB ASC 470�50�40�2 and 40�4 (as amended) (formerly APBOpinion No. 26, Early Extinguishment of Debt), deals with all other changes in debt terms not covered byFASB ASC 470�60 (formerly SFAS No. 15).]

26. Which of the following correctly accounts for a change in debt terms? (Page 47)

a. A borrower transfers an asset with a fair value of $50 and a carrying amount of $40. The borrowerrecords a gain on the transfer. [This answer is correct. Any difference between the fair value and thecarrying amount of assets transferred is an ordinary gain or loss on transfer of assets. In this case,the borrower would recognize a $10 ordinary gain.]

b. The lender forgives a related party debt and records an expense. [This answer is incorrect. Forgivenessof related party debt is ordinarily recorded as an increase in paid�in capital.]

c. An asset with a fair value of $50 is transferred to the creditor in settlement of a $75 debt. The creditorrecognizes a gain of $25. [This answer is incorrect. When assets are transferred in settlement of debt, theborrower should recognize a gain equal to the excess of the debt's carrying amount over the fair value ofassets transferred to the creditor. The borrower would recognize a $25 gain.]

d. The borrower transfers $100 equity interest in settlement of a $150 debt. The borrower would recognizea $50 loss on the transfer. [This answer is incorrect. When equity interests are transferred in settlement ofdebt, the borrower should recognize a gain equal to the excess of the debt's carrying amount over the fairvalue of equity interests transferred to the creditor. The borrower would recognize a $50 gain.]


70

27. Which of the following is an implementation guideline for accounting for a modification or exchange in debtterms? (Page 49)

a. If a third�party intermediary acts as the debtor's agent, the transaction does not qualify as a modificationor exchange. [This answer is incorrect. If a third�party intermediary acts as the debtor's agent, theintermediary should be treated as the debtor to determine whether debt has been exchanged or modified.An example of a third�party intermediary is an investment banker.]

b. If cash is paid to settle a debt, the transaction is accounted for as a debt exchange or modification. [Thisanswer is incorrect. When a debtor pays a creditor cash to settle debt, the transaction is accounted of asan extinguishment of debt.]

c. If a third�party intermediary acts as a principal, the intermediary is not treated as a third�party creditor. [Thisanswer is incorrect. If a third�party intermediary acts as a principal, the intermediary should be treated asa third�party creditor to determine whether debt has been exchanged or modified.]

d. Transactions between creditors do not affect the debtor's accounting for the debt. [This answer iscorrect. Transactions between creditors, such as one creditor selling the debt to another, should notbe treated as a modification or exchange of debt between the debtor and creditor and should notaffect the debtor's accounting for the debt.]

28. Imagine That, a book store, has an existing credit line of $100,000 with a 3 year term remaining. What is theborrowing capacity of this arrangement? (Page 51)

a. $0. [This answer is incorrect. Even though Imagine That may not have any additional credit to borrow from,this is not considered the borrowing capacity of this arrangement.]

b. $100,000. [This answer is incorrect. The borrowing capacity of this arrangement is not equal to the existingline�of�credit in this example.]

c. $300,000. [This answer is correct. Borrowing capacity is calculated by multiplying the remainingterm by the maximum available credit (3 years � $100,000 commitment).]

29. Star Company has a $500,000 loan commitment with two years remaining and unamortized loan costs of$20,000. The debt arrangement is refinanced as a $600,000 commitment for three years at a cost of $30,000.How much of the loan costs will be amortized over the three�year term of the new commitment? (Page 51)

a. $0. [This answer is incorrect. Star Company should amortize loan costs over the term of the newcommitment.]

b. $20,000. [This answer is incorrect. The unamortized loan cost of the old arrangement is not the correctamount to amortize over the term of the new commitment.]

c. $30,000. [This answer is incorrect. The $30,000 loan cost of the new arrangement is not the correct amountto amortize over the term of the new commitment.]

d. $50,000. [This answer is correct. Since the borrowing capacity of the new arrangement ($1,800,000)is more than the borrowing capacity of the old arrangement ($1,000,000), the $50,000 total of the$20,000 loan costs remaining under the old commitment and the $30,000 cost of obtaining the newcommitment should be amortized over the three�year term of the new commitment.]

30. Edgar Company has a $400,000 loan commitment with three years remaining and unamortized loan costs of$20,000. The debt arrangement is refinanced as a $390,000 commitment for two years at a cost of $25,000.How much of the loan costs will be amortized over the two�year term of the new commitment? (Page 51)

a. $20,000. [This answer is incorrect. Edgar Company should amortize more than $20,000 in loan costs overthe term of the new commitment.]

b. $25,000. [This answer is incorrect. The unamortized loan cost of the new arrangement is not the correctamount to amortize over the term of the new commitment.]


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c. $38,000. [This answer is correct. Since the borrowing capacity of the new arrangement ($780,000)is less than the borrowing capacity of the old arrangement ($1,200,000), $7,000 of the $20,000 loancosts remaining under the old commitment is written off (Borrowing capacity is reduced by 35%.Therefore, 35% of the $20,000 costs is $7,000.). The $13,000 remaining under the old commitmentand the $25,000 cost of obtaining the new commitment should be amortized over the three�year termof the new commitment.]

d. $45,000. [This answer is incorrect. The $45,000 total of the $20,000 loan costs remaining under the oldcommitment and the $25,000 cost of obtaining the new commitment is not the correct amount to amortizeover the term of the new commitment.]

31. Which of the following is an extinguishment of debt? (Page 53)

a. A legal defeasance. [This answer is correct. In a legal defeasance, the creditor legally releases thedebtor from being the primary obligor. Therefore, a legal defeasance generally is accounted for asan extinguishment.]

b. An in�substance defeasance. [This answer is incorrect. In an in�substance defeasance, the debtor placesassets in a trust to satisfy the debt. However, the creditor does not relieve the debtor of primary obligationunder the debt; therefore, it is not an extinguishment.]

32. Which of the following authoritative literature was issued to provide specific guidance for accruing legallyrequired environmental remediation? (Page 55)

a. FASB ASC 450�20 (formerly SFAS No. 5). [This answer is incorrect. FASB ASC 450�20 (formerly SFAS No.5, Accounting for Contingencies), does provide guidance on accruing liabilities for loss contingencies;however, it only provides general guidance.]

b. FASB ASC 410�30 (formerly SOP 96�1). [This answer is correct. FASB ASC 410�30 (formerly SOP96�1, Environmental Remediation Liabilities) was issued to provide more specific guidance forrecognizing, measuring, and disclosing liabilities for legally required environmental remediationsince it is difficult to determine when a liability has been incurred and the amount of the liability oftenis difficult to reasonably estimate.]

c. FASB ASC 410�20 (formerly SFAS No. 143). [This answer is incorrect. FASB ASC 410�20 (formerly SFASNo. 143, Accounting for Asset Retirement Obligations) provides accounting and reporting guidance forenvironmental remediation obligations arising from the normal operation of a long�lived asset and that isassociated with the retirement of that long�lived asset.]

d. FASB ASC 410�30�25�16 through 25�19 (formerly EITF Issue No. 90�8). [This answer is incorrect. FASBASC 410�30 (formerly EITF Issue No. 90�8, �Capitalization of Costs to Treat Environmental Contamination")provides guidance for determining whether environmental cleanup costs should be capitalized.]

33. How is the typical guarantee reported according to FASB ASC 460�10�50�2 and 50�3 (formerly SFAS No. 5)?(Page 60)

a. Disclosure of the nature is not required. [This answer is incorrect. Even though the possibility of a loss isremote, the financial statements should disclose the nature of the guarantee.]

b. Liability recognition is required. [This answer is incorrect. Since the possibility of a loss is remote (less thanprobable), liability recognition is not required according to the guidance in FASB ASC 460�10�50�2 and50�3 (formerly SFAS No. 5, Accounting for Contingencies).]

c. Disclosure of the amount is not required. [This answer is incorrect. Even though the possibility of a lossis remote, the financial statements should disclose the amount of the guarantee.]

d. Disclosure of the nature and amount is advised. [This answer is correct. Even though the possibilityof a loss is remote, the financial statements should disclose the nature and amount of theguarantee.]


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EXAMINATION FOR CPE CREDIT

Lesson 1 (PFSTG101)

Determine the best answer for each question below. Then mark your answer choice on the Examination for CPECredit Answer Sheet located in the back of this workbook or by logging onto the Online Grading System.

1. Roger, Inc. incurred an expense but has not received the bill. The liability has been incurred, and the amountcan be reasonably estimated. The estimate for this expense is a range, and the amounts within the range areall equally possible. How much should be reported as an accrued liability at the balance sheet date accordingto GAAP?

a. No accrued liability should be reported because the expense is a range.

b. The accrued liability should be reported at the lowest amount in the range.

c. The accrued liability should be reported at the median amount in the range.

d. The accrued liability should be reported at the highest amount in the range.

2. FASB ASC 712�10 (formerly SFAS No. 112) requires employers to accrue postemployment benefits if all of theconditions listed in the Statement are met. Which of the following is one of the conditions?

a. The obligation is attributable to employees' services already rendered.

b. Payment of the benefit is reasonably possible.

c. The cost of the benefits cannot be reasonably determined.

d. The rights to those benefits are nonvested.

3. This course recommends recording payroll taxes on accrued compensation using which of the followingcaptions?

a. Accrued FICA.

b. Accrued unemployment taxes.

c. Accrued payroll taxes.

d. Compensation.

4. Which of the following measurement or presentation considerations accurately describes the accrual reportingfor claims�made insurance policies?

a. If it is reasonably possible that a loss has been incurred during the policy period but the loss has not beenreported to the insurance company, a liability should be reported.

b. If a loss is probable and reasonably estimated, a liability should be reported if the loss has not beenreported to the insurance company.

c. A subsequent purchase or renewal of claims�made insurance will not affect the liability previously recordedfor unreported losses.

d. A claims�made insurance policy operates the same as an occurrence insurance policy.


73

5. Which of the following is not classified as deferred revenues?

a. Nonrefundable deposits.

b. Refundable damage deposits.

c. Membership fees received in advance.

d. Do not select this answer choice.

6. Archer, Inc. violated a long�term debt agreement with ABC Bank which makes the debt callable within one yearfrom the balance sheet date. In which of the following situations would the debt be classified as a currentliability?

a. Archer speculates that it is possible it will be able to cure the violation within the grace period.

b. The violation is cured after the balance sheet date but before Archer's financial statements are issued.

c. ABC Bank has specifically waived the right to demand payment for more than one year from the balancesheet date.

d. Archer demonstrates that it is probable it will be able to cure the violation within the grace period.

7. Which of the following are Covenant violations that occur subsequent to the balance sheet date?

a. Are never recorded in the financial statements.

b. Are recorded in the financial statements if a technical covenant was violated.

c. Are disclosed in the financial statements if a nonrecognized subsequent event occurred.


8. A loan agreement requires the following working capital levels:

12/31/X1 $300,000

6/30/X2 350,000

12/31/X2 400,000

If working capital at December 31, 20X1 was less than $300,000 but the lender unconditionally waives itsright to call the loan prior to January 1, 20X4, when might classification problems appear?

a. December 31, 20X1.

b. June 30, 20X2.

c. December 31, 20X2.

d. March 31, 20X3.

9. How many steps are in the approach to recognizing tax benefits according to GAAP?

a. 1.

b. 2.

c. 3.

d. 4.


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10. Recognition and measurement of tax benefits as required by GAAP can be determined qualitatively orquantitatively.

a. True.

b. False.

c. Do not select this answer choice.


11. Bubble Company's financial statements report income before income taxes of $600,000, consisting of revenueof $900,000 and expense of $300,000. Bubble believes the expense is deductible in the current�year return and,therefore, the tax return reports taxable income of $600,000, which is the same as pretax income reported inthe financial statements. A single taxing authority imposes a simple 40% tax rate. Bubble did not make anyestimated tax payments during the year. If the entity believes there is greater than a 50% chance that, uponexamination, the tax position for deducting the $300,000 expense in the current�year return would be sustainedand that there is greater than a 50% chance the full amount of the deduction would be allowed, how much willBubble recognize as its current tax provision?

a. $60,000.

b. $120,000.

c. $240,000.

d. $360,000.

12. Assume the same facts as the previous question except that Bubble believes there is less than a 50% chancethe tax position would be sustained. How much will Bubble recognize as its current tax provision?

a. $60,000.

b. $120,000.

c. $240,000.

d. $360,000.

13. Assume the same facts as the previous question. How much will Bubble record as a liability for unrecognizedtax benefit in its financial statements?

a. $60,000.

b. $120,000.

c. $240,000.

d. $360,000.


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14. Bubble reported a liability for unrecognized tax benefit in its financial statements in the previous example.Assuming that the taxing authority does not examine the position before the statute of limitations expires. Whenthe statute of limitations expires, Bubble would eliminate the liability and recognize an offsetting tax benefit byrecording a credit in what account?

a. Income tax due currently.

b. Current tax provision.

c. Deferred tax asset.

d. Deferred tax provision.

15. According to GAAP, entities are required to provide for the effect of interest and penalties on the liability for taxbenefits that have been realized but have not been recognized.

a. True.

b. False.



16. When first applying FASB ASC 740�10 (formerly FIN 48), what guidance in the choices below is correct?

a. The entity should revise any prior�year financial statements that are presented in comparison with the yearFASB ASC 740�10 (formerly FIN 48) is first applied.

b. Any adjustments should be made as of the end of the year immediately preceding the first application ofFASB ASC 740�10 (formerly FIN 48).

c. The entity should determine whether changes would have been needed to the statement of financialposition as of the end of the prior year if this guidance had always been applied.


17. If a reduction of an asset or liability causes a temporary difference to reverse, then the temporary difference isrelated to a specific asset or liability. What would be an example of a reduction of a liability?

a. Sale.

b. Amortization.

c. Depreciation.

d. Collection of installment receivable.

18. Which of the following would create a temporary difference?

a. Tax�exempt interest.

b. Nondeductible portion of meals.

c. Penalties and fines.

d. Tax credit carryforward.


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19. An entity is subject to federal income taxes at the 34% rate. It has a $300,000 operating loss that it may carryforward for 20 years. The deferred tax asset for the loss carryforward is not related to a particular asset or liabilityfor financial reporting. The entity expects to offset $15,000 of the loss carryforward against taxable income inthe next year. The entity expects $120,000 of the loss carryforward will expire unused. How much will it reportas a net current deferred tax asset?

a. $3,060.

b. $15,000.

c. $40,800.

d. $102,000.

20. Assume the same facts as the previous question. How much will the entity report as a net noncurrent deferredtax asset?

a. $15,000.

b. $40,800.

c. $58,140.

d. $61,200.

21. The value of current maturities of long�term debt is easily attainable if which of the following occurs?

a. The interest rate floats.

b. Payments are in arrears.

c. An amortization schedule is provided.


22. Which of the following best describes the costs included in the �interest method?"

a. The interest rate on the principal.

b. The interest rate on the principal and the amortization of premium or discount.

c. The interest rate on the principal, the amortization of premium or discount, and costs incurred in obtainingthe debt.

d. The interest rate on the principal, the amortization of premium or discount, costs incurred in obtaining thedebt, and the principal repayment.

23. When determining an appropriate interest rate at the inception of the note, which of the following should notbe considered?

a. The discount rate of similar financing from other sources on the same date.

b. The discount rate of similar financing of other borrowers with similar credit ratings.

c. The prevailing rate of similar transactions between independent parties.

d. Changes in market conditions occurring after the signing of the debt agreement.


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24. Imputing interest on a loan for cash is essential in which of the following situations?

a. When it is an interest�free loan between related parties.

b. When other rights or privileges are received.

c. When it is a related party loan at below�market rates.

d. For premium payments made on split dollar life insurance arrangements.

25. Which of the following is correct concerning changes in debt terms?

a. A modification of terms is accounted for retrospectively.

b. Forgiveness of principal is not a change in debt terms.

c. A borrower reduces the carrying amount of the debt to the total future cash payments of the new terms.

d. When a modification occurs, interest expense is always recognized when making a payment.

26. What percentage is used when considering whether an exchange of debt or modification of terms issubstantial?

a. 10%.

b. 15%.

c. 20%.

d. 25%.

27. The cash flows computation determines the gain or loss on debt extinguishment.

a. True.

b. False.



28. When does FASB ASC 470�50 [formerly EITF Issue No. 06�6, �Debtor's Accounting for a Modification (orExchange) of Convertible Debt Instruments"] apply?

a. When an embedded conversion option is separately accounted for as a derivative subsequent to themodification.

b. When an embedded conversion option is separately accounted for as a derivative prior to the modification.

c. When an embedded conversion option is separately accounted for as a derivative both prior to andsubsequent to the modification.

d. When a modification of a debt instrument adds or eliminates an embedded conversion option.


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29. Moon Company has a $200,000 loan commitment with four years remaining and unamortized loan costs of$10,000. The debt arrangement is refinanced as a $240,000 commitment for four years at a cost of $12,000.How much of the loan costs will be amortized over the four�year term of the new commitment?

a. $10,000.

b. $12,000.

c. $21,000.

d. $22,000.

30. Which of the following guidance should be used by borrowers to amortize fees charged by lending institutions?

a. Fees for a revolving line of credit, fees should be charged to interest expense using the interest method.

b. If a loan is payable on demand, fees should be charged to interest expense when the loan is paid in full.

c. When an unexercised loan commitment expires, the fees should be charged to interest expense in thatperiod.

d. If a loan is payable on demand, fees should be charged to interest expense using the interest method.

31. When would a lender record collateral on its balance sheet?

a. When the lender has the right to sell or repledge the collateral.

b. When the lender sells the collateral.

c. When the debtor defaults on the loan.

d. When a debtor grants a security interest in an asset.

32. Which of the following is included in environmental remediation costs?

a. Legal costs for allocation of costs among PRPs.

b. Costs related to routine environmental compliance matters.

c. Legal costs associated with potential recoveries.


33. The accrual of environmental liabilities should not be based on which of the following?

a. Anticipated changes in laws.

b. Productivity improvements.

c. Technology improvements.



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Lesson 2:�Stockholders' Equity

INTRODUCTION

The components of stockholders' equity and the recommended order of presentation are as follows:

a. Preferred stock

b. Common stock

c. Additional paid�in capital

d. Stock subscriptions receivable

e. Retained earnings

f. Accumulated other comprehensive income

g. Treasury stock

When treasury stock is present, stockholders' equity is generally subtotaled after retained earnings (or accumu�lated other comprehensive income, if presented). However, a caption for the subtotal is unnecessary.

If liabilities exceed assets, a negative equity balance will be reported. The term �equity" should not be used in thosesituations and instead recommend using the following captions:

� Negative equity shown in all periods�Deficiency in assets" or �Stockholders' deficit"

� Negative equity shown in one period and a positive equity shown in another period�Stockholders' equity(deficiency in assets)" or �Stockholders' equity (deficit)"


Completion of this lesson will enable you to:� Identify and correctly report stockholders' equity on the balance sheet.

Preferred and Common Stock

Usually, each class of stock is disclosed on the face of the balance sheet (in the order of priority in liquidation). Thepresentation of the equity section of the balance sheet is affected by a mixture of legal and accounting require�ments. The terms used to describe classes of stock should be the legal title of the stock issue, for example, capitalstock, common stock, or some other title. Traditionally, the following information is disclosed for each class ofstock.

a. Title of issue, for example, common stock or Class A common stock

b. Par value (or stated value) per share

c. Shares authorized

d. Shares issued

e. Shares outstanding

Common Stock. Normally, the disclosures may be provided on the face of the balance sheet by expansion of thecaption. For example:


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20X2 20X1

Common stock, $10 par value; 1,000 shares authorizedand 500 shares issued and outstanding 5,000 5,000

The following illustrates appropriate disclosure for a company with more than one class of common stock:

20X2 20X1

Class A common stock, $10 par value; 1,000 sharesauthorized and 500 shares issued and outstanding 5,000 5,000

Class B common stock, $10 par value; 5,000 sharesauthorized and 2,500 shares issued and outstanding 25,000 25,000

Preferred Stock. The rights attaching to preferred stock may include preferences over common stock in distribu�tions of earnings and assets. Specific disclosure requirements apply to preferred stock. FASB ASC 505�10�50�3through 50�5 (formerly SFAS No. 129, Disclosure of Information about Capital Structure) requires the followingdisclosures:

a. Liquidation preferences substantially in excess of par or stated value (in the equity section of the balancesheet)

b. Aggregate or per�share amounts at which preferred shares may be called or are subject to redemptionthrough sinking�fund operations or otherwise

c. Aggregate and per�share amounts of cumulative preferred dividends in arrears

As previously noted, liquidation preferences must be disclosed in the equity section of the balance sheet. Forexample:

5% cumulative preferred stock, $20 par value ($150,000 aggregateliquidation preference), 5,000 shares authorized, issued, andoutstanding 100,000

The other disclosures may be in the notes.

Certain other disclosures, including a description of the rights and privileges of securities, required the number ofshares issued during the most recent annual period and any subsequent interim period presented, and redemptionrequirements for all issues of stock usually are made in the notes to the financial statements.

Accounting for Share�based Payments

FASB ASC 505; 718 [formerly SFAS No. 123(R), Share�Based Payment] establishes accounting standards forshare�based payment transactions. The following discussion focuses only on these requirements relevant tononpublic entities. See PPC's Guide to GAAP for a more complete discussion of accounting for share�basedpayments.

Scope. GAAP establishes accounting standards for companies that receive goods or services, including theservices of employees, in exchange for its equity instrumentssuch as equity shares, equity share options, orother equity instruments. It also applies to liabilities that are based, at least in part, on the price of a company'sequity instruments, or that may be settled by issuing equity instruments, that are incurred in exchange for goods orservices. These situations are referred to as share�based payment transactions. While this guidance establishes theaccounting for all share�based payment transactions involving the receipt of goods or services, it focuses primarilyon those involving the receipt of employee services. It does not change the accounting for share�based paymenttransactions with parties that are not employees as provided in the original SFAS No. 123 and FASB ASC 505�50(formerly EITF Issue No. 96�18). This guidance also does not address accounting for employee stock ownershipplans.


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Accounting for Share�based Payment Transactions with Employees. A company should measure the cost ofemployee services received in exchange for awards of equity instruments based on the grant�date fair value of theequity instruments, with limited exceptions, net of any amount paid or to be paid by the employee. The fair value ofequity share options and similar instruments should be measured using observable market prices if available. Inthe absence of such market prices, fair value should be estimated using a valuation technique such as anoption�pricing model.

One of the variables in an option�pricing model is the volatility of the underlying stock. If a nonpublic company isunable to reasonably estimate fair value because it is impracticable to estimate the expected volatility of thecompany's share price, the value may be calculated using the historical volatility of an appropriate industry sectorindex in place of the expected volatility of the company's share price. Furthermore, while GAAP indicates it shouldbe possible to reasonably estimate the fair value of most equity instruments at the grant date, it does provide analternative for equity instruments with terms that make it impossible to reasonably estimate fair value at the grantdate. Those equity instruments should be accounted for based on the intrinsic value of the instruments and shouldbe remeasured at each reporting date through the date of exercise or other settlement.

Compensation cost should be recognized over the period that the employee is required to provide services inexchange for the award with a corresponding credit to equity, generally to paid�in capital. That period is referred toas the requisite service period and is generally the vesting period. Compensation cost should not be recognized ifthe requisite service has not been provided, however.

To illustrate accounting for share�based compensation, assume that a company issued 5,000 stock options onDecember 31, 20X6. The fair value of each option on that date was $15, and each option entitles its holder toreceive one share of $10 par common stock at an exercise price of $50 per share. Furthermore, the options vest infive years (no other award conditions are assumed). Total compensation cost at the grant date is $75,000 (5,000 �$15) and would be recognized by making the following entry during each year of the vesting period: (For simplicity,the illustration ignores the effects of estimated forfeitures and deferred taxes.)

Compensation expense ($75,000 ��5) 15,000

Additional paid�in capitalstock options 15,000

Assuming the options are exercised at the end of the five�year vesting period, the following entry would be neededto record the issuance of common stock:

Cash (5,000 � $50) 250,000

Additional paid�in capitalstock options 75,000

Common stock (5,000 � $10) 50,000

Additional paid�in capitalcommon stock 275,000

Certain financial instruments awarded in share�based payment transactions should be classified as liabilities (usingan account such as share�based compensation liability) and not as equity. While the measurement objective of aliability award is similar to an equity award, it differs in that liability awards are remeasured at the end of eachreporting period until they are settled. GAAP allows nonpublic entities to elect, as a policy decision, either the fairvalue method or the intrinsic value method for measuring all liability awards under share�based payment arrange�ments. In either case, liabilities are required to be remeasured at each reporting date until the settlement date.

FASB ASC 718�10�35�15 [formerly FSP FAS 123(R)�4, �Classification of Options and Similar Instruments Issued asEmployee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event"] amends theguidance for options or similar instruments that are issued as part of employee compensation arrangements andrequire cash settlement upon the occurrence of a contingent event, such as the death or disability of the holder ora change in control. As a result of the amendment, liability recognition is not required for a cash settlement featurethat can be exercised only upon the occurrence of a contingent event that is outside the employee�s control untilthe event is probable of occurring. If the event becomes probable of occurring, the accounting is similar to theaccounting for a modification from an equity award to a liability award. The entity should recognize a share�basedliability equal to the portion of the award attributed to past service multiplied by the award's fair value on that date.


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Changes in the fair value or intrinsic value of liability awards are recognized as compensation cost over the requisiteservice period. At the end of any reporting period, the percentage of the fair value or intrinsic value recognizedshould equal the percentage of requisite service that has been rendered at that date. That is, if the requisite serviceperiod is four years and as of December 31, 20X7 three years of service have been provided, 75% (3 years � 4years) of the fair value or intrinsic value should be recognized as a liability. Changes in the fair value or intrinsicvalue after the requisite service period are recognized as compensation cost in the period of change. Similarly, anydifference between the settlement amount of the liability award and its fair value is an adjustment of compensationcost in the period of settlement.

Transactions with Nonemployees. A company that issues stock options or other equity instruments (or incursliabilities based on the price of its stock or other equity instruments) in return for goods or services from nonemploy�ees (e.g., suppliers) must account for the transaction using either the fair value of (a) the goods or services receivedor (b) the stock options or other equity instruments issued, whichever can be more reliably measured. The fair valueof goods or services received from suppliers usually can be reliably measured, and therefore should be used toaccount for the fair value of the equity instrument issued. However, if the fair value of the equity instrument is usedto account for the transaction, FASB ASC 505�50�30�11 (formerly EITF Issue No. 96�18, �Accounting for EquityInstruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices") indicates that the fair value of the equity instrument issued to a nonemployee should be measured usingthe stock price on the earlier of (a) the date at which a performance commitment by the nonemployee is reached(A performance commitment is a commitment under which the nonemployee's performance to earn the equityinstruments is probable because of sufficiently large disincentives for nonperformance. Forfeiture of the equityinstruments in the event of nonperformance is not considered sufficient disincentive. In addition, the ability to suefor nonperformance is not, in and of itself, a sufficiently large disincentive to ensure that performance is probable.)or (b) the date at which the nonemployee's performance is complete. Performance is complete when the nonem�ployee has delivered or purchased the goods or services, even if the quantity or terms of the equity instruments stilldepends on other events (such as a target stock price requirement) at that date. [FASB ASC 505�50�30�6;505�50�30�8 and 30�9 (formerly EITF Issue No. 96�18) address transactions in which the fair value of the equityinstruments issued to nonemployees can be more reliably measured than the fair value of the goods or servicesreceived. (It does not address accounting for equity instruments issued to a lender or investor who providesfinancing or in a business combination.)] FASB ASC 505�50�30 also concludes that

a. equity instruments should be measured at their fair value if the quantity and terms of the equity instruments(1) do not depend on market conditions or the nonemployee's performance or (2) depend only on theachievement of market conditions.

b. equity instruments should be measured at the lowest amount within a range of aggregate fair values if thequantity and terms of the equity instruments (1)�depend on the achievement of nonemployee performanceconditions that, based on the various possible outcomes, result in a range of aggregate fair values, or (2)depend on the achievement of both market conditions and nonemployee performance conditions that,based on the various possible outcomes, result in a range of aggregate fair values. (If the quantity or termsof the equity instruments are revised after the measurement date, the lowest aggregate fair value amountshould be adjusted to reflect any additional cost of the transaction. The adjustment is the differencebetween the fair value of the instruments after revision and the fair value of the instruments before revision.)

In addition, an asset or expense (or sales discount) should be recognized as if the company paid cash rather thanequity instruments for the goods or services (or used cash rebates as sales discounts). A recognized asset orexpense (or sales discount) should not be reversed if a nonemployee's stock option expires unexercised. Thisguidance provides numerous examples that illustrate its application in various situations. Regardless of the methodused to determine fair value, a company that issues equity instruments to acquire goods or services from nonem�ployees should make disclosures similar to those made for share�based employee compensation if they wouldhelp financial statement readers better understand the effects of the transactions on the financial statements.

Although FASB ASC 505�50 (formerly EITF Issue No. 96�18) provides accounting guidance for companies thatissue stock to nonemployees in return for goods or services, it does not address how the grantee should accountfor the transaction. FASB ASC 505�50 (formerly EITF Issue No. 00�8, �Accounting by a Grantee for an EquityInstrument to Be Received in Conjunction with Providing Goods or Services"), provides similar guidance for the


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grantee in determining (a) which date the grantee should use to measure the fair value of the equity instrument and(b) how the grantee should account for an increase in fair value after the measurement date due to an adjustmentbased on market or performance conditions.

Practice Alert 2000�1, Accounting for Certain Equity Transactions, issued by the AICPA's Professional Issues TaskForce, provides several examples of accounting for transactions in which companies issue stock to nonemployeesin exchange for goods or services. Such transactions should be accounted for using either the fair value of thegoods or services received or the stock issued, whichever can be more reliably measured. If neither the fair valueof the goods or services received nor the stock issued can be reliably measured, the Practice Alert states that thetransaction should be recorded at a nominal value. It further specifies that the book, par, or stated value of the stockor the contractual value assigned to the goods or services generally is not a reliable measure of the transaction'svalue. The Practice Alert also addresses stock issued to an owner in return for expertise or intellectual capitalcontributed to a business. Generally, such transactions should be recorded at the transferor's historical cost underGAAP. Although the Practice Alert is nonauthoritative and intended for auditors, it may help financial statementpreparers better understand various types of equity transactions. The Practice Alert can be accessed via theAICPA's website at www.aicpa.org.

Accounting for Income Tax Benefits under the Fair Value Method. The income tax effect of share�basedcompensation is accounted for essentially as provided by FASB ASC 740 (formerly SFAS No. 109, Accounting for

Income Taxes). That is, if amounts deducted for income tax purposes differ from the amounts expensed for financialreporting, deferred taxes should be provided. If the tax deduction is higher than the cumulative amount expensedfor financial reporting for an equity award, the tax effect of the difference (that is, the excess tax benefit) should beadded to paid�in capital unless the excess is due to a reason other than changes in the fair value of shares betweenthe measurement dates used for accounting and tax. If the excess is due to another reason, the difference shouldbe included in income. Conversely, if the tax deduction is lower than the cumulative amount expensed for financialreporting, the tax effect of the difference (that is, the write�off of the deferred tax asset) should be subtracted fromadditional paid�in capital, but only to the extent it is attributable to excess tax benefits from previous awardsaccounted for under the fair value method.

Transition. For nonpublic entities, FASB ASC 505; 718 [formerly SFAS No. 123(R)] is effective as of the beginningof the first annual reporting period beginning after December 15, 2005. It applies to all awards that are granted afterits effective date and should not be applied to awards granted before the effective date unless they are modified,repurchased, or cancelled after the effective date. Thus, the transition period may be for an extended number ofyears. The cumulative effect of initially applying this guidance, if any, should be recognized at the effective date.

As of the effective date, the method of transition depends on the method of accounting for share�based compensa�tion used prior to the effective date:

� Modified Prospective Method. Nonpublic companies that used the fair�value based method for eitherrecognition or disclosure under the original FASB ASC 505; 718 are required to use this method. Thismethod requires this guidance to be applied to all new awards and awards modified, repurchased, orcancelled after the effective date. Compensation cost for existing awards with unrecognized compensationcost as of the effective date is recognized as service is rendered for those awards. However, compensationcost for such awards must be based on the grant�date fair value as calculated under FASB ASC 505; 718[formerly SFAS No. 123(R)]no change to the previously determined grant�date fair value is allowed. Inaddition, the previous method of attributing compensation cost to future periods must be continued afterthe effective date, with the exception that recognizing forfeitures only as they occur should not becontinued. Remaining deferred compensation or other contra�equity accounts should be eliminatedagainst equity.

� Prospective Method. Nonpublic companies that used the minimum value method under FASB ASC 505;718 [formerly SFAS No. 123(R)] for either measurement or disclosure must continue to use their existingaccounting method for remaining portions of outstanding awards. These provisions should be appliedprospectively to new awards, as well as to those modified, repurchased, or cancelled after the effectivedate.


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For the modified prospective method, the following is required as of the effective date:

a. If an instrument is classified as a liability but was previously classified as equity, the appropriate portion ofthe fair value liability should be recognized (based on requisite service). The liability is recorded byreducing equity to the extent of previously recognized compensation cost, and any difference is reflectedin income, net of tax. For previous liability instruments that were measured at intrinsic value, the effect ofmeasuring the liability at fair value should also be reflected in income, net of tax. The income effect in bothsituations is recognized as the cumulative effect of a change in accounting principle.

b. Companies that previously recognized the effect of forfeitures as they occurred should estimate thenumber of instruments expected to be forfeited and adjust the related balance sheet accounts (net of taxeffects) through income as the cumulative effect of a change in accounting principle. (No other transitionadjustment as of the required effective date should be made for any deferred tax assets associated withoutstanding equity instruments that continue to be accounted for as equity instruments. However, the entityshould calculate the net excess tax benefits available to absorb tax deficiencies if deferred tax assets needto be written off in subsequent periods.

Additional Paid�in Capital

A descriptive balance sheet caption, such as �additional paid�in capital" or �capital in excess of par or stated value"is used for this account, and it is presented immediately following preferred and common stock. The account maybe affected by the following capital�related transactions:

a. Sale of stock at an amount in excess of par or stated value

b. Issuance of awards of equity instruments in share�based payment transactions

c. Purchase or sale of treasury stock

d. Capitalization of retained earnings, for example, for stock dividends

e. Fair value of contributed assets at the date of contribution

f. Reorganization costs

However created, additional paid�in capital may not be used to relieve income of current or future charges thatwould otherwise be made against income. The only exception is in reorganization or quasi reorganization of acompany [FASB ASC 505�10�25�1 (formerly ARB No. 43, Ch. 1A)]. In some states there is no legal prohibitionagainst issuing stock at less than par value. When that occurs, a caption such as �Discount on issuance of commonstock" may be used.

FASB ASC 505�10�50�2 (formerly APB Opinion No. 12) requires changes in additional paid�in capital to be dis�closed. Changes usually are disclosed in a separate statement or in combination with changes in other elementsof stockholders' equity or in the notes to the financial statements.

Stock Subscriptions Receivable

A subscription for the purchase of stock normally is debited to subscriptions receivable and credited either to stocksubscribed or common stock issued and additional paid�in capital. Stock subscription agreements may be formalor informal, and stock may be either issued in advance of collection or as the receivable is collected. Theaccounting issue is when to recognize capital from the transaction. Stock subscriptions receivable generally shouldbe recognized as a deduction from stockholders' equity as follows:


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20X2 20X1

Stockholders' Equity

Common stock, $25 par value, 10,000 shares authorized1,400 issued20X2, 1,000 issued20X1 35,000 25,000

Additional paid�in capital 25,000 15,000

Stock subscriptions receivable (20,000 ) �


105,000 90,000

Stock subscriptions receivable should be shown as an asset only in rare circumstances (a) when there is substan�tial evidence of ability and intent to pay, such as when notes for stock are secured by irrevocable letters of credit orhave been discounted at a bank and (b) when the obligations mature in a reasonably short period of time. In thosecases, the agreement would be reported as an asset using a caption such as �Stock subscriptions receivable" or�Notes receivable" and classified as current or noncurrent based on the payment schedule.

Forgiveness of Related Party Receivables and Payables

For a variety of reasons, an entity may forgive the amount receivable from a related party or a related party mayforgive the amount due from an entity. According to Practice Alert 00�1, Accounting for Certain Equity Transactions,both of those events ordinarily should be accounted for as equity transactions, with no effect on earnings. Inaddition, FASB ASC 470�50�40�2 (formerly footnote 1 to Paragraph 20 of APB Opinion No. 26, Early Extinguishment

of Debt), says �extinguishment transactions between related entities may be in essence capital transactions."

The financial statements should disclose forgiveness of related party receivables and payables in connection withother changes in equity. The following note illustrates disclosure of forgiveness of a related party payable.

NOTE XINCREASE IN PAID�IN CAPITAL IN 20X9

Paid�in capital is for 200 shares of common stock; 1,000 shares are authorized. In 20X9, theCompany paid the negotiated balance of $119,673 that was due for back charges related totobacco�processing equipment that it finished manufacturing for a foreign customer in 20X5.Wilson Machinery then forgave the Company's $377,565 liability for components that WilsonMachinery fabricated for the equipment. Under generally accepted accounting principles, for�giveness of related party debt generally is viewed as in essence a capital transaction. Accord�ingly, forgiveness of the Wilson Machinery debt is reported in the 20X9 financial statements as a$377,565 increase in paid�in capital, from $2,724,671 at the end of 20X8 to $3,102,236 at the endof 20X9.

Retained Earnings

Retained earnings represent undistributed earnings. A statement of changes in retained earnings (presentedseparately or combined with the income statement) is generally considered necessary to present results ofoperations in conformity with GAAP.

Balance Sheet Caption. Normally the caption �Retained earnings" is sufficient. However, an exception is neces�sary when negative retained earnings are reported. The following captions are recommended in comparativebalance sheets:

� When balance sheets report negative retained earnings in all periods, a caption such as �Accumulateddeficit" is suggested.

� When the balance sheet in one period presents a negative balance and another period presents a positivebalance, a caption such as �Retained earnings (accumulated deficit)" is appropriate.

Restrictions on Retained Earnings. According to FASB ASC 505�10�45�3 (formerly Paragraph 15 of SFAS No. 5,Accounting for Contingencies), appropriations of retained earnings are permitted, provided they are shown withinthe stockholders' equity section of the balance sheet. An appropriate presentation would be:


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20X2 20X1


Common stock, $15 par value, 10,000 shares authorizedand issued 150,000 150,000

Additional paid�in capital 50,000 50,000

Retained earnings

Appropriated for self�insured losses 60,000 50,000

Unappropriated 100,000 60,000

360,000 310,000

An appropriation of retained earnings is, in essence, a bookkeeping entry and a way of disclosing restrictions onretained earnings. It does not indicate that funds have been segregated, nor does it affect income. FASB ASC505�10�45�4 (formerly SFAS No. 5) also states that costs or losses should not be charged to an appropriation ofretained earnings and that none of it should be transferred to income. Most companies disclose restrictions onretained earnings in the notes to the financial statements rather than on the face of the balance sheet. For example,a loan agreement may contain a restriction on payment of dividends, which represents a retained earningsrestriction that is typically disclosed in the notes to the financial statements.

Changes in Retained Earnings. Changes in retained earnings are generally limited to:

a. net income or loss for the year,

b. distribution of earnings (dividends), and

c. adjustments to the opening balance. The opening balance in retained earnings may be adjusted as a resultof:

(1) certain changes in accounting principles, or

(2) prior�period adjustments.

Dividends. Dividends are distributions of accumulated assets to stockholders generally in the form of cash,property, or stock. Cash dividends are liabilities of the company as of the date the dividends are declared. Theamount of the dividend is presented as a reduction of retained earnings in the statement of retained earnings orstockholders' equity. If unpaid at the balance sheet date, the amount also is recorded as a current liability. Althoughnot required by generally accepted accounting principles, some companies choose to disclose the per shareamount of dividends paid to stockholders as well as the total amount in the statement of retained earnings. Suchdisclosure is usually made in the dividend caption as the following illustrates.

20X2 20X1

Dividends declared, $.10 per share in 20X2 and $.09 pershare in 20X1 10,000 9,000

Property dividends reduce retained earnings in an amount equal to the fair value of the assets distributed [FASBASC 845�10�30�1 (formerly APB Opinion No. 29)]. At the date property dividends are declared, the companyrecognizes a gain or loss for the difference between the carrying value and the fair value of the assets distributed.For example, if property dividends consist of inventory with a carrying value of $75,000 and a fair value at thedeclaration date of $100,000, entries such as the following would be made:

Inventory ($100,000 fair value less $75,000 carrying value) 25,000

Gain on distribution of inventory 25,000

Retained earnings (fair value of assets distributed) 100,000

Property dividends distributable 100,000

Stock Dividends. A corporation may elect to distribute stock dividends in lieu of, or in addition to, cash or propertydividends. Accounting for stock dividends is discussed in FASB ASC 505�20 (formerly Chapter 7B of ARB No. 43).


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Stock dividends are generally no more than a realignment of stockholders' equity. However, GAAP recognized thatthe public looks at stock dividends as distributions of corporate earnings and usually in an amount equal to the fairvalue of the shares received. Thus, GAAP provides that as long as the number of shares issued in a stock dividendis so small in comparison to the number of shares outstanding that they have no apparent effect on the market priceof the shares, the stock dividend should be accounted for by transferring an amount equal to the fair value of theshares issued from retained earnings to capital stock and additional paid�in capital. Thus, stock dividends reduceretained earnings, but they do not reduce total stockholders' equity. They are disclosed in a statement of retainedearnings or stockholders' equity in a manner similar to cash or property dividends.

However, GAAP added that in closely held companies, there would be no need to capitalize retained earnings(other than to meet legal requirements) for stock dividends. That conclusion was based on the presumption thatshareholders of a closely held company are intimately knowledgeable of the company's affairs and therefore theygenerally would not consider stock dividends as a distribution of company earnings. Thus, stock dividends ofclosely held companies may be treated in a manner consistent with stock splits.

Stock Splits. Stock splits are similar to stock dividends in that they both involve the issuance by a company of itsown shares to its shareholders. However, the term stock split is used to refer to such distributions of sharesgenerally in excess of 20% to 25% of currently outstanding shares. Accounting for stock splits, however, is verydifferent from the accounting for stock dividends. When a distribution is classified as a stock split, no part ofretained earnings should be capitalized, other than that required by the laws of the state of incorporation of thecompany (generally not exceeding the par value of the shares issued). Instead, there is an increase in the numberof shares of stock outstanding and a corresponding decrease in the par value per share. Stock splits made after thebalance sheet date but before the financial statements are available to be issued are recognized subsequentevents, and accordingly, they should be reflected in the financial statements as if they had occurred as of thebalance sheet date.

Adjustments to Opening Retained Earnings for Accounting Changes. FASB ASC 250�10�05�2 (formerly SFASNo. 154, Accounting Changes and Error Corrections), establishes retrospective application as the required methodfor reporting a change in accounting principle unless it is impracticable to do so or the newly adopted accountingprinciple contains explicit transition requirements. Retrospective application may require an adjustment to theopening balance of retained earnings.

Prior�period Adjustments. The balance of retained earnings at the beginning of the period should be restated forthe effects of prior�period adjustments. (Since the beginning retained earnings balance must be restated forprior�period adjustments, FASB ASC 220�10 (formerly SFAS No. 130, Reporting Comprehensive Income), statesthat prior�period adjustments are, in effect, included in comprehensive income of earlier periods and should not bedisplayed in comprehensive income of the current period.) According to FASB ASC 250�10�45�23 (formerly SFASNo. 154), adjustment of prior period financial statements should only be made for the correction of an error in thefinancial statements of a prior period. [Certain other types of adjustments are permitted for interim financialstatements. According to FASB ASC 740 (formerly SFAS No. 109), however, the realization of income tax benefitsof preacquisition operating loss carryforwards of purchased subsidiaries is not treated as a prior�period adjust�ment.]

FASB ASC 250�10�20 (formerly SFAS No. 154), defines an error in previously issued financial statements as �anerror in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematicalmistakes, mistakes in the application of generally accepted accounting principles (GAAP), or oversight or misuseof facts that existed at the time the financial statements were prepared. A change from an accounting principle thatis not generally accepted to one that is generally accepted is a correction of an error."

Although the authoritative literature is not explicit, a change to GAAP from a comprehensive basis of accountingother than GAAP also should be accounted for as a correction of an error. Financial statements of prior periodsshould be restated or, if that is not practicable, opening balances of the current�period financial statements shouldbe adjusted to conform with generally accepted accounting principles. Prior�period financial statements should notbe presented in comparative form with those of the current period unless they have been restated.

RAR Adjustments (Income Tax Audit Adjustments). Adjustments to income taxes paid in prior years as a resultof IRS agent examinations usually fall into two categories: (a) those resulting from obvious errors such as using an


88

incorrect income tax rate or (b) those resulting from negotiated settlements of gray areas of tax law. While there aresound theoretical arguments to treat error corrections as prior�period adjustments, to do so necessitates a time�consuming and subjective evaluation of the nature of each adjustment on an RAR. Such adjustments ordinarily arenot material, and accordingly, the additional assessment ordinarily may be recorded as an adjustment of incometax expense in the year the assessment is made. Practice generally has adopted that approach. (If corrections oferrors of previously reported income tax expense are recorded as prior�period adjustments, the charge to retainedearnings should be the amount of the additional tax due. Penalty and interest should be reported as expenses ofthe year in which the additional assessment is made.)

Accumulated Other Comprehensive Income

FASB ASC 220�10�45�14 (formerly SFAS No. 130) requires the accumulated balance of other comprehensiveincome to be displayed separately from retained earnings and additional paid�in capital in the equity section of thebalance sheet and labeled with a descriptive title such as �accumulated other comprehensive income." In May2010, the FASB issued an exposure draft of a proposed ASU, Statement of Comprehensive Income, which wouldrequire entities to present a separate statement of comprehensive income. The proposed standard would notchange the items that are required to be reported in other comprehensive income or when an item must bereclassified from other comprehensive income to net income. It would also not change the requirement to displayaccumulated other comprehensive income separately in the balance sheet. However, it would only permit an entityto disclose accumulated balances for each component of other comprehensive income in the statement ofchanges in equity or in the notes to the financial statements. The following is an example presentation:

STOCKHOLDERS' EQUITYCommon stock $ 500,000Additional paid�in capital 100,000Retained earnings 300,000Accumulated other comprehensive income 50,000

950,000

In addition, the accumulated balances for each component of other comprehensive income should be presentedon the face of the balance sheet, in the statement of changes in stockholders' equity, or in the notes to the financialstatements. The following example illustrates presenting the accumulated balance for each component of othercomprehensive income on the face of the balance sheet:

STOCKHOLDERS' EQUITYCommon stock $ 500,000Additional paid�in capital 100,000Retained earnings 300,000Accumulated other comprehensive income:

Foreign currency translation adjustments $ 5,000Unrealized holding gains on securities 45,000 50,000

950,000

If accumulated other comprehensive income consists of only one component, such as unrealized gains or losseson available�for�sale marketable securities, that component could be listed individually on the face of the balancesheet, as follows:

STOCKHOLDERS' EQUITYCommon stock $ 500,000Additional paid�in capital 100,000Retained earnings 300,000Unrealized holding gains on securities 50,000

950,000

Treasury Stock

Stock issued should correspond with the dollar amount reported for the stock caption. Accordingly, if shares havebeen acquired and retired they would be eliminated from shares issued. However, if shares have been acquired


89

and are being held as treasury stock they would be included in shares issued. Traditionally, the following informa�tion is disclosed:

a. Title of the issue

b. Number of shares held in treasury

c. Carrying basis

d. Restrictions of state laws, if any

Most of the disclosures generally may be provided through expansion of the balance sheet caption. Although thecaption �Treasury stock" is acceptable, more descriptive captions such as �Common stock held by the Companyin treasury" or simply �Common stock held by the Company" may be clearer to readers. For example:

20X2 20X1


Common stock, $250 par value, 5,000 shares authorizedand 2,500 shares issued 625,000 625,000


750,000 720,000

Cost of 1,500 shares of common stock held by theCompany (435,000 ) (435,000 )

315,000 285,000

When stock is retired or purchased for constructive retirement, the par value of the shares should be charged to thespecific stock issue. In addition, FASB ASC 505�30�30�8 and 30�9 (formerly ARB No. 43, Chapter 1B, Paragraph 7)provides the following guidance on accounting for treasury stock when stock is retired or purchased for construc�tive retirement:

a. an excess of the purchase price over par value may be charged to additional paid�in capital with any excessremaining charged to retained earnings (alternatively, the excess may be charged entirely to retainedearnings); and

b. an excess of par value over the purchase price should be credited to additional paid�in capital.

Treasury stock refers to a corporation's own stock that it holds. As a general rule, treasury stock should bepresented in the financial statements as a deduction from stockholders' equity or as a deduction from capital stockoutstanding. (However, when a corporation purchases treasury stock as part of a systematic method of fulfilling itsrequirements to issue shares in connection with an employee stock option plan, it may be shown as an asset.)

a. When stock is acquired for purposes other than retirement, or when ultimate disposition has not beendecided, the cost of the stock may be handled in either of the following ways:

(1) A deduction from the sum of capital stock, additional paid�in capital, and retained earnings

(2) Treated the same as retired stock

(3) In rare instances, shown as an asset

b. If treasury stock has been shown as a deduction from other equity components and is subsequently sold:

(1) Gains should be credited to additional paid�in capital.

(2) Losses are normally charged first to additional paid�in capital, then to retained earnings.


90

The predominant practice for nonpublic companies appears to be to report treasury stock as a deduction fromother equity components.

Costs of Issuing Stock and Reorganizing

FASB ASC 505�30�30�2 through 30�4 (formerly FASB Technical Bulletin No. 85�6, Accounting for a Purchase of

Treasury Shares and Costs Incurred in Defending Against a Takeover Attempt), requires considering whether thetotal amount paid in a treasury stock transaction includes the receipt of stated or unstated rights, privileges, oragreements in addition to the capital stock, such as a seller's agreement to settle litigation or to abandon certainacquisition plans. If those other elements are present, the excess of the amount paid over the cost of the treasuryshares should be allocated to the other elements and accounted for according to their substance. For example,agreements to settle litigation or to abandon acquisition plans probably would be charged to expense. GAAPpermits allocations based either on an assessment of the fair value of the stock acquired or on the fair value of thoseother elements. The allocation of amounts paid and their accounting treatment should be disclosed.

GAAP also requires recording costs incurred under the following arrangements (commonly referred to as �green�mail") as ordinary expenses:

� Payments under an agreement in which a present or former stockholder agrees not to purchase additionalshares

� Costs incurred by a company in defending itself against a takeover attempt

Although such arrangements may be more common to public companies, analogous situations also might occurin nonpublic companies, for example, due to dissident minority shareholders.

Costs of issuing stock should be deducted from the proceeds of the issue and should not be reported as an asset.(Similarly, syndication costs (for example, costs paid to attorneys or accountants and fees paid to selling agents ofa limited partnership) for an offering of a limited partnership should be accounted for in a manner similar to costsassociated with the issuance of stock. In effect, the costs are charged against additional paid�in capital. Reorgani�zation costs normally should also be charged against additional paid�in capital. However, if that causes a negativebalance in additional paid�in capital, reorganization costs should be charged against retained earnings.

Disclosure of Changes in Capital Accounts

FASB ASC 250�10�50�9 (formerly APB Opinion No. 9, Reporting the Results of Operations), implies that disclosureof changes in retained earnings should be made for each period an income statement is presented. Often, that isaccomplished through expansion of the income statement. When both a balance sheet and an income statementare presented, GAAP requires disclosing changes in accounts comprising stockholders' equity in addition tochanges in retained earnings and in the number of shares of equity securities to be disclosed.

Changes in equity accounts other than retained earnings and other comprehensive income may be disclosed inany of the following ways depending on space requirements:

a. Line item in the balance sheet

b. Separate statement

c. Notes to the financial statements

For a nonpublic company, changes usually may be incorporated in expanded balance sheet captions. For exam�ple, a change in common stock might be disclosed as follows:

20X2 20X1

Common stock, $20 par value, 1,000 shares authorized,shares issued750 in 20X2 and 500 in 20X1 15,000 10,000


91

A change in treasury stock might be disclosed as follows:

20X2 20X1

Cost of 1,500 shares of common stock held by theCompany in 20X2 and 500 shares held in 20X1 135,000 46,000

GAAP requires all entities to disclose the number of shares issued during at least the most recent annual period andany subsequent interim period presented.


92


93

SELF�STUDY QUIZ


34. What balance sheet caption is appropriate when one period has negative equity and the other period haspositive equity?

a. Stockholders' equity.

b. Stockholders' deficit.

c. Deficiency in assets.

d. Stockholders' equity (deficit).

35. Which of the following preferred stock disclosures is disclosed in the equity section of the balance sheet?

a. Redemption requirements for all issues of stock.

b. A description of the rights and privileges of securities.

c. Liquidation preferences that are substantially in excess of par or stated value.

d. The number of shares issued during the most recent annual period.

36. Which of the following applies to the issuance of an equity instrument to a nonemployee in exchange for goods?

a. Sales discounts should be recognized in this situation.

b. The grant date should be used to value the equity instrument.

c. The value of the goods received is always used to value the equity instrument.

d. The equity instruments are measured at the highest amount within a range of fair values.

37. Forgiveness of a receivable from a related party is an equity transaction.

a. True.

b. False.

38. Edge Corporation, a publicly traded corporation, issued a small amount of stock dividends. How would thecorporation account for the stock dividends?

a. In this situation, the stock dividends should be accounted for like a stock split.

b. The corporation should reduce retained earnings and increase capital stock and additional paid�in capital.

c. Edge Corporation should not capitalize a portion of retained earnings.

d. Edge Corporation should increase the number of outstanding shares and decrease the par value pershare.


94



34. What balance sheet caption is appropriate when one period has negative equity and the other period haspositive equity? (Page 79)

a. Stockholders' equity. [This answer is incorrect. If liabilities exceed assets, the term �equity" should not beused. A negative equity balance can be reported using a different caption.]

b. Stockholders' deficit. [This answer is incorrect. �Stockholders' deficit" could be used if negative equity isshown in all periods.]

c. Deficiency in assets. [This answer is incorrect. �Deficiency in assets" is an acceptable caption to report anegative equity balance on the balance sheet when all periods show negative equity.]

d. Stockholders' equity (deficit). [This answer is correct. When negative equity is shown in one periodand a positive equity is shown in another period, �Stockholders' equity (deficiency in assets)" or�Stockholders' equity (deficit)" may be used.]

35. Which of the following preferred stock disclosures is disclosed in the equity section of the balance sheet?(Page 80)

a. Redemption requirements for all issues of stock. [This answer is incorrect. Redemption requirements forall issues of stock are usually made in the notes to the financial statements.]

b. A description of the rights and privileges of securities. [This answer is incorrect. A description of the rightsand privileges of securities is disclosed in the notes to the financial statements.]

c. Liquidation preferences that are substantially in excess of par or stated value. [This answer iscorrect. Liquidation preferences must be disclosed in the equity section of the balance sheet, whilemost other disclosures are made in the notes.]

d. The number of shares issued during the most recent annual period. [This answer is incorrect. In the notesto the financial statements, a disclosure is made regarding the number of shares issued during the mostrecent annual period and any subsequent interim period presented.]

36. Which of the following applies to the issuance of an equity instrument to a nonemployee in exchange for goods?(Page 82)

a. Sales discounts should be recognized in this situation. [This answer is correct. An asset or expense(or sales discount) should be recognized as if the company paid cash rather than equity instrumentsfor the goods. In addition, a recognized sales discount should not be reversed if a nonemployee'sstock option expires unexercised.]

b. The grant date should be used to value the equity instrument. [This answer is incorrect. If the fair value ofthe equity instrument is used to account for the transaction, FASB ASC 505 and 718 [formerly SFAS No.123(R)] does not prescribe the measurement date. However, FASB ASC 505�50 (formerly EITF Issue No.96�18) gives guidance that the fair value of the equity instrument is used to measure the stock price on theearlier of (a) the date at which a performance commitment by the nonemployee is reached or (b) the dateat which the nonemployee's performance is complete.]

c. The value of the goods received is always used to value the equity instrument. [This answer is incorrect.A company that uses equity instruments in return for goods from nonemployees must account for thetransaction using either the fair value of the goods received or the equity instruments issued, whichevercan be more reliably measured.]


95

d. The equity instruments are measured at the highest amount within a range of fair values. [This answer isincorrect. Equity instruments should be measured at the lowest amount within a range of aggregate fairvalues if the quantity and terms of the equity instruments (1) depend on the achievement of nonemployeeperformance conditions that, based on the various possible outcomes, result in a range of aggregate fairvalues, or (2) depend on the achievement of both market conditions and nonemployee performanceconditions that, based on the various possible outcomes, result in a range of aggregate fair values.]

37. Forgiveness of a receivable from a related party is an equity transaction. (Page 85)

a. True. [This answer is correct. When an entity forgives a receivable from a related party or a relatedparty forgives the amount due from an entity, the events should ordinarily be accounted for as equitytransactions, with no effect on earnings.]

b. False. [This answer is incorrect. Forgiveness of a receivable from a related party should not affect theearnings of the entity. FASB ASC 470�50�40�2 (formerly APB Opinion No. 26, Early Extinguishment of Debt),says �extinguishment transactions between related entities may be in essence capital transactions."]

38. Edge Corporation, a publicly traded corporation, issued a small amount of stock dividends. How would thecorporation account for the stock dividends? (Page 86)

a. In this situation, the stock dividends should be accounted for like a stock split. [This answer is incorrect.If Edge Corporation was a closely held company, the stock dividends may be treated in a mannerconsistent with stock splits, because shareholders of a closely held company are intimately knowledge�able of the company's affairs and therefore they generally would not consider stock dividends as adistribution of company earnings.]

b. The corporation should reduce retained earnings and increase capital stock and additional paid�incapital. [This answer is correct. GAAP provides that as long as the number of shares issued in astock dividend is so small in comparison to the number of shares outstanding that they have noapparent effect on the market price of the shares, the stock dividend should be accounted for bytransferring an amount equal to the fair value of the shares issued from retained earnings to capitalstock and additional paid�in capital. Thus, stock dividends reduce retained earnings, but they do notreduce total stockholders' equity.]

c. Edge Corporation should not capitalize a portion of retained earnings. [This answer is incorrect. Stocksplits do not capitalize a portion of retained earnings. Stock dividends, however, affect the retainedearnings account.]

d. Edge Corporation should increase the number of outstanding shares and decrease the par value pershare. [This answer is incorrect. In stock splits, the number of outstanding shares increases and the parvalue per share decreases. This is not the correct way to account for stock dividends.]


96


Lesson 2 (PFSTG101)


34. If present, what component of stockholders' equity is generally listed after all other stockholders' equity itemsare subtotaled?

a. Accumulated other comprehensive income.

b. Stock subscriptions receivable.

c. Additional paid�in capital.

d. Treasury stock.

35. When an employee receives equity instruments in exchange for employee services, what date is used to valuethe equity instruments?

a. The reporting date.

b. The grant date.

c. The date exercised.

d. The vesting date.

36. Which of the following would not affect additional paid�in capital?

a. Reorganization costs.

b. Purchase or sale of treasury stock.

c. Sale of stock at stated value.

d. Capitalization of retained earnings for stock dividends.

37. Which of the following items best describes restrictions on retained earnings?

a. An appropriation of retained earnings affects income.

b. An appropriation of retained earnings discloses restrictions on retained earnings.

c. An appropriation of retained earnings indicates that funds have been segregated.

d. Most appropriations of retained earnings are disclosed on the face of the balance sheet.

38. Treasury stock is included in the number of shares issued.

a. True.

b. False.




97

Lesson 3:�Accounting Changes

INTRODUCTION

According to FASB ASC 250�10�05�01; 250�10�05�4 (formerly SFAS No. 154, Accounting Changes and Error

Corrections), the term accounting changes includes changes in an accounting estimate,changes in the reportingentity, and changes in an accounting principle. The term does not include correction of errors.


Completion of this lesson will enable you to:� Identify and report accounting changes on the balance sheet.

Change in Accounting Estimate

A change in accounting estimate results from new information. Examples of accounting estimates that periodicallychange are allowances for bad debts, useful lives or salvage values of depreciable assets, and inventory obsoles�cence. The effects of changes in estimates should be reported in the period of change and subsequent periods.Restatement or retrospective adjustment of amounts reported in prior period financial statements or the presenta�tion of pro forma prior period amounts is not permitted. For example, a change in the estimated useful lives ofassets would be accounted for by adjusting depreciation expense in the current and future periods to depreciatethe carrying value of assets over their remaining (new) useful lives.

Changes that are inseparable from changes in accounting principle, such as a change in depreciation, amortiza�tion, or depletion method for long�lived nonfinancial assets, should be accounted for as a change in accountingestimate effected by a change in accounting principle. Such changes are accounted for as a change in an estimate.However, a change in accounting estimate effected by a change in accounting principle is permitted only if thereporting entity can justify the new principle on the basis that it is preferable. Changing from certain depreciationmethods, for example, the Modified Accelerated Cost Recovery System (MACRS), to the straight�line method at aspecified point in the life of an asset to fully depreciate the asset's cost over its estimated life is not a change inaccounting principle if the change had been planned when the asset was placed in service and the policy is appliedconsistently.

Change in Reporting Entity

A change in reporting entity refers to a change that results in financial statements that are, in effect, the statementsof a different reporting entity. Typically, such changes are limited to changes in the companies or subsidiaries thatare included in combined or consolidated financial statements. Changes in the reporting entity are accounted forby retrospectively applying the change to the financial statements of all previous periods presented to show thefinancial information for the new reporting entity for the previous periods.

Change in Accounting Principle

A change in accounting principle is generally defined as a change from one acceptable principle to another or achange in the method of applying an acceptable accounting principle. A change from an unacceptable principle toan acceptable principle is a correction of an error and not a change in accounting principle as defined by GAAP.

The following events or circumstances are not considered to be accounting changes for the purpose of applyingthis guidance:

a. Initial adoption of a new accounting principle for new events or transactions or for material events ortransactions that were previously immaterial

b. Adoption or modification of an accounting principle due to substantially different events or transactionsthan those previously occurring


98

Justifying Changes in Accounting Principles

GAAP permits a change in accounting principle only if a company justifies the use of an alternative acceptableaccounting principle on the basis that it is preferable or a newly issued accounting pronouncement requires thechange.

Accounting for and Reporting of a Change in Accounting Principle

This guidance applies to all voluntary changes in accounting principle as well as to changes required by anaccounting pronouncement when that pronouncement does not include explicit transition provisions. If a pro�nouncement includes explicit transition provisions, those provisions should be applied.

A change in accounting principle should be reported by retrospective application of the new principle to thefinancial statements of all prior periods, unless it is impracticable to determine either the period�specific effects orthe cumulative effect of the change. Retrospective application is the application of a different accounting principleto previous accounting periods as if it had always been used. The following steps are required to retrospectivelyapply a new accounting principle:

a. Determine the cumulative effect of the change to the new accounting principle on periods before theperiods presented. Apply the cumulative effect of the change to the carrying amounts of assets andliabilities as of the beginning of the first period presented.

b. If necessary, record an offsetting adjustment to the opening retained earnings balance (or otherappropriate components of equity or net assets) for that period.

c. Adjust the financial statements for each individual prior period presented to reflect the period�specificeffects of applying the new accounting principle.

If the cumulative effect of applying the change to all prior periods can be determined, but it is impracticable todetermine the period�specific effects of the change on all prior periods presented, the cumulative effect of thechange should be applied to the balances of assets and liabilities as of the beginning of the earliest period to whichthe new principle can be applied. In those situations, an offsetting adjustment to the opening retained earningsbalance (or other appropriate components of equity or net assets) for that period may be necessary. If it isimpracticable to determine the cumulative effect of applying a change in accounting principle to any prior period,the new principle should be applied as if it were adopted prospectively from the earliest date practicable.

When applying a new accounting principle retrospectively, an entity should include only the direct effects of thechange and the related income tax effects, if any. The retrospective application should not include any indirecteffects that would have been recognized if the new principle had been used in previous periods. Indirect effects ofthe change that are actually incurred and recognized should be reported in the period the change is made. Anexample of an indirect effect is a change in a nondiscretionary profit�sharing contribution that is based on netincome.


99

SELF�STUDY QUIZ


39. All Pro needs to report a change in the salvage value of its production equipment. In what periods should thechange be reported?

a. All Pro will restate prior period financial statements.

b. All Pro would present pro forma prior period amounts.

c. All Pro will make a retrospective adjustment.

d. All Pro will report the change in the current and subsequent periods.

40. Which of the following is considered a change in accounting principle?

a. A change in the method of applying an acceptable accounting principle.

b. A change to an acceptable principle from an unacceptable principle.

c. Initial adoption of a new accounting principle for new transactions.

d. A modification of an accounting principle due to substantially different events.


100



39. All Pro needs to report a change in the salvage value of its production equipment. In what periods should thechange be reported? (Page 97)

a. All Pro will restate prior period financial statements. [This answer is incorrect. Restatement of amountsreported in prior period financial statements is not permitted for a change in accounting estimate.]

b. All Pro would present pro forma prior period amounts. [This answer is incorrect. The presentation of proforma prior period amounts is not permitted for a change in an accounting estimate.]

c. All Pro will make a retrospective adjustment. [This answer is incorrect. A change in an accounting methodis not reported my making a retrospective adjustment of amounts in prior period financial statements. Infact, retrospective adjustments are not permitted.]

d. All Pro will report the change in the current and subsequent periods. [This answer is correct. Theeffects of changes in estimates should be reported in the period of change and subsequent periods.Examples of accounting estimates that periodically change are allowances for bad debts, usefullives or salvage values of depreciable assets, and inventory obsolescence.]

40. Which of the following is considered a change in accounting principle? (Page 97)

a. A change in the method of applying an acceptable accounting principle. [This answer is correct. Achange in accounting principle is generally defined as a change from one acceptable principle toanother or a change in the method of applying an acceptable accounting principle.]

b. A change to an acceptable principle from an unacceptable principle. [This answer is incorrect. A changefrom an unacceptable principle to an acceptable principle is a correction of an error and not a change inaccounting principle as defined by GAAP.]

c. Initial adoption of a new accounting principle for new transactions. [This answer is incorrect. The initialadoption of a new accounting principle for new events or transactions or for material events or transactionsthat were previously immaterial is not considered to be accounting changes for the purpose of applyingthe guidance.]

d. A modification of an accounting principle due to substantially different events. [This answer is incorrect.An adoption or modification of an accounting principle due to substantially different events or transactionsthan those previously occurring is not considered to be an accounting change for the purpose of applyingthe guidance.]


101


Lesson 3 (PFSTG101)


39. Which of the following is not an accounting change?

a. An error correction.

b. An accounting estimate change.

c. A change in the reporting entity.

d. Accounting principle changes.

40. Which of the following is not one of the required steps to retrospectively apply a new accounting principle?

a. Reflect the period�specific effects of applying the new accounting principle by adjusting the financialstatements for each individual prior period presented.

b. Determine and apply the cumulative effect of the change to the beginning of the first period presented.

c. Adjust the opening balance of retained earnings, if necessary, for the first period presented.

d. Determine and apply any indirect effects of the change to the beginning of the first period presented.


102


103

GLOSSARY

Accrued Liabilities: Estimates of the obligation for expenses that have been incurred but for which no billing hasbeen received.

Claims�made Insurance Policy: Cover only those asserted claims and incidents that are reported to the insurancecarrier while the policy is in effect. Thus, a claims�made policy does not represent a transfer of risk for claims andincidents that have been incurred but not reported to the insurance carrier.

Current Assets: Cash and other assets that are reasonably expected to be realized in cash or sold or consumedduring one year or within the company's normal operating cycle if it is longer than a year.

Current Liabilities: Obligations whose liquidation is reasonably expected to require the use of current assets or thecreation of other current liabilities.

Debt Covenant: Part of the conditions of a loan agreement, these covenants are the promises by the managementof the borrowing firm to adhere to certain limits in the firm's operations. For example, not to allow certain balancesheet items or ratios to fall below or go over an agreed upon limit.

Deferred Income Tax Asset: A deferred tax asset is recognized for temporary differences that will result in deductibleamounts in future years and for carryforwards.

Deferred Income Tax Liability: Excess of income tax amount shown on an income statement over the actual taxamount, which occurs when book�income exceeds taxable income. This excess is recognized as a liability in thetaxpayer's balance sheet, and is written off in the following accounting period.

Demand Loan: a loan payable upon the demand of the lender.

Long�term Debt: Amount owed for a period exceeding 12 months from the date of the balance sheet. It could bein the form of a bank loan, mortgage bonds, debenture, or other obligations not due for one year. A firm must discloseits long�term debt in its balance sheet with its interest rate and date of maturity. Amount of long�term debt is a measureof a firm's leverage, and is distinguished from long term liabilities which may include supply of services already paidfor.

Operating Cycle: The time needed to convert cash first into materials and services, then into products, then by saleinto receivables, and finally by collection back into cash.

Secured Borrowings: Loan agreement under which a borrower pledges a specific asset or property which thelender can seize in case of default.

Share�based Payment: A transaction in which an entity issues equity instruments, share options or incurs a liabilityto pay cash based on the price of the entity's equity instruments to another party as compensation for goods receivedor services rendered.

Short�term Debt: Debt payable within 12 months, it includes the current portion of the long�term debt.

Stock Dividends: Generally, an actual or constructive distribution of stock to a corporation's shareholders.

Stock Splits: Division of already issued (outstanding) shares of a firm into a larger number of shares, to make themmore affordable and thus improve their marketability while maintaining the current stockholders' proportionalownership of the firm. The aggregate value of the shares remains the same as before the split, but the price (anddividend) per share declines with the split ratio. For example, if the shares are split by a multiple of two (2:1 split),a share with a par value of $10 becomes two shares, each with a par value of $5.


104


105

INDEX

A

ACCOUNTING CHANGE� Change in accounting principle 97. . . . . . . . . . . . . . . . . . . . . . . . . � Change in basis of accounting 87. . . . . . . . . . . . . . . . . . . . . . . . . . � Change in classification 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in estimate 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in estimate effected by a change in accounting

principle 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in principle

�� From unacceptable method to GAAP 87, 97. . . . . . . . . . . . . . �� Justifying changes 98. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Required by new pronouncements 98. . . . . . . . . . . . . . . . . . .

� Change in reporting entity 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Correction of an error 87, 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Retrospective application 98. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ACCOUNTS PAYABLE� Captions 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Composition 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cutoff 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Debit balance 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Discounts 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unrecorded amounts 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

AGENCY TRANSACTIONS� Balance sheet presentations 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

AMORTIZATION� Interest method 44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Rule of 78s method 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B

BALANCE SHEET� Authoritative basis 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Basic financial statement 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Offsetting assets and liabilities 35. . . . . . . . . . . . . . . . . . . . . . . . . . � Operating cycle 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

BUSINESS COMBINATIONS� Purchased loss carryforwards 87. . . . . . . . . . . . . . . . . . . . . . . . . . .

C

CAPTIONS� Accounts payable 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Accrued liability 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Accumulated other comprehensive income 88. . . . . . . . . . . . . . . � Common stock 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Debt issue costs 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deferred revenues 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes 33. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Retained earnings 85. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term debt 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stockholders' equity, negative 79. . . . . . . . . . . . . . . . . . . . . . . . . .

CASH VALUE OF LIFE INSURANCE� Imputed interest 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COMPREHENSIVE INCOME� Accumulated other comprehensive income 79, 88. . . . . . . . . . . .

CONTINGENCIES AND COMMITMENTS� Accounting treatment 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Claims�made insurance policies 8. . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax audit adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . � Restrictions on retained earnings 85. . . . . . . . . . . . . . . . . . . . . . . .

COSTS TO RETIRE LONG�LIVED ASSETS 60. . . . . . . . . . . . . . . .

CUTOFF� Accounts payable 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

D

DEFERRED CHARGES� Debt issue costs

�� Amortization 52. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock issue costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Syndication costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DEPRECIATION� Change in estimated useful life 97. . . . . . . . . . . . . . . . . . . . . . . . . . � Change in method planned 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DISCLOSURES� Additional paid�in capital 84. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Changes in retained earnings 90. . . . . . . . . . . . . . . . . . . . . . . . . . . � Changes in stockholders' equity 90. . . . . . . . . . . . . . . . . . . . . . . . . � Common stock 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes

�� Tax adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Preferred stock 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

E

ENVIRONMENTAL REMEDIATION COSTS� Accrual under SOP 96�1

�� Allocating shared costs 58. . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Claims for recovery 59. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Determining when to accrue a liability 56. . . . . . . . . . . . . . . . . �� Effect of changes in laws and regulations 59. . . . . . . . . . . . . . �� Estimating environmental remediation costs 58. . . . . . . . . . . �� Productivity improvements 59. . . . . . . . . . . . . . . . . . . . . . . . . . �� Technology improvements 59. . . . . . . . . . . . . . . . . . . . . . . . . . �� Use of discounting 59. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Authoritative literature 55. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Effect on property impairment 59. . . . . . . . . . . . . . . . . . . . . . . . . . . � Federal environmental laws 55. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ERRORS, CORRECTION OF 87, 97. . . . . . . . . . . . . . . . . . . . . . . . . .

G

GUARANTEES� Accounting treatment 60. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimating fair value of obligation 62. . . . . . . . . . . . . . . . . . . . . . . . � Measurement considerations 63. . . . . . . . . . . . . . . . . . . . . . . . . . . � Product warranties 62. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Related party debt 61. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

I

INCOME TAXES� Audit adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 33. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deferred, liability method

�� Classification as current or noncurrent liability 31. . . . . . . . . . � Disclosures

�� Tax adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Purchased loss carryforward 87. . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Debt extinguishment 50. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Imputed interest 50. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTEREST� Effective rate 45. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Imputing 45. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Incremental borrowing rate 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interest method 44, 45. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Rule of 78s 45, 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unamortized 49, 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


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L

LEASES� Incremental borrowing rate 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIABILITIES� Accounts payable 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Accrued liabilities

�� Accounting treatment 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Agency obligations 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Balance sheet presentation 9. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Compensation and payroll taxes 7. . . . . . . . . . . . . . . . . . . . . . �� Composition 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Retirement plan contributions 8. . . . . . . . . . . . . . . . . . . . . . . . . �� Vacation and sick pay 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Buy�out agreements 47. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Classification as current or long�term 3, 9. . . . . . . . . . . . . . . . . . . . � Components of current liabilities 3. . . . . . . . . . . . . . . . . . . . . . . . . � Costs to retire long�lived assets 60. . . . . . . . . . . . . . . . . . . . . . . . . � Dividends 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Environmental contingencies 55. . . . . . . . . . . . . . . . . . . . . . . . . . . � Extinguishments 53. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes payable

�� Balance sheet presentation 33. . . . . . . . . . . . . . . . . . . . . . . . . . �� Deferred 31. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Offsetting assets against liabilities 35. . . . . . . . . . . . . . . . . . . .

� Long�term debt�� Acceleration clauses 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Balance sheet presentation 54. . . . . . . . . . . . . . . . . . . . . . . . . . �� Changes in debt terms 47. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Credit line or revolving debt arrangements 50. . . . . . . . . . . . . �� Current maturities 44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Effective interest rate 44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Income tax considerations 50. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Installment loans 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� In�substance defeasance 54. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Issue costs 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Postemployment benefits 7. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Secured borrowings 54. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term debt

�� Balance sheet presentation 4. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Bridge loans 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Callable by the creditor 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Captions 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Demand notes 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Expected to be refinanced 10. . . . . . . . . . . . . . . . . . . . . . . . . .

� Unrecorded 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Violation of covenants 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Subjective acceleration clauses 12. . . . . . . . . . . . . . . . . . . . . .

M

MATERIALITY� Vacation pay 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

N

NONMONETARY TRANSACTIONS� Property dividends 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

O

OPERATING CYCLE 3, 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

OTHER COMPREHENSIVE BASIS OF ACCOUNTING� Change in basis of accounting 87, 97. . . . . . . . . . . . . . . . . . . . . . .

P

PARTNERSHIPS� Syndication costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PENSION PLANS� Accrued liabilities 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PREPAID EXPENSES� Retirement plan expense 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PRIOR�PERIOD ADJUSTMENTS� Defined 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Errors 87, 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax audit adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . � Purchased loss carryforwards 87. . . . . . . . . . . . . . . . . . . . . . . . . . .

PROPERTY AND EQUIPMENT� Contributed assets 84. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

R

RECEIVABLES� Allowance for doubtful accounts 97. . . . . . . . . . . . . . . . . . . . . . . . . � Debit balances in accounts payable 4. . . . . . . . . . . . . . . . . . . . . . . � Discounting 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interest, imputed 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Related party 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock subscriptions 84. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Uncollectible accounts 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RELATED PARTY TRANSACTIONS� Receivables 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RETAINED EARNINGS� Adjustment for accounting changed 87. . . . . . . . . . . . . . . . . . . . . � Captions 85. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Changes in 86, 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Dividends

�� Cash 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Property 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stock 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stock splits 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Reorganization costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Restrictions 85. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

REVENUE� Deferred 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

S

STATEMENT OF RETAINED EARNINGS� Combined with income statement 85. . . . . . . . . . . . . . . . . . . . . . . � Separate statement 85. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

STOCKHOLDERS' EQUITY� Accumulated other comprehensive income 88. . . . . . . . . . . . . . . � Additional paid�in capital 84, 89, 90. . . . . . . . . . . . . . . . . . . . . . . . � Captions 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Common stock 79, 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosure of changes 80, 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Forgiveness of related party debt 85. . . . . . . . . . . . . . . . . . . . . . . . � Negative balances 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Order of presentation 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Preferred stock 79, 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Reorganization costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock issue costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock option plans

�� Nonemployees 82. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock redemptions 47, 88. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Subscriptions receivable 84. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Treasury stock 47, 88. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

SUBSEQUENT EVENTS� Covenant violations 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock splits 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


107


COURSE 2

ACCOUNTING FOR CERTAIN TAX TRANSACTIONS (PFSTG102)

OVERVIEW

COURSE DESCRIPTION: This interactive self�study course provides guidance regarding the accounting forvarious tax transactions. Lesson one briefly covers FIN 48, �Accounting forUncertainty in Income Taxes�an Interpretation of FASB Statement No. 109" andaccounts for the change of accounting method or period, asset capitalization andvaluation, investments in partnerships, and property and equipment transactions.Lesson two discusses the accounting of stock redemptions and relatedtransactions, partnerships, limited liability companies, changes in tax status,transactions with owners, leasing transactions, and miscellaneous other taxtransactions.


November 2010



Basic knowledge of financial statements and tax transactions.







Lesson 1Selected Topics Part 1

Completion of this lesson will enable you to:� Determine the effect of tax positions and changes in the treatment of a material item or period on the financial

statements.� Identify various income tax and legal transactions and how they might affect the financial statements.� Determine how to record income tax transactions involving the entity's assets on the financial statements.

Lesson 2Selected Topics Part 2

Completion of this lesson will enable you to:� Determine the income tax and accounting treatment for transactions involving ownership of the entity or various

other transactions.� Calculate adjustments and equity balances for ownership transactions and revenue recognition for lease

transactions for tax and financial reporting.


108








109

Lesson 1:�Selected Topics Part 1

INTRODUCTION

Certain transactions of closely held businesses are first identified because of their income tax significance. Thiscourse provides a bridge to help accountants present specific �tax transactions" in financial statements in confor�mity with GAAP.


Completion of this lesson will enable you to:� Determine the effect of tax positions and changes in the treatment of a material item or period on the financial

statements.� Identify various income tax and legal transactions and how they might affect the financial statements.� Determine how to record income tax transactions involving the entity's assets on the financial statements.

A TAXING AUTHORITY'S EXAMINATION

FASB ASC 740 (formerly FIN 48, �Accounting for Uncertainty in Income Taxes") generally permits recognizingcurrent income tax benefits only if it is more likely than not that the underlying tax position would be sustained if thetaxing authority examined it. A current tax benefit that has been realized through a deduction in a tax return butdoes not meet the �more likely than not" criterion should be deferred. The liability represents the additional incometax that would be assessed if the position is not sustained upon examination by the taxing authority.

If the realized tax benefit of taking a position was previously deferred, FASB ASC 740�10�25�9 (formerly FSP FIN48�1, �Definition of Settlement in FASB Interpretation No. 48") notes that the liability for the deferral should beeliminated, or derecognized, when the �tax position is effectively settled through examination, negotiation, orlitigation" and that when deciding whether the position is effectively settled, the entity should consider the following:

a. Has the taxing authority completed its examination procedures?

b. Does the entity intend to appeal or litigate any aspect of the tax position included in the completedexamination?

c. Is there only a remote chance the taxing authority would examine or reexamine any aspect of the taxposition?

Following this guidance

a. If the tax position was taken in a year for which the return, but not the position, was examined, the positionfor that year may be considered effectively settled.

b. If the tax position was taken in two or more years, examination and acceptance of the position taken in oneyear does not result in effective settlement for the years that are still subject to examination.

c. An examination may provide additional information that causes the entity to change its assessment of themerits of the position or similar tax positions taken in years that are still subject to examination.

Conceptually, if the reporting entity has deferred the realized tax benefit of taking a tax position, the additionalincome tax assessed for the subsequent disallowance of the position will have no effect on earnings. Instead,payment of the assessment will be recorded through a debit to the liability for the previously deferred tax benefitand a credit to cash.

If the realized tax benefit of taking a position has been recognized, the assessment of additional income tax for thesubsequent disallowance of the position should be charged to the current provision for the year. Disallowance of a


110

position does not mean that the assessment of whether the position met the �more likely than not" criterion waswrong. Meeting that criterion requires an assessment of risk and means there is still up to a 49% chance theposition will be disallowed.

The subsequent disallowance of a position for a year may also provide new information that indicates the pre�viously recognized tax benefit from taking the position or similar positions in years still subject to examinationshould be derecognized. The tax benefit derecognized should be recorded through a charge to the current taxprovision for the year and a credit to a liability for the deferral of the tax benefit previously recognized.

Effective Date and September 2009 Amendments

FIN 48, which has been included in the Codification in FASB ASC 740�10, was issued in June 2006 and fornonpublic entities is effective for years beginning after December 15, 2008.

In September 2009 Accounting Standards Update (ASU) No. 2009�06, Implementation Guidance on Accounting for

Uncertainty in Income Taxes and Disclosure Amendments for Nonpublic Entities, was issued and appears in theCodification in various parts of FASB ASC 740�10. Guidance in ASU No. 2009�06 is clarifying, rather than changing,the original guidance.

ASU No. 2009�06 clarifies that if income taxes paid by the entity are attributable to the

a. entity, they should be accounted for following the provisions of FASB ASC 740 (formerly SFAS No. 109,Accounting for Income Taxes).

b. owners, they should be accounted for as a transaction with owners.

For example, a state that recognizes the Subchapter S election may nevertheless require the entity to pay anamount computed by applying the state income tax rate to the entity's taxable income allocated to an out�of�stateowner. The individual would include the allocated income in his return and recognize a tax credit for the paymentby the entity. The payment should be considered attributable to the owner and shown as a dividend in the entity'sfinancial statements.

ASU No. 2009�06 also clarifies that

a. the determination of attribution should be made for each jurisdiction where the entity is subject to incometaxes and determined on the basis of laws and regulations of the jurisdiction, and

b. management's determination of the taxable status of the entity, including its status as a pass�through entityor tax�exempt not�for�profit entity, is a tax position that is subject to the requirements of FASB ASC 740�10(formerly FIN 48).

To illustrate the accounting considerations, assume that a corporation that has elected Subchapter S status takesthe position that it does not have nexus with a state that does not recognize that election. The corporation shouldevaluate whether the position would more likely than not be sustained by the state in an examination. Thatevaluation should consider the positions taken by the state in applying nexus requirements, such as how manyyears are considered open if tax would be assessed retrospectively and whether the state has adopted thresholdsof taxable income attributable to the state below which it will not assert nexus.

As a practical matter, the entity should also consider the materiality of the effects of the position being denied. Forexample, reallocation of taxable income to the state may enable the entity to reduce taxable income originallyallocated to other states, resulting in recovery of state income taxes paid.

Finally, ASU No. 2009�06 clarifies that the reporting entity must consider the tax positions of all entities within thegroup of entities whose financial results are presented in consolidated or combined financial statements. Toillustrate the accounting considerations, assume that a limited liability company has a controlling financial interestin a corporation that has not elected Subchapter S status. Since the limited liability company has a controllingfinancial interest in the corporation, it must include the consolidated financial results of the corporation in its


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financial statements. The tax positions taken by the corporation are subject to the requirements of FASB ASC740�10 in determining whether income taxes for the corporation should be recognized in the consolidated financialstatements.

ASU No. 2009�06 exempts nonpublic entities from two of the original uncertainty in income taxes disclosurerequirements:

a. the requirement to provide a tabular reconciliation of the total amount of unrecognized tax benefits at thebeginning and end of the years presented, and

b. the requirement to disclose the total amount of unrecognized tax benefits that, if recognized, would affectthe effective tax rate.

CHANGES IN ACCOUNTING METHOD OR PERIOD

General

Changes in accounting methods for tax purposes may be made subject to certain IRS regulations (generallyrequiring approval by the Commissioner). A change in accounting methods may involve a change in the treatmentof any material item, e.g., FIFO to LIFO basis of valuing inventories, or a change in the overall basis of accounting,e.g., cash to accrual basis for a small corporation. This section discusses certain changes in a company'saccounting method and accounting period.

Change in the Treatment of a Material Item

A change in the accounting treatment of a material item for tax purposes generally would have the following effectson the company's financial statements:

� If the change is from the method used for financial reporting purposes to a different method, temporarydifferences would be created and deferred taxes would usually be recognized.

� If the change is to the method used for financial reporting purposes, previous temporary differences anddeferred taxes related to the item will reverse (sometimes in the year of change, sometimes over aprescribed period).

� If the change is from the method currently used for financial reporting purposes to another methodacceptable under GAAP and the company also decides to adopt the new method for financial reportingpurposes, financial reporting should follow generally accepted accounting principles for a change inaccounting principle. Under FASB ASC 250�10�45�5 and 45�12 (formerly SFAS No. 154), a change inaccounting principle generally is reported retrospectively through an adjustment of retained earnings, andthe change must be justifiable on the basis that it is preferable.

� If the company uses the tax basis for financial reporting purposes, record the adjustment as a deferred itemand amortizing it to earnings as it is charged to taxable income.

Cash to Accrual and Other Changes in the Basis of Accounting

Changes in the basis of accounting generally are made for both the tax return and the financial statements. Theeffects of those changes on the financial statements are discussed in PPC's Guide to Preparing Financial State�ments.

a. Change from OCBOA to GAAP

b. Change from GAAP to OCBOA

c. Change in accounting principle in tax basis financial statements


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However, changes in the basis of accounting sometimes are made for the tax return only to conform the accountingmethod used for tax purposes with the method used for financial reporting purposes. Those changes only affect theamount of deferred taxes reported in the financial statements.

Changes in Fiscal Year

A taxpayer may, with the permission of the Commissioner of the Internal Revenue Service, change the accountingperiod, e.g., from a December 31 year end to a July 31 year end. The IRS also requires taxpayers to change theirfiscal year in certain circumstances, e.g., a corporation electing S corporation status is required to change to aDecember 31 year end unless it can show that the fiscal year is its natural business year (or the same tax year asthat of shareholders who own more than 50% of its shares) or it pays a deposit. A change in fiscal year requires ashort year (less than 12 months) tax return.

Almost universally, companies also change their fiscal year for financial reporting purposes when a change in taxyear is adopted. Thus, the financial statements of the year of change would cover less than twelve months. NeitherFASB ASC 250 (formerly SFAS No. 154, Accounting Changes and Error Corrections) nor other authoritativepronouncements discuss a change in a company's fiscal year.

A nonauthoritative technical practice aid at TIS 1800.03 indicates that, generally, the change should be disclosedin the current period to make the statements more meaningful. The TPA is interpreted to suggest that in disclosingthe change in the fiscal year, the notes to the financial statements should state whether the effect was to decreasenet income or increase net income, e.g., if, as a result of seasonal differences, the company normally experienceslosses during the months not included in the current period. If the effect is measurable, i.e., the net income for themonths excluded is known, the amount should be disclosed. Best practices indicate that disclosures should bemade whenever the year of change is presented, e.g., in comparative financial statements. The short�year financialstatements may be presented in comparative form with complete years so long as the change in fiscal year isdisclosed, and the financial statements are appropriately captioned such as illustrated below.

� ABC COMPANYBALANCE SHEETSDecember 31, 20X2 and June 30, 20X2

December 31,20X2

June 30,20X2

� ABC COMPANYSTATEMENTS OF INCOMESix Months Ended December 31, 20X2�and Year Ended June 30, 20X2

Six Months EndedDecember 31,

20X2

Year EndedJune 30,

20X2

The following illustrates disclosing the change in the notes:

NOTE BFISCAL YEAR CHANGE

Effective the calendar year beginning January 1, 20X3, the Company will change from a fiscalyear end of June 30 to December 31. A six�month fiscal transition period from July 1, 20X2through December 31, 20X2, precedes the start of the new calendar�year cycle.


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Changes in Depreciable Lives of Assets or the Methods of Depreciation

Changes in the depreciable lives of assets or the methods of depreciation for income tax purposes usually onlyoccur prospectively, with changes in the accelerated depreciation rules for future asset acquisitions. Under FASBASC 250�10�45�17 through 45�19 (formerly SFAS No. 154):

a. The adoption of a depreciation method and the estimate of useful life for a newly acquired asset is not anaccounting change. However, as a practical matter, the adoption of a depreciation method or estimate ofuseful life for newly acquired assets that is different than that of similar existing assets should lead toconsideration of whether the method or estimate of useful life continues to be appropriate for those existingassets.

b. A change in the method of depreciating existing assets is a change in accounting estimate that is effectedby a change in accounting principle. Accordingly, that change should be accounted for prospectively. Asan observation, FASB ASC 250�10�45�20 (formerly SFAS No. 154) does not view a planned change froman accelerated method to the straight�line method at a prescribed point in the estimated useful life of anasset as a change in accounting principle or a change in estimate.


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SELF�STUDY QUIZ


1. According to FASB ASC 740 (formerly FIN 48, �Accounting for Uncertainty in Income Taxes�an Interpretationof FASB Statement No. 109"), when would a current tax benefit that is realized through a deduction in a taxreturn be recognized in the financial statements?

a. Only after the taxing authority examined and approved the deduction.

b. During the same reporting period that the tax benefit is realized in the tax return.

c. When it meets the �more likely than not" criterion.

2. A taxing authority recently examined Ace Corporation's tax return and disallowed a deduction in the returnwhich Ace had determined would be allowed. What action must Ace now take in regard to its financialreporting?

a. Ace will pay the additional tax assessed and debit the liability account for the previously deferred taxbenefit.

b. Ace will pay the additional tax assessed and debit the current tax provision for the current year.

c. Ace will debit the current tax provision and credit a liability for the deferred tax benefit.

d. Ace would not need to take any action since it did not defer the realized tax benefit.

3. According to Accounting Standards Update (ASU) 2009�06, if income taxes paid by the entity are attributableto the entity, the entity should do which of the following?

a. Be accounted for as a transaction with owners.

b. Be accounted for following the FASB ASC 740 provisions.

4. Which of the following changes in the accounting treatment of a material item for tax purposes results in areversal of previous temporary differences and deferred taxes related to that item on the financial statements?

a. When the change for tax purposes is to the method used for financial reporting purposes.

b. When the company uses the tax basis for financial reporting purposes.

c. When the company changes to a different method from the method used for financial reporting purposes.

5. Which of the following choices is considered a change in accounting principle or change in estimate?

a. Arbor Creek Company changes from the double declining depreciation method to the straight�line methodat a certain point in the estimated useful lives of the assets.

b. Arbor Creek Company purchases a new piece of equipment and adopts a depreciation method for the newpiece of equipment that is different than that of similar existing assets.

c. Arbor Creek Company uses a new method of estimating the useful life of an asset when it acquires the newasset.

d. Arbor Creek Company changed the method in which it depreciates its existing assets.


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1. According to FASB ASC 740 (formerly FIN 48, �Accounting for Uncertainty in Income Taxes�an Interpretationof FASB Statement No. 109"), when would a current tax benefit that is realized through a deduction in a taxreturn be recognized in the financial statements? (Page 109)

a. Only after the taxing authority examined and approved the deduction. [This answer is incorrect. If a taxposition is positively settled through examination, it is allowed to be recognized in the financial statements.However, FASB ASC 740 provides a guideline, which if met, allows the expense to be recognized in thefinancial statements before it is examined by the taxing authority, because not all tax positions taken byentities are actually examined by taxing authorities.]

b. During the same reporting period that the tax benefit is realized in the tax return. [This answer is incorrect.Not all current tax benefits realized in a tax return are recognized during the same period in the financialstatements. The recognition in the financial statements may be deferred. Therefore, a tax liability may berecorded in the financial statements for those tax positions that do not meet the criteria in FASB ASC 740.]

c. When it meets the �more likely than not" criterion. [This answer is correct. When evaluating whethera tax position taken on the current tax return meets the FASB ASC 740 criterion, the tax positionshould be examined to determine if would be sustained if the taxing authority examined it. If thecriterion is met, it would be recognized in the financial statements.]

2. A taxing authority recently examined Ace Corporation's tax return and disallowed a deduction in the returnwhich Ace had determined would be allowed. What action must Ace now take in regard to its financialreporting? (Page 109)

a. Ace will pay the additional tax assessed and debit the liability account for the previously deferred taxbenefit. [This answer is incorrect. Since Ace had determined that the deduction would �more likely thannot" be sustained upon examination, the entity did not defer the realized tax benefit. This answer choicewould be correct if Ace had deferred the realized tax benefit.]

b. Ace will pay the additional tax assessed and debit the current tax provision for the current year. [Thisanswer is correct. Ace owes tax on the disallowed deduction. Since the entity realized the deductionon its financial statements, the disallowance will affect earnings. The entity will credit cash and debitthe current tax provision for the current year.]

c. Ace will debit the current tax provision and credit a liability for the deferred tax benefit. [This answer isincorrect. This answer choice would be correct if Ace had deferred a position or similar positions in yearsstill subject to examination and decided the previously recognized tax benefit should be derecognized.]

d. Ace would not need to take any action since it did not defer the realized tax benefit. [This answer isincorrect. Ace did not defer the realized tax benefit, but the entity would still have to take action for thedisallowance of the deduction which would include payment of the tax assessment.]

3. According to Accounting Standards Update (ASU) 2009�06, if income taxes paid by the entity are attributableto the entity, the entity should do which of the following? (Page 110)

a. Be accounted for as a transaction with owners. [This answer is incorrect. According to ASU No. 2009�06,if income taxes paid by the entity are attributable to the owners, they should be accounted for as atransaction with the owners.]

b. Be accounted for following the FASB ASC 740 provisions. [This answer is correct. According to ASUNo. 2009�06,if income taxes paid by the entity are attributable to the entity, they should be accountedfor following the provisions of FASB ASC 740 (formerly SFAS No. 109, Accounting for Income Taxes.]


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4. Which of the following changes in the accounting treatment of a material item for tax purposes results in areversal of previous temporary differences and deferred taxes related to that item on the financial statements?(Page 111)

a. When the change for tax purposes is to the method used for financial reporting purposes. [Thisanswer is correct. When a company changes the accounting treatment of a material item for taxpurposes to the method used for financial reporting purposes, the previous temporary differencesand deferred taxes related to the item will reverse. Sometimes the reversal occurs in the year ofchange, and other times it occurs over a prescribed period. General guidance can be found in FASBASC 250�10�45�5 and 45�12.]

b. When the company uses the tax basis for financial reporting purposes. [This answer is incorrect. When thecompany uses the tax basis for financial reporting purposes, the recommendation is to record anadjustment as a deferred item and amortize it to earnings as it is charged to taxable income.]

c. When the company changes to a different method from the method used for financial reporting purposes.[This answer is incorrect. If the company changes the accounting treatment of a material item for taxpurposes from the method used for financial reporting purposes to a different method, temporarydifferences would be created and deferred taxes would usually be recognized.]

5. Which of the following choices is considered a change in accounting principle or change in estimate?(Page 113)

a. Arbor Creek Company changes from the double declining depreciation method to the straight�line methodat a certain point in the estimated useful lives of the assets. [This answer is incorrect. SFAS No. 154 doesnot view a planned change from an accelerated method to the straight�line method at a prescribed pointin the estimated useful life of an asset as a change in accounting principle or a change in estimate.]

b. Arbor Creek Company purchases a new piece of equipment and adopts a depreciation method for the newpiece of equipment that is different than that of similar existing assets. [This answer is incorrect. Accordingto FASB ASC 250�10�45�17 and 45�19, the adoption of a depreciation method for a newly acquired assetis not an accounting change.]

c. Arbor Creek Company uses a new method of estimating the useful life of an asset when it acquires the newasset. [This answer is incorrect. The adoption of the estimate of useful life for a newly acquired asset is notan accounting change according to FASB ASC 250�10�45 and 45�19. However, the adoption of an estimateof useful life for newly acquired assets that is different than that of similar existing assets should lead toconsideration of whether the method or estimate of useful life continues to be appropriate for those existingassets.]

d. Arbor Creek Company changed the method in which it depreciates its existing assets. [This answeris correct. If a company changes the method of depreciating existing assets, it is considered achange in accounting estimate that is effected by a change in accounting principle according toFASB ASC 250�10�45 and 45�19. That change should be accounted for prospectively.]


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THE CAPITALIZATION OF ASSETS AND CONSIDERATIONS REGARDINGVALUATION

Inventory Costs for Manufacturers, Wholesalers, and Retailers

Prior to the Tax Reform Act of 1986 (TRA), manufacturers were required to capitalize direct material and labor andcertain indirect production costs for tax reporting. The capitalization of indirect production costs was determinedaccording to three categories: category one costs were required to be included in inventory, category two costswere not required to be included in inventory, and category three costs were required to follow the treatment infinancial statements prepared in conformity with GAAP. TRA affects category three by requiring most of those coststo be capitalized regardless of their financial statement treatment. The following are examples of category threecosts that were often expensed in the financial statements and tax returns prior to TRA but are now required to becapitalized for tax reporting:

a. Warehousing costs such as rent or depreciation, insurance premiums, and property taxes attributable toa warehouse

b. Cost of recruiting, hiring, relocating, assigning, and maintaining personnel records of employees whoselabor costs are allocable to inventories

c. Accounting and data services operations related to inventory activities, including cost accounting andaccounts payable

But perhaps the most dramatic changes in inventory capitalization rules are the TRA requirements for certainwholesalers and retailers. Prior to TRA, wholesalers and retailers normally only capitalized as inventory costs theinvoice price and transportation and other direct costs incurred in acquiring the goods. Under TRA, wholesalersand retailers with average annual gross receipts over $10 million are required to capitalize indirect costs similar tothe category three indirect costs for manufacturers. Therefore, they are required to capitalize costs such as thefollowing:

a. Costs incidental to the purchasing activity (such as wages of employees responsible for purchasing)

b. Handling, processing, repackaging, assembly, and similar costs, including labor costs attributable tounloading goods and loading goods for shipment to retail facilities (but not including labor costsattributable to loading of goods for final shipment to customers)

c. Cost of storing goods (for example, rent or depreciation, insurance premiums and taxes attributable to thewarehouse, security costs, and wages of warehouse personnel)

d. The portion of general and administrative costs allocable to the preceding functions (which are generallythe same as items b. and c. in the preceding list)

The FASB's Emerging Issues Task Force (EITF) studied whether the types of costs that are required to be allocatedto inventories under TRA would be capitalizable under GAAP and, if so, whether the new costing method would bea preferable method for purposes of justifying a change in accounting principle. In FASB ASC 330�10�55�3 (formerlyIssue No. 86�46), the EITF concluded that a cost capitalizable for tax purposes does not, in itself, indicate that it ispreferable, or even appropriate, to capitalize that cost for financial reporting purposes. Factors such as the natureof the company's operation and industry practice should be considered in determining whether certain of theadditional costs required to be capitalized for tax purposes also may be capitalized for financial reporting purposes.A conclusion about whether the TRA rules meet GAAP capitalization requirements for a company requires anassessment of whether they are met because of a change in circumstances, e.g., a change in the productionprocess, or because generally accepted accounting principles were applied incorrectly in prior periods. A changein circumstances would be accounted for prospectively and would not require adjustment of beginning inventories,but a correction of an error, if material, would require beginning inventories to be adjusted through a restatement ofretained earnings. Best practices do not indicate that a change in tax law is a change in circumstances for GAAPreporting and it will be difficult to identify a change in circumstance that justifies a change in accounting for the


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types of costs covered by TRA's requirements. In addition, best practices indicate that a conclusion that the typesof costs covered by TRA should have been capitalized in prior GAAP financial statements requires consideration ofwhether they should also have been capitalized for tax reporting, particularly for category three costs of manufac�turers.

A nonauthoritative AICPA Technical Practice Aid at TIS 2140.01 provides guidance on capitalized warehousingcosts. Part of the TPA is reproduced below.

InquiryA client deals in wholesaling and retailing automotive tires for foreign cars. Most of theinventory is imported, and it is valued on the company's records at the actual inventory cost plusfreight�in. At year�end, the warehousing costs are prorated over costs of goods sold and endinginventory. The company's auditor believes the warehousing costs should not be capitalized toinventory, but the entire amount should be expensed in the year the costs are incurred. Arewarehousing costs considered to be product costs or period costs?

ReplyFASB ASC 330�10�30�1 (formerly Statement 3 of Chapter 4, ARB No. 43) states in part:

As applied to inventories, cost means in principle the sum of the applicable expenditures andcharges directly or indirectly incurred in bringing an article to its existing condition and location.

Costs of delivering the goods from the warehouse would be considered a selling expense andshould not be allocated to the goods that are still in the warehouse.

The TPA also quotes an accounting textbook that states it would seem reasonable to allocate to inventories a shareof storage and warehousing costs. However, the quote states that such costs usually are not included in valuinginventories due to the practical difficulties in allocating such costs. Following the guidance in FASB ASC330�10�30�8 (formerly ARB No. 43), best practices indicate that general and administrative expenses such asaccounting and data processing services and officers' salaries related to selling, general, and administrativefunctions ordinarily should not be capitalized as inventory costs for financial reporting.

Construction Period Interest and Real Estate Taxes

Current tax requirements for capitalizing construction period interest and real estate taxes, as summarized below,generally conform with the GAAP requirements:

� Tax law requires capitalizing construction period interest and real estate taxes for real property, tangiblepersonal property with an estimated life of more than 20 years, other tangible personal property requiringtwo or more years to produce or construct, and tangible personal property that has a value in excess of$1 million and requires more than one year to produce or construct. Those types of assets would generallyqualify for similar treatment under GAAP.

� Interest to be capitalized includes costs incurred on debt both directly and indirectly attributable toconstruction or production, which generally is consistent with the GAAP requirement to capitalize intereston directly related debt and to use a weighted average rate for all other debt.

� Capitalized interest and taxes should be added to the basis of the property and depreciated accordingly,which is consistent with the GAAP requirement to treat interest and taxes as a cost of acquiring the asset.

Because current tax law and GAAP requirements are similar, construction period interest and taxes incurred oncurrent projects usually will not generate temporary differences.

Long�term Contracts for Construction Contractors and Manufacturers

Generally accepted accounting principles require using the percentage�of�completion method to recognizeincome under most long�term contracts. Historically, the completed�contract method generally could be used fortax purposes to defer income from those contracts until the contract was substantially complete. As a result of the1989 Tax Act, however, companies must report all of their contract earnings using the percentage�of�completion


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method. (The percentage�of�completion method applies to all long�term contracts, including those of manufactur�ers and those of construction contractors. However, companies that have average annual gross receipts of $10million or less during the three taxable years preceding the taxable year in which a contract is entered into and thatestimate a real property contract will be completed within two years or that a manufacturing contract will becompleted within one year are exempt from using the percentage�of�completion method. Current tax law alsoexempts certain home construction contracts and allows applying the percentage�of�completioncapitalized costmethod on a 70%�30% basis for other residential contracts.)

GAAP permits two general approaches to determining the percentage of completion; input methods base thepercentage on efforts devoted to a contract, and output methods base the percentage on results achieved. Themethods may be applied in a variety of ways. For example, input methods are commonly based on either contractcosts, engineering estimates, or direct labor hours. Best practices indicate that the tax law definition is consistentwith an input method based on contract costs. The percentage of completion is to be determined as the percent�age of costs incurred to total estimated contract costs, and costs directly and indirectly related to the constructionprocess are required to be capitalized. Thus, if a company uses the percentage�of�completion method to accountfor all of its earnings under long�term contracts for tax reporting, the same method usually will be acceptable forGAAP. If companies use the modified method of applying the percentage of completion, however, a temporarydifference will arise for the portion reported under a method other than the percentage�of�completion method.

Liquidations

Tax Attributes. Current tax law requires a taxable gain to be recognized for appreciation of assets distributed aspart of a liquidation. For tax purposes, the gain is recognized when the assets are distributed.

Accounting under GAAP. Best practices indicate that if liquidation of an entity appears imminent, financialinformation may be prepared on the assumption that liquidation will occur. An auditing interpretation at AU9508.33�.37 states that a liquidation basis of accounting may be considered generally accepted accountingprinciples for entities in liquidation or for which liquidation appears imminent. An example of when the liquidationbasis may not be appropriate is when management has the intention and capability of waiting for a certain price.Best practices indicate that the liquidation basis usually involves reporting assets at net realizable values, i.e., theamounts of cash expected to be received.

For financial statement purposes, the value of assets generally will be converted to market value when liquidationis imminent. The resulting adjustments to record assets at market value will trigger the recognition of gains andlosses. In other words, gains and losses will be recognized in the financial statements before they are realized.When gains and losses are realized, an entry should be made debiting cash (or a receivable account), crediting theasset account, and recognizing an additional gain or loss if the amount realized from liquidation of the assets differsfrom the market value at the time the assets were converted to liquidation basis.

Since the liquidation basis is GAAP for companies in liquidation, this course views the adjustments to the amountof gain or loss described in the preceding paragraph as changes in estimates and, accordingly, believe they shouldbe reflected in earnings in the year they can be estimated. Note that deferral would not be appropriate since deferralcustomarily implies that recognition will occur in the future. Similarly, best practices do not indicate that restatementwould be appropriate since the change is within GAAP instead of from GAAP to an OCBOA.

In October 2008 the FASB issued an exposure draft of a proposed Statement of Financial Accounting Standardstitled Going Concern. There are two primary objectives of this proposed statement: (a) to address the preparationof financial statements as a going concern and an entity's responsibility to evaluate its ability to continue as a goingconcern and (b) to address disclosure requirements when financial statements are not prepared on a goingconcern basis and when there is substantial doubt as to an entity's ability to continue as a going concern.

The FASB's goal is for the guidance to converge with the guidance in the international accounting standards andthe auditing literature. The comment period ends on December 8, 2008 and the proposed effective date is forfinancial statements issued after the FASB Codification is ratified. The FASB decided not to address the liquidationbasis of accounting as part of this project. Future editions of this course will update the status of this project.

Although tax requirements to recognize a gain or loss on liquidation are consistent with GAAP requirements, thetiming of recognition is different. For tax purposes, the gain or loss is recognized on distribution of the assets. As


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explained in the preceding paragraphs, however, the gain or loss is recognized when liquidation is imminent inGAAP presentations. Accordingly, once liquidation appears imminent, GAAP presentations prior to actual liquida�tion should provide for the deferred tax liability related to the gain or the deferred tax asset related to the loss thathas been recognized in the financial statements but deferred to a future period for tax reporting.

The amount of gain or loss for GAAP reporting may differ from the taxable gain or loss because of depreciationdifferences. If so, prior�period financial statements should have provided for the deferred tax effect of the depreci�ation differences.

Illustration. The following example illustrates the gain to be reported for financial statement and tax purposes:

FINANCIAL STATEMENTS INCOME TAX

Fair value of real estate to be distributedin liquidation $ 500,000 $ 500,000

Cost of real estate $ 300,000 $ 300,000

Accumulated depreciation 100,000 200,000

Undepreciated cost 200,000 100,000

Gain $ 300,000 $ 400,000

The $500,000 basis of the real estate for financial reporting exceeds its tax basis ($100,000) by $400,000. Bestpractices indicate that the taxable temporary difference normally should be expected to reverse in the year ofdistribution. Ignoring state taxes and assuming a 30% tax rate, the deferred tax liability should be increased to$120,000 (that is, $400,000 � 30%). Assuming a deferred tax liability of $30,000 had been provided previously forthe $100,000 taxable difference (that is, the excess of the financial basis of $200,000 over the tax basis of $100,000),the following entry would be made:

Real estate $ 200,000Accumulated depreciation 100,000Tax provision 90,000

Gain from appreciation $ 300,000Deferred tax liability 90,000

The following entry would record distribution of the property:

Deferred tax liability $ 120,000Equity 500,000

Real estate $ 500,000Taxes payable (30% �

$400,000) 120,000

Reorganization under the Bankruptcy Code

Companies filing petitions for bankruptcy do so either as a reorganization under Chapter 11 of the BankruptcyCode or as a liquidation under Chapter 7. Guidance on accounting for reorganizations is provided by FASB ASC852�10 (formerly AICPA Statement of Position 90�7, Financial Reporting by Entities in Reorganization Under theBankruptcy Code) and PPC's Guide to Troubled Businesses and Bankruptcies.

Under this guidance, special financial statement considerations occur on two dates: the date the petition is filedand the date the plan of reorganization is approved by the bankruptcy court. When the petition is filed, the companyformally begins reorganization proceedings. On that date the presentation of liabilities is changed to distinguish thestatus of creditors in the proceedings, and the results of operations and cash flows related to the proceedings arepresented separately from normal operations. When the plan of reorganization is approved, liabilities are adjustedto the amounts ordered by the bankruptcy court. In addition, if certain conditions are met, assets are revalued totheir current values, retained earnings or accumulated deficit is eliminated, and the company is treated as a newreporting entity.


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Prior to filing the petition for bankruptcy, there are no special financial statement considerations. Therefore, if acompany is preparing its financial statements for the year ended December 31, 20X0, and files a petition in March20X1 before those statements are issued, no measurement or presentation considerations would be reflected in thestatements. The bankruptcy filing would merely be disclosed as a subsequent event.

General Financial Statement Considerations during Chapter 11 Proceedings. The general concept of aChapter 11 reorganization is that the company is a going concern. Therefore, the financial statements duringreorganization should be presented for the customary reporting periods. For example, a company that prepares itsfinancial statements on a calendar�year basis and files its petition in June 20X1 would still present a balance sheetas of December 31, 20X1, and statements of income and retained earnings and cash flows for the year then ended.Although not prohibited, it is recommend that financial statements for earlier years not be presented in comparison,however, since the operations are not comparable, and presentation considerations are different. Some companiesprefer to add a parenthetical caption to financial statement titles such as �Debtor in Possession" to emphasize thatthe company is in bankruptcy proceedings. Best practices indicate, however, that the presentation of the financialstatements and the disclosure in the accompanying notes adequately disclose that fact. Thus, there is no need tomodify financial statement titles or headings.

Balance Sheet Considerations during Chapter 11 Proceedings. Unlike liquidation accounting, the carryingamounts of assets should not be adjusted unless there is an impairment of value. Liabilities also should not beadjusted even if the company believes that they will be settled for less than their carrying amounts. Under a Chapter11 reorganization, liabilities are generally classified as follows:

a. Prepetition liabilities are incurred prior to filing the petition for bankruptcy. They are the liabilities from whichthe company is seeking relief and, thus, are the only liabilities that are subject to compromise. Prepetitionliabilities consist of the following general classes:

(1) Secured claims are liabilities that are secured by collateral with a value at least equal to the amountof the claim.

(2) Undersecured claims are liabilities that are secured by collateral with a value that is less than theamount of the claim.

(3) Unsecured claims are liabilities that are not secured. They generally include the excess ofundersecured claims over the value of the collateral, trade creditors, legal and accounting feesincurred before the petition is filed, and claims under executory contracts such as terminatedoperating leases.

b. Postpetition liabilities are incurred after the petition is filed and are not subject to compromise. Generally,they are incurred only with the permission of the bankruptcy court.

The carrying amount of liabilities of companies in Chapter 11 proceedings is determined the same as for othercompanies. Claims are measured and recorded following the requirements of FASB ASC 450�20 (formerly SFASNo.�5). If the court subsequently allows a claim that is different from the recorded amount, the carrying amount ofthe liability should be adjusted and a gain or loss charged to the results of operations.

The presentation of assets and the components of stockholders' equity in the balance sheet of a company inChapter 11 proceedings is generally the same as for other companies. The presentation of the company's liabilitiesis different, however. The presentation must distinguish between liabilities that are subject to compromise (i.e.,unsecured or undersecured claims) and those that are not (i.e., secured prepetition debt and postpetition liabili�ties). Liabilities subject to compromise should be presented together as unclassified liabilities. Their componentsshould be disclosed either as line items in the balance sheet or in the notes to the financial statements. Liabilitiesnot subject to compromise should be classified as current or noncurrent. The following illustrates the appropriatebalance sheet presentation of liabilities:


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LIABILITIES NOT SUBJECT TO COMPROMISE

Current

Short�term bank note $ 50,000

Current portion of fully secured long�term note 20,000

Postpetition trade accounts payable 70,000

Accrued postpetition expenses 10,000

150,000

Fully secured long�term note, less current portion 300,000

450,000

LIABILITIES SUBJECT TO COMPROMISE

Subordinated note 200,000

Prepetition trade accounts payable 100,000

300,000

Income Statement Considerations during Chapter 11 Proceedings. The income statement of a companyduring Chapter 11 proceedings should present the results of reorganization activities separately from other activi�ties. Reorganization activities include revenues, expenses, realized gains and losses, and provisions for losses thatwould not have arisen if the company were not reorganizing. The following are common results of reorganizationactivities:

� Gains and losses may arise from the sale of assets specifically intended to generate cash to liquidatecreditors' claims. For example, a bank may, with the bankruptcy court's permission, foreclose oninvestment land securing its note.

� As a result of the stay on payments during bankruptcy proceedings, a company may accumulate largercash balances than normal. Interest earned on those excess cash balances should be considered to beincome from reorganization activities.

� Legal and accounting fees may be incurred in connection with the proceedings and charged to operationswhen incurred as a reorganization activity. The criteria for capitalizing expenses incurred by a company inreorganization proceedings are the same as for other companies.

If the proceedings reduce interest during the reorganization period, the reduced interest expense recognizedshould be charged to operations rather than reorganization activities. In addition, the difference between the actualinterest and contractual interest should be disclosed.

If generally accepted accounting principles require that a gain or loss be recognized, those requirements should befollowed even if the gain or loss arose in connection with the reorganization. For example, if a component of anentity is disposed of to provide cash for liquidation of prepetition liabilities, the gain or loss would not be includedin reorganization items. Instead, it would be accounted for as the disposal of a component.

Reorganization items should be disclosed as unusual or infrequently occurring items. Accordingly, they should notbe presented net of income taxes. All other presentation considerations are the same as for companies not inChapter 11 proceedings. The following illustrates the presentation of an income statement of a retail companyduring Chapter 11 proceedings:

SALES $ 1,000,000

COST OF MERCHANDISE SOLD 600,000

GROSS PROFIT 400,000


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OPERATING EXPENSES

Selling

Advertising 40,000

Compensation 100,000

Other 60,000

Administrative

Compensation 80,000

Interest, less $10,000 reduction below stated rates 5,000

Other 15,000

300,000

INCOME BEFORE REORGANIZATION ITEMSAND INCOME TAXES 100,000

REORGANIZATION ITEMS

Loss on disposal of stores (100,000 )

Legal and accounting fees (25,000 )

Interest income on cash accumulated during Chapter 11 proceedings 5,000

(120,000 )

LOSS BEFORE INCOME TAXES (20,000 )

INCOME TAX BENEFIT 5,000

NET LOSS (15,000 )

BEGINNING ACCUMULATED DEFICIT (300,000 )

ENDING ACCUMULATED DEFICIT $ (315,000 )

Statement of Cash Flows Considerations during Chapter 11 Proceedings. Reorganization items should bedisclosed separately within the operating, investing, and financing categories of the statement of cash flows. FASBASC 852�10 (formerly SOP 90�7) states that the direct method is preferred. (If the indirect method is used, however,details of operating cash receipts and payments resulting from the reorganization must be disclosed.) The follow�ing illustrates an appropriate presentation:

CASH FLOWS FROM OPERATING ACTIVITIES

Collections from customers $ 1,200,000

Cash paid to suppliers for merchandise (500,000 )

Cash paid to employees and other suppliers (295,000 )

Cash paid for interest (5,000 )

400,000

Reorganization items

Interest received on cash accumulated during Chapter 11 proceedings 5,000

Payment of legal and accounting fees (25,000 )

380,000

CASH FLOWS FROM INVESTING ACTIVITIES

Cash received from disposal of stores 300,000

CASH FLOWS FROM FINANCING ACTIVITIES

Cash received from short�term loans 50,000

Principal payments of prepetition debt (250,000 )

(200,000 )


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INCREASE IN CASH 480,000

BEGINNING CASH OVERDRAFT (20,000 )

ENDING CASH $ 460,000

The reconciliation of net income with net cash provided by operating activities should be disclosed either on thestatement or in the notes to the financial statements. This course recommends disclosure in the notes, however,because adding the reconciliation to the statement is distracting. The reconciliation should be prepared similarly tothose for companies not in Chapter 11 proceedings. There is no need to disclose reconciling adjustments relatedto the reorganization separately from other adjustments.

Disclosure Considerations during Chapter 11 Proceedings. The disclosures required by generally acceptedaccounting principles apply to financial statements of companies in Chapter 11 proceedings. Therefore, compa�nies are still required to disclose significant accounting policies, minimum lease payments due under existingleases, maturities of long�term debt, and other items. Although FASB ASC 852�10 (formerly SOP 90�7) adds nodisclosure requirements, this course suggest the notes to the financial statements should include a disclosure thatthe company is in Chapter 11 proceedings as the first note in the summary of significant accounting policies. Thefollowing is an example of an appropriate note:

NOTE ASUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Reorganization under Bankruptcy Proceedings

In June 20X1 the Company filed petitions under Chapter 11 of the Bankruptcy laws. This gener�ally delays payment of liabilities incurred prior to filing those petitions while the Company devel�ops a plan of reorganization that is satisfactory to its creditors and allows it to continue as a goingconcern. The carrying amounts of assets and liabilities are unaffected by the proceedings, butliabilities are presented according to the status of the creditors.

Best practices indicate that other effects of the proceedings can most conveniently be disclosed in separate notes.To illustrate, the disclosure of long�term debt might be modified as follows:

NOTE HLONG�TERM NOTES

Long�term notes consist of the following:

Note to a bank that is payable in monthly installments of $1,000 plus interestat 10%, secured by the Company's operating real estate, and provides thebank with the right to petition the court to permit it to foreclose against theproperty $ 300,000

Note to a former stockholder that is payable in quarterly installments of$5,000, including interest at 12%, and secured by a subordinated interestin the Company's operating real estate that effectively places it in the roleof an unsecured creditor 100,000

Special Considerations for Consolidated Financial Statements during Chapter 11 Proceedings. If some, butnot all, of the companies reflected in consolidated financial statements are in Chapter 11 proceedings, theconsolidated statements should provide separate disclosure of the combined results of those companies.

Financial Statement Considerations When a Company Emerges from Reorganization Proceedings. When theplan of reorganization is approved (i.e., confirmed) by the bankruptcy court, the company's financial statementsshould reflect the following:

a. Financial statements should be presented for customary reporting periods. For example, if the plan for acalendar�year company is approved in September 20X1, the financial statements for 20X1 would includeall transactions for the year.


126

b. Assets should only be adjusted for impairment of value.

c. Liabilities should be adjusted to the amounts reflected in the plan. Specifically, they should be adjusted tothe present value of amounts to be paid under the plan using appropriate current interest rates.

In certain circumstances, however, the company is essentially considered to be a new entity, and the basis of itsassets and liabilities should be adjusted to their fair values on the date the plan is approved (referred to as�fresh�start reporting"). Fresh�start reporting must be used if both of the following criteria are met:

a. The fair value of the assets of the emerging entity immediately before the date of plan approval is less thanthe total of all postpetition liabilities and allowed claims.

b. Holders of existing voting shares immediately before plan approval receive less than 50% of the votingshares of the emerging company.

Fresh�start reporting is appropriate provided the loss of control by the former stockholders is substantive and nottemporary. An entity emerging from bankruptcy that applies fresh�start reporting should follow only the accountingstandards in effect at the date fresh�start reporting is adopted, which include those standards eligible for earlyadoption if an election is made to adopt early.

The fair value (or reorganization value) of the emerging entity's assets is the price a willing buyer would pay for thecompany's assets immediately after emergence. It may be calculated using a variety of methods. It is oftencalculated by discounting cash flows, however, and consists of the following components:

a. The discounted cash flows determined for the prospective period

b. The present value of the business attributable to the period beyond the prospective period (referred to as�residual value" or �terminal value")

c. The current value of any excess working capital or other assets that are not needed in reorganization

If fresh�start reporting is appropriate, the reorganization value should be allocated to assets. Any excess reorgani�zation value should be reported as an intangible asset using the caption �Reorganization value in excess ofamounts allocable to identifiable assets." The intangible asset should be amortized or tested for impairment.

Deferred income taxes should be provided the same as for other businesses. Benefits realized from preconfirma�tion loss carryforwards should first reduce reorganization value in excess of amounts allocable to identifiableassets. Any excess preconfirmation loss carryforwards should be recorded as an addition to paid�in capital.

Since fresh�start reporting assumes the formation of a new entity, this course suggests that all transactions throughthe confirmation date (including the adjustments to assets and liabilities to reflect fresh�start reporting) should beincluded in the company's final financial statements. The adjustments should only be presented as extraordinaryitems in the final financial statements if they meet the criteria. Most adjustments normally will not meet the strict testsas both unusual and infrequent prescribed by FASB ASC 225�20�45�1 through 45�7 (formerly APB Opinion No. 30).

The first financial statements of the reorganized company should begin immediately after the confirmation date.They should report the fresh�start values, have no beginning retained earnings, and disclose the following:

a. Adjustments to the historical amounts of individual assets and liabilities

b. The amount of debt forgiveness

c. The amount of prior retained earnings or accumulated deficit eliminated

d. Significant matters relating to the determination of reorganization value such as the following:

(1) The method or methods used to determine reorganization value and factors such as discount rates,tax rates, the number of years for which prospective cash flows were developed, and the method ofdetermining terminal value


127

(2) Sensitive assumptions; that is, assumptions about which there is a reasonable possibility of theoccurrence of a variation that would have significantly affected measurement of reorganization value

(3) Assumptions about anticipated conditions that are expected to be different from current conditions,unless otherwise apparent

Financial statements after the confirmation date should not be presented in comparison with those for priorperiods.

Preconfirmation Contingencies. Some uncertainties usually remain at the reorganization date, such as

a. amounts to be ultimately realized from the sale of assets designated for sale in the confirmed plan,

b. nondischargeable claims, such as environmental issues, and

c. other claims that were estimated for purposes of voting on the reorganization plan.

Uncertainties that exist at the bankruptcy reorganization date are referred to as preconfirmation contingencies, andPractice Bulletin, No. 11, Accounting for Preconfirmation Contingencies in Fresh�Start Reporting, previously pro�vided guidance on accounting for them. However, because fresh�start reporting generally requires accounting forthe reorganization as a business combination, FASB ASC 805 [formerly SFAS No. 141(R)], should be applied. Thatguidance, which nullifies Practice Bulletin No. 11 for years beginning on or after December 15, 2008 with earlierapplication prohibited, states that preconfirmation contingencies should be accounted for as assets and liabilitiesarising from contingencies.

After that guidance becomes effective, under FASB ASC 805�20�25�19 through 25�20B [formerly Paragraph 24 ofSFAS No. 141(R), as amended], fresh�start reporting should result in recognizing an asset or liability for a preconfir�mation contingency only if

a. the fair value of the asset or liability can be determined during the measurement period or

b. information available before the end of the measurement period indicates that it is probable that an assetexisted or that a liability had been incurred at the date of reorganization and the amount of the asset orliability can be reasonably estimated.

The entity should also develop a system and a rational basis for subsequently measuring and accounting for assetsand liabilities arising from contingencies, depending on their nature.

Effect of Section 338 Rules on Financial Statements

If one company acquires the stock of another company, and the purchase price exceeds the acquired company'sbook value, Section 338 of the IRC provides an election that enables the acquiring company to treat the transactionas if it were a purchase of assets and to step up the basis of the acquired company's assets for tax purposes.

Current tax law requires using the residual method to allocate the purchase price of a business. Under thatapproach, individual assets and liabilities are valued at their fair value, and the excess of the purchase price overthe assigned values (or the �residual") is charged to goodwill. Goodwill acquired after August 10, 1993 may beamortized and deducted over 15 years for tax purposes. Under GAAP, however, the amount allocated to goodwillis not amortized but is tested for impairment at least annually.

Because the primary tax motivation for a Section 338 election is to increase depreciation and amortization deduc�tions arising from an increase in the basis of assets, when the purchase price is below the tax basis of the acquiredcompany, deductions are maximized by retaining the tax basis of the acquired corporation and, therefore, theSection 338 election would not be desirable.


128


129

SELF�STUDY QUIZ


6. How can the effect of the Tax Reform Act of 1986 on GAAP reporting be summarized?

a. If costs were capitalized in prior GAAP financial statements, the costs do not have to be capitalized for taxreporting under the TRA.

b. The change in tax law is most likely not a change in accounting for GAAP reporting.

c. The change in tax law is most likely considered an error correction for GAAP reporting purposes.

7. Which of the following methods of recognition of income is required by GAAP?

a. Completed�contract method.

b. Percentage�of�completion capitalized cost method.

c. Percentage�of�completion modified method.

d. Percentage�of�completion method.

8. Which of the following choices discloses the difference between tax and GAAP accounting for assets as a partof a liquidation?

a. The timing of the recognition of the gains or losses on the assets is different.

b. The gain or loss for GAAP reporting is the same as the amount for tax reporting.

c. The timing of the realization of the gains or losses occurs at different times.

d. The taxable temporary difference will reverse when liquidation appears imminent.

9. ABC Company filed for reorganization under Chapter 11 of the Bankruptcy Code. The company has a $100,000liability secured by an asset worth $55,000. How would the $45,000 in excess debt over the value of the assetbe classified?

a. It should be classified as a secured claim.

b. It should be classified as an undersecured claim.

c. It should be classified as an unsecured claim.

10. Which of the following income statement items would be charged to operating expenses during Chapter 11proceedings?

a. Interest earned on excess cash balances due to reorganization activities.

b. Interest expense incurred during reorganization at below contract rate.

c. Gains or losses from the sale of assets to generate cash for claims.

d. Losses from the disposal of stores due to reorganization activities.


130

11. How should the statement of cash flows be presented for a company during Chapter 11 proceedings?

a. The cash flows statement should not be presented with the standard categories: operating, investing, andfinancing activities.

b. This course suggests reconciling net income with net cash provided by operating activities directly on thestatement of cash flows.

c. The cash flows statement should be presented with four categories: operating, investing, and financingactivities, plus an additional category titled reorganization items.

d. The direct method of presenting the statement of cash flows is preferred when a company is in Chapter11 proceedings.

12. When the bankruptcy court approves the plan of reorganization, all of the following actions/presentationsshould be reflected in the financial statements except:

a. Assets are adjusted to their fair values on the date the plan is approved.

b. Liabilities are to be adjusted to the amounts approved by the bankruptcy court.

c. Customary reporting periods are used for financial reporting.

d. Assets are adjusted for impairment of value.

13. Which of the following choices follows the guidance for financial statements of an entity using fresh�startreporting?

a. Prepetition financial statements can be presented in comparison financial statements after confirmation.

b. Prior retained earnings (or the accumulated deficit) will be reset to zero for fresh�start reporting.

c. The total reorganization value should be allocated to physical assets. No intangible assets are to bereported.

d. The adjustments to assets and liabilities to reflect fresh�start reporting should be reported as extraordinaryitems.


131



6. How can the effect of the Tax Reform Act of 1986 on GAAP reporting be summarized? (Page 118)

a. If costs were capitalized in prior GAAP financial statements, the costs do not have to be capitalized for taxreporting under the TRA. [This answer is incorrect. The conclusion that the types of costs covered by TRAshould have been capitalized in prior GAAP financial statements requires consideration of whether theyshould also have been capitalized for tax reporting.]

b. The change in tax law is most likely not a change in accounting for GAAP reporting. [This answeris correct. Best practices do not indicate that a change in tax law is a change in circumstances forGAAP reporting and it will be difficult to identify a change in circumstance that justifies a changein accounting for the types of costs covered by TRA's requirements.]

c. The change in tax law is most likely considered an error correction for GAAP reporting purposes. [Thisanswer is incorrect. Beginning inventories would not be adjusted through a restatement of retainedearnings, because a change in tax law in this instance would not be considered as incorrectly appliedaccounting principles in prior periods.]

7. Which of the following methods of recognition of income is required by GAAP? (Page 120)

a. Completed�contract method. [This answer is incorrect. The completed contract method is not anacceptable method for reporting income under GAAP. Historically, the completed�contract methodgenerally could be used for tax purposes to defer income from most long�term contracts until the contractwas substantially complete. As a result of the 1989 Tax Act, companies must report all of their contractearnings using the percentage�of completion method unless exempted.]

b. Percentage�of�completion capitalized cost method. [This answer is incorrect. Current tax law exemptscertain home construction contracts and allows applying the percentage�of�completion�capitalized costmethod on a 70%�30% basis for other residential contracts. However, this method is not acceptable byGAAP.]

c. Percentage�of�completion modified method. [This answer is incorrect. If companies use the modifiedmethod of applying the percentage�of�completion method under tax reporting, a temporary difference willarise for the portion reported under a method other than the percentage�of�completion method since themodified method is not acceptable under GAAP.]

d. Percentage�of�completion method. [This answer is correct. Generally accepted accountingprinciples require using the percentage�of�completion method to recognize income under mostlong�term contracts. GAAP permits two general approaches to determining the percentage ofcompletionthe input method and the output method.]

8. Which of the following choices discloses the difference between tax and GAAP accounting for assets as a partof a liquidation? (Page 120)

a. The timing of the recognition of the gains or losses on the assets is different. [This answer is correct.Current tax law requires a taxable gain to be recognized for appreciation of assets distributed aspart of a liquidation. For tax purposes, the gain is recognized when the assets are actuallydistributed. For financial reporting purposes, the gain or loss is recognized when liquidation isimminent in GAAP presentations. The value of assets generally will be converted to market valueat that time.]

b. The gain or loss for GAAP reporting is the same as the amount for tax reporting. [This answer is incorrect.Depreciation differences between GAAP and tax reporting will cause the gain or loss for GAAP reporting


132

to be a different than the taxable gain or loss. Prior�period financial statements should have provided forthe deferred tax effect of the depreciation differences.]

c. The timing of the realization of the gains or losses occurs at different times. [This answer is incorrect. Whenthe liquidation occurs, the gains or losses will be realized for tax and accounting reporting by debiting cash(or a receivable account), crediting the asset account, and recording or adjusting the gain or loss.Realization occurs when the assets are actually distributed. However, recognition may occur at a differenttime than realization in GAAP presentations if the liquidation appears imminent.]

d. The taxable temporary difference will reverse when liquidation appears imminent. [This answer is incorrect.The taxable difference is expected to reverse in the year of distribution. The gain or loss is recognized whenliquidation is imminent in GAAP presentations. The GAAP presentations prior to actual liquidation willprovide for a deferred tax liability related to the gain or a deferred tax asset related to the loss that has beenrecognized in the financial statements but deferred to a future period for tax reporting.]

9. ABC Company filed for reorganization under Chapter 11 of the Bankruptcy Code. The company has a $100,000liability secured by an asset worth $55,000. How would the $45,000 in excess debt over the value of the assetbe classified? (Page 122)

a. It should be classified as a secured claim. [This answer is incorrect. Secured claims are liabilities that aresecured by collateral with a value at least equal to the amount of the claim. Since the value of the collateralis less than the liability amount, no part of this debt will be classified as a secured claim.]

b. It should be classified as an undersecured claim. [This answer is incorrect. Undersecured claims areliabilities that are secured by collateral with a value that is less than the amount of the claim. Since the valueof the collateral is less than the liability amount, the liability is undersecured. However, the $45,000 portionshould not be classified as undersecured.]

c. It should be classified as an unsecured claim. [This answer is correct. Unsecured claims areliabilities that are not secure. They generally include the excess of undersecured claims over thevalue of the collateral. Therefore, the $45,000 ($100,000 liability less $55,000 asset value) isclassified as an unsecured claim.]

10. Which of the following income statement items would be charged to operating expenses during Chapter 11proceedings? (Page 123)

a. Interest earned on excess cash balances due to reorganization activities. [This answer is incorrect. As aresult of the stay on payments during bankruptcy proceedings, a company may accumulate larger cashbalances than normal. Interest earned on those excess cash balances should be considered to be incomefrom reorganization activities.]

b. Interest expense incurred during reorganization at below contract rate. [This answer is correct. Ifthe proceedings reduce interest during the reorganization period, the reduced interest expenserecognized should be charged to operations rather than reorganization activities. Reorganizationactivities include revenues, expenses, realized gains and losses, and provisions for losses thatwould not have arisen if the company were not reorganizing. The interest expense would be incurredeven if the company were not in reorganization.]

c. Gains or losses from the sale of assets to generate cash for claims. [This answer is incorrect. Gains andlosses may arise from the sale of assets specifically intended to generate cash to liquidate creditors'claims. These gains and losses are classified as reorganization items.]

d. Losses from the disposal of stores due to reorganization activities. [This answer is incorrect. Losses dueto disposal of stores as instructed by the bankruptcy court are recorded on the balance sheet as areorganization item because the losses would not have arisen if the company were not reorganizing.]


133

11. How should the statement of cash flows be presented for a company during Chapter 11 proceedings?(Page 124)

a. The cash flows statement should not be presented with the standard categories: operating, investing, andfinancing activities. [This answer is incorrect. A company in Chapter 11 bankruptcy will still present thestatement of cash flows with the operating, investing, and financing activities categories. These threecategories are still important to the users of financial statements. However, the readers must be able todistinguish between cash receipts and payments resulting from regular operations and those resultingfrom the reorganization.]

b. This course suggests reconciling net income with net cash provided by operating activities directly on thestatement of cash flows. [This answer is incorrect. The reconciliation can be disclosed either on thestatement or in the notes to the financial statements. However, this course recommends disclosure in thenotes, because adding the reconciliation to the statement is distracting.]

c. The cash flows statement should be presented with four categories: operating, investing, and financingactivities, plus an additional category titled reorganization items. [This answer is incorrect. Reorganizationitems should be disclosed separately within the operating, investing, and financing categories of thestatement of cash flows.]

d. The direct method of presenting the statement of cash flows is preferred when a company is inChapter 11 proceedings. [This answer is correct. FASB ASC 852�10 (formerly SOP 90�7) states thatthe direct method is preferred. If the indirect method is used, details of operating cash receipts andpayments resulting from the reorganization must be disclosed.]

12. When the bankruptcy court approves the plan of reorganization, all of the following actions/presentationsshould be reflected in the financial statements except: (Page 125)

a. Assets are adjusted to their fair values on the date the plan is approved. [This answer is correct.Assets are not adjusted to their fair values unless the company is considered a new entity and�fresh�start reporting" is required.]

b. Liabilities are to be adjusted to the amounts approved by the bankruptcy court. [This answer is incorrect.Adjusting liabilities to the amounts reflected in the plan is an action that must be taken when the plan isapproved. Specifically, liabilities should be adjusted to the present value of amounts to be paid under theplan using appropriate current interest rates.]

c. Customary reporting periods are used for financial reporting. [This answer is incorrect. FASB ASC 852�10(formerly SOP 90�7) does not specify any special reporting periods. Therefore, the financial statements arepresented for customary reporting periods. For example, if the plan for a calendar�year company isapproved in September 20X1, the financial statements for 20X1 would include all transactions for the year.]

d. Assets are adjusted for impairment of value. [This answer is incorrect. Assets are to be adjusted if theirvalue is impaired. Adjustments are not allowed for any other reason unless the entity qualifies for�fresh�start reporting."]

13. Which of the following choices follows the guidance for financial statements of an entity using fresh�startreporting? (Page 126)

a. Prepetition financial statements can be presented in comparison financial statements after confirmation.[This answer is incorrect. Financial statements reporting fresh�start values should not be presented incomparison with those for prior periods.]

b. Prior retained earnings (or the accumulated deficit) will be reset to zero for fresh�start reporting.[This answer is correct. The first financial statements of the reorganized company should beginimmediately after the confirmation date. They should report the fresh�start values and have nobeginning retained earnings per FASB ASC 852�10 (formerly SOP 90�7).]


134

c. The total reorganization value should be allocated to physical assets. No intangible assets are to bereported. [This answer is incorrect. The reorganization value should be allocated to assets. Any excessreorganization value should be reported as an intangible asset using the caption �Reorganization valuein excess of amounts allocable to identifiable assets."]

d. The adjustments to assets and liabilities to reflect fresh�start reporting should be reported as extraordinaryitems. [This answer is incorrect. The adjustments should only be presented as extraordinary items in thefinal financial statements if they meet the criteria. Most adjustments normally will not meet the strict testsas both unusual and infrequent.]


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HOW TO ACCOUNT FOR INVESTMENTS IN PARTNERSHIPS

Brief Description and Tax Attributes

Income and losses from partnerships generally pass through to the partners in the proportion specified in thepartnership agreement. However, the deduction of losses by the partners is subject to two significant limitations:

� At�risk Rules. At�risk rules limit the amount of the deduction to the capital contributions adjusted forpass�through items, distributions, loans to the partnership, and the portion of recourse and qualifiednonrecourse partnership debt allocated to the partner. Disallowed losses under the at�risk rules may becarried forward indefinitely. Each year, loss carryforwards generally are added to any loss for the year, andthe total is subject to the at�risk rules to determine the deduction for the year. The at�risk rules generallyapply to partners that are individuals, estates, trusts, and C corporations in which 50% of the stock is ownedby no more than five individuals. (Although the rules do not apply to partnerships and S corporations thatare partners, they do apply to the individual partners or shareholders of such entities.)

� Passive Activity Rules. An investor is considered �passive" if it is not involved in the operations of theinvestee on a regular, continuous, and substantial basis. Under the Uniform Limited Partnership Act, limitedpartners are considered passive investors. Thus, income and losses allocated to them generally areconsidered to be from passive activities. In addition, general partners can be considered passive investors.Passive losses that satisfy the requirements for deduction under the at�risk rules are deductible, under thepassive activity rules, only to the extent they can be offset against passive income. Unused losses areavailable for offset against future passive income indefinitely. The passive activity rules apply to partnersthat are individuals, estates, trusts, C�corporations that are personal service corporations, andC�corporations in which 50% of the stock is owned by no more than five individuals. (Although the rulesdo not apply to partnerships and S�corporations that are partners, they do apply to the individual partnersor shareholders of such entities.)

Accounting under GAAP

Accounting for investments in partnerships is not directly addressed in authoritative literature. FASB ASC 323(formerly APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock) comes closestto being on point, although it applies specifically to investments in common stock. However, FASB ASC323�30�15�3; 323�30�35�2 (formerly AICPA Accounting Interpretation No. 2 of APB Opinion No. 18), while specifi�cally stating that FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) does not address investments in partner�ships, does state that many of those provisions of FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) areappropriate in accounting for such investments.

Based on GAAP corporations, partnerships, and proprietorships ordinarily should use the equity method ofaccounting for investments of 20% or more but less than 50% of a partnership or unincorporated joint venture.[FASB ASC 323�10�15�5 (formerly APB Opinion No. 18 only) applies to investments held by business entities. Itdoes not apply to investments held by nonbusiness entities (such as estates, trusts, and individuals).] However, forpartnerships in certain industries, e.g., oil and gas ventures, it may be appropriate for the investor to record in itsfinancial statements its prorata share of the assets, liabilities, revenues, and expenses of the venture. (Such apresentation may be appropriate if the investor owns an undivided interest in each of the venture's assets and isproportionately liable for its share of each of the venture's liabilities. However, the EITF concluded in FASB ASC323�30�25�1; 910�810�45�1; 930�810�45�1; and 932�810�45�1 (formerly Issue No. 00�1, �Investor Balance Sheet andIncome Statement Display under the Equity Method for Investments in Certain Partnerships and Other Ventures")that such a presentation is not appropriate for investments in unincorporated legal entities accounted for by theequity method unless the investee is in either the construction industry or an extractive industry that traditionally hasused that presentation.) For investments of less than 20%, the cost method generally should be used.

If the equity method is used to account for an investment in a partnership, e.g., when the investor has more than a20% interest and has the ability to exercise significant influence over partnership policies, the investor would recordits prorata share of partnership profits or losses by adjusting the carrying value of its investment in the partnership.

The equity method ordinarily is discontinued when the investment (and net advances) are reduced to zero.However, if the investor has guaranteed obligations of the partnership or is otherwise committed to provide further


136

financial support, losses should continue to be recorded by the investor to the extent of the additional fundscommitted. (See TIS 2220.12.) An investment in a partnership accounted for by the equity method that has beenreduced below zero should be presented as a liability in the balance sheet.

GAAP also states that the equity method is not a valid substitute for consolidation. Accountants should considerwhether FASB ASC 810 (formerly ARB No. 51) requires consolidation because the reporting entity controls thepartnership through a means other than ownership of a majority voting interest. FASB ASC 810 [formerly FIN 46(R)]provides guidance on criteria for determining when looking at nominal voting rights is not effective for determiningif the reporting entity has a controlling financial interest in the partnership and provides guidance on looking for acontrolling financial interest in those situations.

In addition, FASB ASC 810�20�25�3 through 25�5 (formerly EITF Issue No. 04�5, �Determining Whether a GeneralPartner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the LimitedPartners Have Certain Rights" establishes a presumption that the general partners in a limited partnership controlthat partnership, regardless of the extent of the general partners' ownership interests. The assessment of whetherthe rights of the limited partners should overcome that presumption is a matter of judgment that depends on thefacts and circumstances. The general partners do not control the limited partnership if the limited partners haveeither:

a. the substantive ability to dissolve (liquidate) the limited partnership or otherwise remove the generalpartners without cause, or

b. substantive participating rights.

Illustration

Assume that ABC Company, which is owned by three individuals, owns 10% of Cost Ltd. Partnership and 45% ofEquity Ltd. Partnership. Also, assume (a) that the cost method is considered appropriate for Cost Ltd. and theequity method for Equity Ltd., (b) that the losses from both limited partnerships are not considered to be frompassive activities for tax reporting, and (c) that the partnerships have no debt. Assume a 30% tax rate and thefollowing additional facts:

10% of Cost Ltd.

45% of Equity Ltd.

Original investment by ABC 1/1/X1 $ �50,000 $ 50,000

Prorata share of losses YE 12/31/X1 (75,000 ) (75,000 )

Loss deducted by ABC Company YE 12/31/X1 (50,000 ) (50,000 )

Additional contribution YE 12/31/X2 �40,000 40,000


Loss deducted by ABC Company YE 12/31/X2 (40,000 ) (40,000 )

Assuming no permanent decline in the value of the investments and that reduction of the equity method investmentbelow zero is appropriate, the combined investment in Cost Ltd. and Equity Ltd. should be presented in thefinancial statements as follows:

Balance Sheet

20X2 20X1

ASSETS

Investments and other assets

Cost Ltd. Partnership $ 90,000 $ 50,000

LIABILITIES

Share of deficiency in assets of Equity Ltd. Partnership 40,000 25,000


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Statement of Income

20X2 20X1

Other income (loss)

Share of loss of Equity Ltd. Partnership (55,000 ) (75,000 )

The difference between the amounts reported in the financial statements and the tax basis of the investments resultin temporary differences for which a deferred tax asset and liability would be provided as follows:

20X2 20X1

Investment in Cost Ltd.

Taxable difference

Financial basis $ 90,000 $ 50,000

Tax basis � �

$ 90,000 $ 50,000

Deferred tax liability $ 27,000 $ 15,000

Investment in Equity Ltd.

Deductible difference

Financial basis $ (40,000 ) $ (25,000 )

Tax basis � �

$ (40,000 ) $ (25,000 )

Deferred tax asset $ (12,000 ) $ (7,500 )

The losses deducted by ABC Company are limited to the amount at risk, but unused losses are available forcarryforward to future years. A deferred tax asset would be provided for them as follows:

20X2 20X1

Loss carryforward

Cost Ltd. $ 40,000 $ 25,000

Equity Ltd. 40,000 25,000

$ 80,000 $ 50,000

Deferred tax asset $ 24,000 $ 15,000

A valuation allowance would be provided if it is more likely than not that some or all of the deferred tax asset will notbe realized. The carryforwards are available indefinitely and are used when the tax basis of the investment isincreased, for example, through undistributed taxable income. (If the losses were considered to be from a passiveactivity, their use after meeting the at�risk rules would require future taxable income from passive activities. Theappropriate income could come from other passive activities, from the same passive activity, or from the sale of theinvestment.)

Assuming that no valuation allowance is needed for the deferred tax asset and that the losses deducted offset othertaxable income of ABC Company, the following tax benefits would be reported in the income statement of ABCCompany:


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20X2 20X1

Current benefitloss deducted � 30%

Cost Ltd. $ (12,000 ) $ (15,000 )

Equity Ltd. (12,000 ) (15,000 )

(24,000 ) (30,000 )

Deferred benefit

Increase in deferred tax liability 12,000 15,000

Increase in deferred tax asset

For deductible difference (4,500 ) (7,500 )

For loss carryforward (9,000 ) (15,000 )

(1,500 ) (7,500 )

$ (25,500 ) $ (37,500 )

The following reconciles the tax benefit that would be obtained by applying the assumed 30% with the benefitreported:

20X2 20X1

Benefit obtained by applying 30% to the loss reported inthe income statement $ (16,500 ) $ (22,500 )

Tax benefit of increase in loss carryforwards (9,000 ) (15,000 )

Benefit reported in the income statement $ (25,500 ) $ (37,500 )

Carryforwards of losses passed through from investees affect temporary differences. A carryforward of a lossdisallowed, either because of the at�risk rules or the passive activity rules, effectively is a deferral of a basisreduction for tax reporting. Thus, the recognition of a deferred tax asset for it is a reconciling item.

Difference between Book and Tax Earnings on Investments in Partnerships

For federal income tax purposes, partnerships may report earnings and losses to their partners on Schedule K�1 ofForm 1065 using a basis that differs from GAAP. Common examples are the partnership's use of the cash basis orits use of an accrual basis that differs from GAAP because, for example, contingent liabilities have not beenaccrued.

If the partnership's basis of accounting does not differ materially from GAAP, the investor partner could recognizeearnings and losses based on amounts reported in the K�1. As an example, assume that a corporation is a generalpartner in a partnership that leases an airplane and that the partnership uses the cash basis for tax reporting. If rentsare paid on completion of trips, unpaid operating expenses are not recorded, and the recovery period for the planeis significantly shorter than its estimated useful life, the understatement of operating expenses may offset theoverstatement of depreciation, and the K�1 earnings and losses might, therefore, approximate GAAP amounts.

If the partnership's K�1 amounts differ from its GAAP amounts, but the difference is not material to the investor'searnings, the K�1 earnings and losses could be recorded in the investor's GAAP financial statements. To illustrate,assume that in the preceding example the understatement of operating expenses was not offset by the overstate�ment of depreciation but that the net difference was not material to the investor's earnings. In that case, theunadjusted K�1 earnings could be recorded as the equity pick�up in the investor's financial statements. (Note thatin both examples, the cumulative difference also would have to be evaluated to determine whether the investmentaccount in the investor's balance sheet was materially misstated.)

However, if there is a material difference, the K�1 earnings and losses should be converted to GAAP. In many cases,the conversion of a few key items will bring the K�1 amounts materially close to GAAP, and a complete conversion


139

will be unnecessary. To illustrate, assume that a corporation is a general partner in a partnership that leases officefacilities constructed prior to 1987. If rents are collected in advance and unpaid expenses are insignificant, the onlymaterial difference from GAAP may arise from depreciating a building and amortizing capitalized interest overperiods that are significantly shorter than the building's estimated useful life. In that situation, building depreciationand interest amortization could be converted to GAAP, and the resulting earnings probably would not differmaterially from GAAP.

For tax purposes, investors recognize earnings based on the K�1 regardless of whether the investor and thepartnership use the same basis of accounting. Although the investor uses the equity method for both GAAP and taxreporting, a temporary difference between the amount of the equity pick�up for financial and tax purposes will ariseif the K�1 amounts differ materially from GAAP.

TRANSACTIONS INVOLVING PROPERTY AND EQUIPMENT

ACRS Depreciation

For tax purposes, property and equipment are depreciated on the Accelerated Cost Recovery System (ACRS),which eliminates the need to determine the useful life of an asset and narrows the selection of a depreciationmethod. The term ACRS to refer to tax depreciation for post�1980 acquisitions, including the modifications thatwere established by TRA. The following summarizes the major provisions of the modified ACRS system (dubbedMACRS):

a. Recovery periods of real property are 271/2 years for residential rental property and 39 years for all otherreal property. Recovery periods of personal property are prescribed based on classifying assets accordingto the Asset Depreciation Range (ADR) midpoint life as follows:

ADR Class Lives (in years) MACRS Recovery Period

4 or less 3 years

More than 4 but less than 10 5 years

10 or more but less than 16 7 years



25 or more 20 years

b. Depreciation methods are prescribed for the various recovery periods:

(1) Real propertyStraight�line method

(2) 3, 5, 7, and 10 year recovery classes200% declining balance method (with a switch to straight�lineat the midway point in the life of the asset to maximize deductions)

(3) 15 and 20 year recovery classes150% declining balance method (with a switch to straight�line atthe midway point in the life of the asset to maximize deductions)

(Salvage value is ignored in both the 150% and 200% declining balance methods.)

c. Conventions that determine the allowable depreciation for the year the assets are placed in service areprescribed for the recovery classes:

(1) Real propertyMid�month convention (Property is treated as placed in service halfway through themonth in which the property is actually put to use.)

(2) All otherHalf�year convention (which assumes that the property is depreciable for half of the taxableyear it is placed in service regardless of when the asset actually was acquired), except a mid�quarterconvention is required for all assets acquired during the year if more than 40% of the property is placedin service in the last quarter.

d. The expense allowance under Section 179.


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GAAP require the cost of depreciable assets to be allocated to expense over the expected useful lives of the assetsin a systematic manner. Many tax depreciation methods are used to stimulate investments by accelerating deduc�tions, and their statutory write�off periods for various assets are not intended to approximate the expected usefullives of the assets. Although taxpayers may elect the straight�line method for tax reporting, the tax methods stilldiffer from GAAP because the recovery period is prescribed and salvage value is not considered. As a result,differences between depreciation for financial and tax purposes may arise even when the straight�line method isused, and the differences should be considered when evaluating the materiality of using tax depreciation methodsin GAAP statements.

The MACRS tax method is an acceptable GAAP method unless salvage value would be material, and best practicesindicate that using the conventions normally should not result in depreciation that differs materially from GAAP. Ingeneral, best practices indicate that the MACRS recovery periods are closer to GAAP than the ACRS periods. Therecovery periods for real estate and for three� and five�year property probably would be acceptable for GAAP.However, large acquisitions in the other classes should be evaluated to determine whether different depreciablelives should be used for financial reporting. Similarly, tax depreciation for significant pre�1987 investments inbuildings and heavy machinery or equipment would be expected to differ materially from GAAP.

When tax methods used for financial reporting purposes result in material differences from GAAP, the accountant'sor auditor's report should be appropriately modified for a GAAP departure. (See Chapter 6 of PPC's Guide to

Compilation and Review Engagements or Chapter 3 of PPC's Guide to Auditor's Reports.)

For tax reporting, there are limitations on depreciation of certain automobiles (commonly referred to as luxuryvehicles) used in the business. The effect of the limitations is to require a longer depreciation period for thosevehicles than for other types of five�year property. For tax reporting, some companies will, therefore, be depreciat�ing some five�year property over longer periods than others, which raises the question of whether the use ofdifferent depreciation periods for similar assets is appropriate for GAAP. Best practices indicate that generally, thelives should be the same unless the difference can be attributed to an identifiable condition. Accordingly, thatcriteria should be considered in determining whether accelerated tax methods differ materially from GAAP meth�ods. To illustrate, assume that a company acquires an automobile for $36,000 and can deduct depreciation of$3,060 for the first year, $4,900 for the second year, $2,950 for the third year, and $1,775 for each subsequent year.The full cost would, therefore, be deducted over 18�years and, if the estimated life were considered to be five years,depreciation assuming a five�year period should be computed and compared with the tax deduction in consideringwhether the effect is material.

The Section 179 Deduction and Bonus Depreciation

The Small Business Jobs Act of 2010, signed into law September 27, 2010, increases the maximum Section 179deduction from $250,000 to $500,000 for tax years beginning in 2010 and 2011. It also increases from $800,000 to$2,000,000 the phase�out threshold of the cost of qualifying additions beyond which there is a dollar�for�dollarreduction in the Section 179 deduction. Therefore, for example

� An entity with qualifying additions of $500,000 could deduct all of those additions in the year of acquisition.

� An entity with qualifying additions of $2,600,000 could not deduct any of its additions in the year ofacquisition because the total cost exceeds the $2,000,000 phase�out limitation by more than $500,000,which is the maximum Section 179 deduction allowed. Deductions lost because of the phase�out provisioncannot be carried forward to future years.

The Section 179 deduction is limited by the amount of taxable income before the deduction. Therefore, forexample, no Section 179 deduction is allowable in the year there is a taxable loss before the deduction. Similarly,if the entity has qualifying additions of $100,000 and taxable income before the deduction of $50,000, the Section179 deduction for the year is limited to $50,000. However, the remainder can be carried forward.

For the tax year beginning in 2010, the Small Business Jobs Act of 2010 allows a bonus depreciation deduction of50% of the depreciable basis of qualifying property purchased and placed in service before January 1, 2011. It alsoextends for an additional year the 50% bonus depreciation deduction for certain longer�lived assets and transporta�tion property. Bonus depreciation is computed after the Section 179 deduction and there is no limitation on bonus


141

depreciation. Therefore, for example, an entity that purchased qualifying property for $2,600,000 would have noSection 179 deduction, but could elect bonus depreciation of $1,300,000, which is 50% of the $2,600,000 cost.

Cost remaining after the Section 179 deduction and bonus depreciation is subject to normal depreciation rules. Toillustrate, assume that in 2010 an entity purchases and places in service qualifying five�year property that costs$900,000. Depreciation for 2010 would be $740,000, consisting of the following:

Section 179 deduction $ 500,000Bonus depreciation 200,000Regular MACRS deduction 40,000

$ 740,000

The $500,000 Section 179 deduction is the maximum allowable and reduces the depreciable basis from $900,000to $400,000. The 50% bonus depreciation allowance is applied to $400,000, resulting in additional first�yeardepreciation of $200,000. Basis of $200,000 remains ($400,000 � $200,000 bonus depreciation) and is subject tonormal depreciation rules. Applying the double declining balance method with a mid�year convention would yieldadditional depreciation of $40,000 [($200,000 � 5 years) � 2 � 1/2].

While the entity would be able to deduct $740,000 of the $900,000 cost in the year of acquisition for federal incometax reporting, the deduction would likely be smaller for state income tax reporting. Many states presently do notallow bonus depreciation, and some may impose a lower maximum on the Section 179 deduction.

Like�kind Exchanges

Brief Description and Tax Attributes. In a Section 1031 like�kind exchange, one property is exchanged for anotherproperty that is similar in use. In a properly arranged like�kind exchange, no gain is recognized by either partyexcept to the extent of boot received (cash, or other property that does not qualify for nonrecognition of gain, plusthe excess of debts transferred over debts assumed). If a party to a like�kind exchange gives boot consisting ofproperty that has appreciated or depreciated in value, that party will recognize a gain or loss on such property. Thetax basis of the asset received is equal to the tax basis of the asset transferred when no boot is involved. If gain isrecognized because of boot received, the basis of the property received is equal to the basis of the property givenup, increased by the gain recognized and decreased by the boot received. If a loss is realized but not recognized,and boot has been received, the basis of the property received is equal to that of the property given up, decreasedby the boot received.

Uses. Historically, Section 1031 like�kind exchanges were commonly used to turn appreciated real estate proper�ties without incurring large capital gains. Current tax law does not allow special tax rates for corporate capital gainsbut continues the deferral of the tax for like�kind exchanges.

Accounting under GAAP. FASB ASC 845�10�30�1 (formerly APB Opinion No. 29) generally requires recording anexchange of nonmonetary assets at fair value unless the exchange does not have commercial substance. Thenotion of commercial substance was added because the FASB believed the notion of commercial substance ismore consistent with the fair value measurement principle on which GAAP is based, produces financial informationthat more faithfully represents the economics of the exchange, and can be more easily and consistently applied. Anonmonetary exchange has commercial substance if either

a. the configuration of future cash flows is expected to change significantly as a result of the exchange or

b. the entity�specific value of the asset received differs significantly from the entity�specific value of the assetsurrendered.

IRC Sec. 1031 establishes the general presumption of an exchange of like�kind property. However, the interpretiveguidance in the regulations and cases has enabled some exchanges of nonmonetary assets to qualify under IRCSec. 1031 even though they may not appear to be like�kind. Accordingly, some exchanges that qualify under IRCSec. 1031 may have commercial substance, and, as a result, the carrying amount of the asset received in theexchange may be carryover basis for income tax reporting and fair value for financial statement reporting.


142

Determining whether an IRC Sec. 1031 exchange has commercial substance requires judgment based on ananalysis of the facts and circumstances. If the exchange has commercial substance, the asset received generallyshould be recorded at the fair value of the asset surrendered unless the fair value of the asset received is moreclearly evident. If the fair value of the asset received is more clearly evident than the fair value of the assetsurrendered, the asset received should be recorded at its fair value.

In the common situation in which the exchange does not have commercial substance:

a. If the exchange does not involve monetary consideration, it should be based on recorded amounts, andno gain recognized. (A loss should be recognized if indicated, however.)

b. If the exchange involves monetary consideration:

(1) the entity receiving the monetary consideration should recognize a portion of the gain in the ratio ofcash received to total consideration received, i.e., cash plus fair value of asset received;

(2) the entity paying monetary consideration should not recognize any gain, i.e., the new asset shouldbe recorded at the carrying amount of the asset surrendered plus any payments; and

(3) any losses should be recognized.

However, in an exchange of real estate in which at least 25% of the total consideration is monetary, the gain shouldbe allocated between the monetary and nonmonetary portion.

Illustration. Assume that on 1/1/X3, XYZ Corporation exchanges Parcel A for $80,000 plus Parcel�B (previouslyowned by John Doe). Also assume that the exchange is considered to not have commercial substance as that termis defined in FASB ASC 845�10�30�4 (formerly SFAS No. 153 and that the mortgages are assumed by the newowners in each case.

Parcel A Parcel B

Current market value $ 1,500,000 $ 1,250,000

Cost to XYZ Corporation 500,000 N/A

Mortgage 370,000 200,000

The tax and book gains to XYZ Corporation are calculated as follows:

Total gain Taxable gain Book gain

Fair value of asset given up ($1,500,000� $370,000) $ 1,130,000

Less book value of asset given up($500,000 � $370,000) 130,000

$ 1,000,000

Taxable gain is limited to boot received:

Cash $ 80,000

Excess of debt transferred over debtassumed 170,000

$ 250,000


143

The monetary consideration is 25% or less, and therefore, the book gain is limited to:

$80, 000�� $170, 000

$80, 000�� $170, 000�� $1, 250, 000�� $1, 000, 000��

Monetary�consideration�received�

Total�consideration�received�� Total�gain

$ 166,667

The book gain of $166,667 would likely be presented as an infrequently occurring item in the financial statements,i.e., as a separate line item before income taxes. The difference between the gain recorded for financial and taxpurposes is a temporary difference.

Deferred Condemnation or Casualty Gains

For tax purposes, certain condemnation and casualty gains may be deferred for a prescribed period and offsetagainst the basis of replacement property. For GAAP, however, FASB ASC 605�40�25�3 (formerly FASB Interpreta�tion No. 30) requires recognizing gain or loss when monetary consideration is receivable, even if replacement iscontemplated. As a result, in most instances, there will be a difference between GAAP and taxable income and thebases of the assets and liabilities when material condemnation or casualty gains are deferred for tax purposes. Theinterpretation requires treating those differences as temporary differences.

For example, assume that a company receives proceeds of $250,000 from a fire insurance policy covering a smallwarehouse with a book value (and an adjusted basis for tax purposes) of $100,000. For GAAP reporting, thefollowing entry would be made to record the transaction:

Cash $ 250,000Old warehouse (net) $ 100,000Casualty gain 150,000

For GAAP reporting, the entire $150,000 gain would be reported as a casualty gain in the year the proceeds arereceivable. It would be reported as an extraordinary item only if it meets the criteria in FASB ASC 225�20�45�2(formerly APB Opinion No.�30), i.e., unusual nature and infrequency of occurrence. In practice, best practicesindicate that gains and losses from fires normally do not meet those criteria and, accordingly, should be reportedas an element of income from operations. In multiple�step income statements, the gains often are included in an�other income" section following operating income.

For tax purposes, the $150,000 gain could be deferred for a prescribed period and offset against the cost of areplacement facility. If the warehouse is not replaced within the prescribed period, the gain would be taxable.Regardless of whether the warehouse is replaced within the prescribed time period, a temporary difference wouldresult because of the difference between the financial and tax basis of the warehouse at the end of each period. Ifthe asset is replaced within the time period, a basis difference would result from the deferred gain that was offsetagainst the replacement property. If the asset is not replaced within the prescribed time period, a basis differencewill exist until the deferred gain is reported for tax purposes.

To illustrate, assume the warehouse was replaced at a cost of $300,000 within the prescribed time period. The basisof the warehouse for GAAP would be $300,000 and the basis for tax would be $150,000 (or the $300,000 cost lessthe $150,000 deferred gain). Deferred taxes would be provided on the $150,000 basis difference. The temporarydifference would reverse through depreciation in each subsequent year.


144


145

SELF�STUDY QUIZ


14. The guidance in FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) applies to investments held by whattype of entities?

a. Individuals.

b. Business entities.

c. Trusts.

d. Estates.

15. Which of the following statements is correct regarding accounting for investments in partnerships?

a. The equity method can be used instead of presenting consolidated financial statements.

b. Some entities that should use the equity method may be able to record its prorata share of the partnership'sassets, liabilities, revenues, and expenses.

c. The general partners control the limited partnership if the limited partners have substantive participatingrights.

d. The general partners control the limited partnership if the limited partners have the ability to dissolve thepartnership.

16. Smart Company owns 10% of Learning Ltd. Partnership and 40% of Exam Ltd. Partnership. Smart accountsfor the investment in Learning using the cost method and accounts for the investment in Exam using the equitymethod. The losses from the partnerships are not considered to be from passive activities for tax reporting. Thepartnerships have no debt. Assume a 30% tax rate and the following facts:

10% ofLearning Ltd.

40% ofExam Ltd.

Original investment by Smart 1/1/X1 $ 25,000 $ 25,000


Losses deducted by Smart YE 12/31/X1 (25,000 ) (25,000 )




Assuming no permanent decline in the value of the investments and that reduction of the equity methodinvestment below zero is appropriate, how should the investment in Learning be presented in the financialstatements for 20X1?

a. As an asset with a zero balance.

b. As a $25,000 asset.

c. As a $20,000 asset.

d. As a $45,000 asset.


146

17. Using the information in the previous question, how should the investment in Exam be presented in the financialstatements for the year ended 12/31/X2?

a. As a $45,000 asset.

b. As a $25,000 loss.

c. As a $15,000 liability and a $25,000 loss.

d. As a $10,000 liability and a $35,000 loss.

18. At 12/31/X2, how much is the deferred tax asset or liability resulting from the temporary difference for theinvestment in Learning Ltd. Partnership?

a. A $7,500 deferred tax asset.

b. A $13,500 deferred tax asset.

c. A $7,500 deferred tax liability.

d. A $13,500 deferred tax liability.

19. Which of the following choices is correct concerning a difference between book and tax earnings oninvestments in partnerships?

a. Earnings and losses are reported on Schedule K�1 using GAAP.

b. K�1 earnings and losses may be recorded in the investor's GAAP financial statements.

c. Investors can only recognize book earnings for tax purposes if the investor and partnership use the samebasis of accounting.

d. If there is a material difference between K�1 earnings and GAAP, a complete conversion is necessary.

20. If conditions are right, which basis allows for nonrecognition of gain in a like�kind exchange?

a. GAAP basis financial statements.

b. Tax basis financial statements.

c. Both GAAP and tax basis financial statements.

d. Gain must be recognized in both GAAP and tax basis financial statements.

21. On 1/1/X5, Baker Corporation exchanges Parcel A for $50,000 plus Parcel B. The exchange is considered tonot have commercial substance and the mortgages are assumed by the new owners in each case.

Parcel A Parcel B

Current market value $ 800,000 $ 650,000

Cost to Baker Corporation 400,000 N/A

Mortgage 200,000 100,000


147

How much is the taxable gain to Baker Corporation?

a. $50,000.

b. $100,000.

c. $150,000.

d. $400,000.

22. Assume the same facts as the previous example. How much is the book gain to Baker Corporation?

a. $0.

b. $25,000.

c. $75,000.

d. $400,000.

23. May Corporation receives proceeds of $500,000 from a fire insurance policy covering a small building with abook value (and an adjusted basis for tax purposes) of $300,000. The building is replaced at a cost of $525,000within the prescribed time period. How much is the temporary difference before any depreciation is taken onthe new asset?

a. $0.

b. $200,000.

c. $325,000.

d. $525,000.


148



14. The guidance in FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) applies to investments held by whattype of entities? (Page 135)

a. Individuals. [This answer is incorrect. Individuals do not have to abide by the guidance in FASB ASC323�10�15�5 (formerly APB Opinion No. 18) concerning accounting for investments in partnerships.However, proprietorships ordinarily would.]

b. Business entities. [This answer is correct. FASB ASC 323�10�15�5 (formerly APB Opinion No. 18)only applies to investments held by business entities such as corporations, partnerships, andproprietorships.]

c. Trusts. [This answer is incorrect. Trusts do not abide by the guidance in FASB ASC 323�10�15�5 (formerlyAPB Opinion No. 18) concerning accounting for investments in partnerships.]

d. Estates. [This answer is incorrect. Estates do not follow the guidance in FASB ASC 323�10�15�5 (formerlyAPB Opinion No. 18) to account for investments in partnerships.]

15. Which of the following statements is correct regarding accounting for investments in partnerships? (Page 135)

a. The equity method can be used instead of presenting consolidated financial statements. [This answer isincorrect. FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) states that the equity method is not a validsubstitute for consolidation. While accounting for investments in partnerships is not directly addressed inauthoritative literature, FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) comes closest to being onpoint.]

b. Some entities that should use the equity method may be able to record its prorata share of thepartnership's assets, liabilities, revenues, and expenses. [This answer is correct. GAAP notes thatfor partnerships in certain industries it may be appropriate for the investor to record in its financialstatements its prorata share of the assets, liabilities, revenues, and expenses of the venture.]

c. The general partners control the limited partnership if the limited partners have substantive participatingrights. [This answer is incorrect. According to FASB ASC 810�20�25 (formerly EITF Issue No. 04�5), thegeneral partners do not control the limited partnership if the limited partners have substantive participatingrights.]

d. The general partners control the limited partnership if the limited partners have the ability to dissolve thepartnership. [This answer is incorrect. The general partners do not control the limited partnership if thelimited partners have the substantive ability to dissolve (liquidate) the limited partnership or otherwiseremove the general partners without cause according to FASB ASC 810�20�25 (formerly EITF IssueNo.�04�5.]

16. Smart Company owns 10% of Learning Ltd. Partnership and 40% of Exam Ltd. Partnership. Smart accountsfor the investment in Learning using the cost method and accounts for the investment in Exam using the equitymethod. The losses from the partnerships are not considered to be from passive activities for tax reporting. Thepartnerships have no debt. Assume a 30% tax rate and the following facts:

10% of Learning Ltd.

40% of Exam Ltd.

Original investment by Smart 1/1/X1 $ 25,000 $ 25,000




149

40% of Exam Ltd.

10% of Learning Ltd.




Assuming no permanent decline in the value of the investments and that reduction of the equity methodinvestment below zero is appropriate, how should the investment in Learning be presented in the financialstatements for 20X1? (Page 136)

a. As an asset with a zero balance. [This answer is incorrect. This is Smart's tax basis in Learning Ltd.Partnership.]

b. As a $25,000 asset. [This answer is correct. Since Learning Ltd. Partnership is reported on Smart'sfinancial statements using the cost method, the original investment is reported on the 1/1/X1financial statements as a $25,000 asset.]

c. As a $20,000 asset. [This answer is incorrect. $20,000 is the additional contributions for the year 20X2.]

d. As a $45,000 asset. [This answer is incorrect. This is the amount reported for the investment in Learningat 12/31/X2.]

17. Using the information in the previous question, how should the investment in Exam be presented in the financialstatements for the year ended 12/31/X2? (Page 136)

a. As a $45,000 asset. [This answer is incorrect. This would be the amount reported for the investment inExam at 12/31/X2 if the cost method was appropriate.]

b. As a $25,000 loss. [This answer is incorrect. The loss should be reported on the Statement of Income.However, a liability for the share of deficiency in asset of Exam Ltd. Partnership should also be presented.]

c. As a $15,000 liability and a $25,000 loss. [This answer is correct. Since Exam Ltd. Partnership isreported on Smart's financial statements using the equity method, the liability for Smart's share ofdeficiency in assets of Exam at 12/31/X2 is $15,000 ($10,000 excess losses for 20X1 and $5,000 for20X2) and Smart's share of losses for 20X2 are reported on the Statement of Income.]

d. As a $10,000 liability and a $35,000 loss. [This answer is incorrect. For the equity method, this is thepresentation on the 20X1 financial statements.]

18. At 12/31/X2, how much is the deferred tax asset or liability resulting from the temporary difference for theinvestment in Learning Ltd. Partnership? (Page 137)

a. A $7,500 deferred tax asset. [This answer is incorrect. Based on the cost method, Smart would record adeferred tax liability for its investment in Learning Ltd. Partnership.]

b. A $13,500 deferred tax asset. [This answer is incorrect. Smart would record a deferred tax liability for itsinvestment in Learning Ltd. Partnership.]

c. A $7,500 deferred tax liability. [This answer is incorrect. $7,500 is the deferred tax liability at 12/31/X1.]

d. A $13,500 deferred tax liability. [This answer is correct. The financial basis is $45,000 while the taxbasis is zero. Therefore, $45,000 at the 30% tax rate is $13,500.]


150

19. Which of the following choices is correct concerning a difference between book and tax earnings oninvestments in partnerships? (Page 138)

a. Earnings and losses are reported on Schedule K�1 using GAAP. [This answer is incorrect. It is possible thatthe partnership's K�1 earnings and losses may not materially differ from GAAP. However, the partnershipmay report accelerated depreciation amounts on its tax return above what it reports on GAAP financialstatements. In addition, a partnership may not report contingent liabilities in its tax reporting that would beappropriate in GAAP financial statements.]

b. K�1 earnings and losses may be recorded in the investor's GAAP financial statements. [This answeris correct. If the partnership's K�1 amounts differ from its GAAP amounts, the K�1 earnings andlosses could be recorded in the investor's GAAP financial statements provided that the differenceis not material to the investor's earnings.]

c. Investors can only recognize book earnings for tax purposes if the investor and partnership use the samebasis of accounting. [This answer is incorrect. For tax purposes, investors recognize earnings based onthe K�1 regardless of whether the investor and the partnership use the same basis of accounting.]

d. If there is a material difference between K�1 earnings and GAAP, a complete conversion is necessary. [Thisanswer is incorrect. If the partnership's basis of accounting does not differ materially from GAAP, theinvestor partner could recognize earnings and losses based on amounts reported in the K�1. However, ifthere is a material difference, the K�1 earnings and losses should be converted to GAAP. In many cases,the conversion of a few key items will bring the K�1 amounts materially close to GAAP, and a completeconversion will be unnecessary.]

20. If conditions are right, which basis allows for nonrecognition of gain in a like�kind exchange? (Page 141)

a. GAAP basis financial statements. [This answer is incorrect. If certain requirements are met, no gain will berecognized for like�kind exchanges on the financial statements. However, this is not the correct answer tothis question.]

b. Tax basis financial statements. [This answer is incorrect. Recognition of gain can be deferred in Section1031 exchanges. However, this is not the correct answer to this question.]

c. Both GAAP and tax basis financial statements. [This answer is correct. Certain transactions mayqualify for nonrecognition of gain as long as the specific details meet the requirements provided fortax and/or GAAP reporting per IRC Sec. 1031 and FASB ASC 845�10�3�1 (formerly APB Opinion No.29).]

d. Gain must be recognized in both GAAP and tax basis financial statements. [This answer is incorrect.Like�kind exchanges do not require gain recognition in both GAAP and tax basis financial statements.Recognition of gain is dependent upon the specific details of the transaction.]

21. On 1/1/X5, Baker Corporation exchanges Parcel A for $50,000 plus Parcel B. The exchange is considered tonot have commercial substance and the mortgages are assumed by the new owners in each case.

Parcel A Parcel B



Mortgage 200,000 100,000

How much is the taxable gain to Baker Corporation? (Page 142)

a. $50,000. [This answer is incorrect. This is the amount of cash received. This amount is used to computethe taxable gain. The example has other types of boot. Boot can be cash, other property that does notqualify for nonrecognition of gain, and the excess of debts transferred over debts assumed.]


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b. $100,000. [This answer is incorrect. This is the excess of debts transferred over debts assumed. Thisexample has other types of boot.]

c. $150,000. [This answer is correct. Taxable gain is limited to boot received. Baker Corporationreceived $50,000 cash and gave up $200,000 in debts but only received a $100,000 debt.]

d. $400,000. [This answer is incorrect. This is the total gain. The fair value of asset given up ($800,000 �$200,000) less book value of asset given up ($400,000 � $200,000) equals the $400,000 total gain.]

22. Assume the same facts as the previous example. How much is the book gain to Baker Corporation? (Page 142)

a. $0. [This answer is incorrect. No gain would be recognized if the exchange did not involve monetaryconsideration. However, Baker Corporation did receive monetary consideration in the form of cash anda reduction in debt.]

b. $25,000. [This answer is incorrect. The calculation should include the $100,000 of excess debt transferredover debt assumed.]

c. $75,000. [This answer is correct. The book gain is calculated by dividing the monetary considerationreceived by the total consideration received and multiplying this percentage by the total gain. Themonetary consideration received is $50,000 in cash and $100,000 of excess debt transferred overdebt assumed. The total consideration received includes the $50,000 cash, $100,000 of excess debttransferred over debt assumed, and the $650,000 current value of Parcel B. The total gain is$400,000. Therefore, the book gain is $75,000 (($50,000+$100,000) / ($50,000 + $100,000 +$650,000) � $400,000).]

d. $400,000. [This answer is incorrect. This is the total gain. The fair value of asset given up ($800,000 �$200,000) less book value of asset given up ($400,000 � $200,000) equals the $400,000 total gain.]

23. May Corporation receives proceeds of $500,000 from a fire insurance policy covering a small building with abook value (and an adjusted basis for tax purposes) of $300,000. The building is replaced at a cost of $525,000within the prescribed time period. How much is the temporary difference before any depreciation is taken onthe new asset? (Page 143)

a. $0. [This answer is incorrect. Since the casualty gain is deferred for tax purposes and the gain is recognizedfor GAAP, there is a difference between the tax basis and GAAP basis of the new building. A basis differenceresults from the deferred gain that offset against the replacement property.]

b. $200,000. [This answer is correct. The warehouse was replaced at a cost of $525,000 within theprescribed time period. The basis of the warehouse for GAAP is $525,000 and the basis for tax is$325,000 ($525,000 cost of the new building less the $200,000 deferred gain). The temporarydifference is $200,000 (GAAP basis less the tax basis of the new warehouse). The temporarydifference will reverse through depreciation in each subsequent year.]

c. $325,000. [This answer is incorrect. This is the tax basis of the new building. This amount is determinedby taking the cost of the new building of $525,000 and subtracting the deferred gain amount of $200,000on the old building.]

d. $525,000. [This answer is incorrect. $525,000 is the GAAP basis of the new building. This is the purchaseprice of the new building which will be depreciated on the GAAP financial statements.]


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Lesson 1 (PFSTG102)


1. Which of the following examples follows the guidance in FSP FIN 48�1, �Definition of Settlement in FASBInterpretation No. 48?"

a. Company A's return for year 2 was examined, but the tax position in question was not examined. CompanyA can consider the position to be settled.

b. Company B's deduction was examined and accepted in year 1, therefore, it is assumed by the entity thatthe same deduction will be accepted in year 3.

c. Once Company C decides its stance on a tax position, the entity may not change its assessment if the taxposition has not been examined.

d. Company D's liability for year 1 can be recognized when the tax position in question is accepted by thetaxing authority.

2. A taxing authority recently examined Bass Corporation's tax return, and disallowed a deduction which Bass haddetermined would not meet the �more likely than not" criterion. What action must Bass now take in regard toits financial reporting?

a. Bass would not need to take any action since it did not defer the realized tax benefit.

b. Bass will pay the additional tax assessed and debit the liability account for the previously deferred taxbenefit.

c. Bass will pay the additional tax assessed and debit the current tax provision for the current year.

d. Bass will debit the current tax provision and credit a liability for the deferred tax benefit.

3. Lucky Company changed its year end for tax reporting and financial reporting purposes. Which of the followingactions correctly discloses the change in the financial statements?

a. The comparative financial statements are presented that include the statements of income for the yearsended December 31, 20X1 and December 31, 20X2 and the balance sheets for December 31, 20X1 andDecember 31, 20X2.

b. The period in which Lucky changed its year end for tax and financial reporting purposes, the notes to thefinancial statements include a disclosure concerning the change in fiscal year, but financial statementsmay not be presented in comparative form.

c. Comparative financial statements are presented that include the statements of income for the six monthsended December 31, 20X1 and the year ended June 30, 20X1 and the balance sheet for December 31,20X1.

d. In the year of the change, the financial statement presentation covers less than 12 months. Additionally,a disclosure is made in the notes to the financial statements regarding the change including any seasonaleffects to net income.


153

4. What change made by the Tax Reform Act of 1986 would require consideration for financial reporting purposes?

a. Category three costs are now mostly required to be capitalized for tax purposes.

b. Category one costs are now required to be included in inventory for tax purposes.

c. Category three costs are now to be accounted for according to GAAP for tax purposes.

d. Category two costs are no longer required to be included in inventory for tax purposes.

5. EITF Issue No. 86�46 states that:

a. Costs capitalizable for tax purposes should preferably be capitalized for financial reporting purposes.

b. The nature of operation and industry practice should be considered for asset capitalization purposes.

c. Costs capitalizable for tax purposes must be capitalized for financial reporting purposes.

d. Generally accepted accounting principles were incorrectly applied in prior periods.

6. Usually, temporary differences are recorded on the financial statements due to the differences in taxrequirements and GAAP requirements for construction period interest and taxes incurred on current projects.

a. True.

b. False.



7. Sherry's Staples has been encountering some financial difficulties and a liquidation of the company is on thehorizon. Which of the following is true regarding the liquidation?

a. The company's financials should be prepared assuming the liquidation will occur.

b. The assets should be reported at historical value when a liquidation is pending.

c. If the company has the resources to wait for a specific price, the financials should still be presented usingliquidation basis.

d. Gains and losses should not be recognized in the financial statements until they are realized under aliquidation.

8. Calico Company filed a petition for Chapter 11 bankruptcy on February 1, 20X3. How would this event affectthe December 31, 20X2 financial statements being prepared in March?

a. The presentation of liabilities in the financial statements will reflect the status of the creditors (i.e., secured,undersecured, and unsecured claims).

b. The results of cash flows from operations will be presented separately from the cash flows related to thebankruptcy proceedings.

c. A disclosure will be included in the financial statements concerning the subsequent event, but no otherconsiderations would be presented.

d. The company should not present financial statements for earlier years in comparison to the December 31,20X2 financial statements.


154

9. Which type of liability is not subject to compromise and, therefore, will be classified as such on the balancesheet?

a. Undersecured claim.

b. Unsecured claim.

c. Prepetition liability.

d. Postpetition liability.

10. Which of the following choices is correctly presented in the financial statements of a company in Chapter 11proceedings?

a. Reorganization items should be presented net of income taxes.

b. Reorganization items should be disclosed as unusual or infrequently occurring items.

c. The presentation of assets is generally no different in Chapter 11 proceedings.

d. The presentation of stockholders' equity is generally not different in Chapter 11 proceedings.

11. SOP 90�7 requires companies in Chapter 11 proceedings to disclose such in the notes to the financialstatements.

a. True.

b. False.



12. Which of the following is one of the criteria requiring a company emerging from reorganization proceeding toemploy �fresh�start reporting?"

a. Many of the assets are considered impaired, and values are adjusted to less than 50% of pre�bankruptcyvalues.

b. Holders of voting stock before plan approval receive less than half of the voting shares of the emergingcompany.

c. The fair value of all assets after reorganization are less than the total of postpetition liabilities.

d. The fair value of the assets before the date of plan approval are less than all of the allowed claims.

13. Which one of the following is a preconfirmation contingency?

a. Environmental issues that are classified as nondischargeable claims.

b. Estimates used to allocate the reorganization value to the entity's assets.

c. Income tax related estimates covered by SFAS No. 109.



155

14. Generally, the equity method of accounting should be used when corporations, partnerships, andproprietorships own what percentage of a partnership?

a. Less than 20%.

b. 20% or more but less than 50%.

c. 50% or more but less than 80%.

d. More than 80%.

15. Generally, when should the cost method be used to account for an investment in a partnership?

a. When the investment is less than 20% of the partnership.

b. When the investment is less than 50% of the partnership.

c. When the investment is more than 50% of the partnership.

d. When the investment is less than 100% of the partnership.

16. A Company owns 15% of B Ltd. Partnership and 45% of C Ltd. Partnership. A Company accounts for theinvestment in B Ltd. using the cost method and accounts for the investment in C Ltd. using the equity method.The losses from the partnerships are not considered to be from passive activities for tax reporting. Thepartnerships have no debt. Assume a 30% tax rate and the following facts:

15% ofB Ltd.

45% ofC Ltd.

Original investment by A Co. 1/1/X1 $ 50,000 $ 50,000


Losses deducted by A Co. YE 12/31/X1 (50,000 ) (50,000 )



Losses deducted by A Co. YE 12/31/X2 (40,000 ) (40,000 )

Assuming no permanent decline in the value of the investments and that reduction of the equity methodinvestment below zero is appropriate, how should the investment in B Ltd. be presented in the financialstatements for 20X2?





17. Using the information in the previous question, how should the investment in C Ltd. be presented in the financialstatements for the year ended 12/31/X1?






156

18. Using the information in questions 15 and 16, How much is the deferred tax asset or liability resulting from thetemporary difference for the investment in B Ltd. Partnership at 12/31/X1?

a. A $15,000 deferred tax asset.

b. A $27,000 deferred tax asset.

c. A $15,000 deferred tax liability.

d. A $27,000 deferred tax liability.

19. Which of the following resembles GAAP depreciation?

a. Allocating expenses over the expected useful life of the asset while considering salvage value.

b. Stimulate investments by accelerating deductions.

c. Using statutory write�off periods for groups of various assets.

d. Specific depreciation methods are used for the various recovery periods.

20. When is the tax method of depreciation acceptable for GAAP financial statements?

a. When the tax method used is ACRS.

b. When depreciating significant pre�1987 investments in equipment.

c. When using MACRS and salvage value is immaterial.

d. When depreciating luxury vehicles used in the business.

21. What happens when an exchange does not have a commercial substance and does not involve monetaryconsideration?

a. Losses should be recognized.

b. The receiving entity should recognize only a portion of the gain in the ratio of cash received to the entireconsideration received.

c. The new asset should be recorded at the carrying amount of the asset yielded plus any payments.

d. No gain should be recognized and the exchanges should be based on recorded amounts.

22. On 1/1/X1, Carter Corporation exchanges Parcel A for $100,000 plus Parcel B. The exchange is considered tonot have commercial substance and the mortgages are assumed by the new owners in each case.

Parcel A Parcel B



Mortgage 100,000 50,000

How much is the taxable gain to Carter Corporation?

a. $37,500.

b. $150,000.

c. $350,000.

d. $500,000.


157

23. Assume the same facts as the previous example. How much is the book gain to Carter Corporation?

a. $37,500.

b. $150,000.

c. $350,000.

d. $500,000.

24. Excalibur Corporation receives proceeds of $225,000 from a fire insurance policy covering a small building witha book value (and an adjusted basis for tax purposes) of $50,000. The building is replaced at a cost of $230,000within the prescribed time period. How much is the temporary difference before any depreciation is taken onthe new asset?

a. $55,000.

b. $175,000.

c. $225,000.

d. $230,000.


158


159

Lesson 2:�Selected Topics Part 2

INTRODUCTION

Lesson 2 provides additional guidance for accountants presenting specific �tax transactions" in financial state�ments in conformity with GAAP.


Completion of this lesson will enable you to:� Determine the income tax and accounting treatment for transactions involving ownership of the entity or various

other transactions.� Calculate adjustments and equity balances for ownership transactions and revenue recognition for lease

transactions for tax and financial reporting.

REDEMPTIONS OF STOCK AND RELATED TRANSACTIONS

Stock Redemptions

Brief Description. A stock redemption takes place when a corporation transfers cash or other assets to astockholder in exchange for his stock (generally all of his stock).

Tax Attributes. When the transaction meets the tax requirements of a redemption, a stockholder generally willreceive capital gains treatment on the exchange of his shares (instead of the dividend treatment usually applied tocorporate distributions), and distributions of appreciated assets will result in the corporation recognizing gains asif the property were sold to the stockholders at its fair market value. However, deducting losses on distribution ofassets is not permitted.

Uses. Stock redemptions are used to buy out stockholders and to purchase the stock of a deceased stockholderin a closely held business, e.g., when the corporation and stockholder have entered into a buy�sell agreementfunded by company�owned insurance on the life of the stockholder.

Accounting under GAAP. With respect to the corporation, the transaction is a treasury stock purchase. If thetreasury stock is to be retired (whether formally or constructively), any excess of purchase price over par or statedvalue should either be charged entirely to retained earnings or allocated between additional paid�in capital andretained earnings. If the treasury stock will not be retired but used for other purposes, e.g., for reissue to a newstockholder, or when ultimate disposition has not yet been decided, the cost of treasury stock may be shownseparately as a deduction from the total of capital stock, additional paid�in capital, and retained earnings (the costmethod) or may be treated the same as retired stock (the par value method).

Frequently, small businesses purchase treasury stock for a price in excess of retained earnings and additionalpaid�in capital of the corporation, for example, when the shares of a major stockholder are redeemed and thecompany is worth substantially more than its book value. (State law may restrict retained earnings for the amountof the cost of the treasury stock or prohibit the purchase of treasury stock in excess of retained earnings andadditional paid�in capital. Some states allow appraisal increases in assets to produce available retained earnings.Except as discussed later, such appraisal increases should not be recorded in the financial statements. Legalcounsel should be consulted when the proposed redemption price exceeds available retained earnings.) In suchsituations, recording the transaction as if the stock will be retired would most likely result in a deficit in retainedearnings. Although total stockholders' equity is the same under both methods, the cost method does not directlyreduce retained earnings and also is easier to apply. However, the par value method should be used if the companyis not considering reissuing the stock. (In addition, in some states the corporate franchise tax base includes thecost of treasury stock, and retirement of the stock would reduce state franchise costs.)

Illustration. Assume XYZ Corporation is wholly owned by two stockholders in equal percentages (50/50) and thateach has a buy�sell agreement with the corporation requiring the corporation to purchase his shares for $600,000


160

in the event of his death. Assuming one of the stockholders dies, the stockholders' equity section of the corpora�tion's balance sheet before and after the redemption would appear as follows:

Before After

CostMethod

Par ValueMethod


Common stock, $1 par value, 20,000shares authorized and issued $ 20,000 $ 20,000 $ 10,000

Additional paid�in capital 30,000 30,000 15,000

Retained earnings 280,000 280,000 (295,000 )

330,000 330,000 (270,000 )

Less cost of 10,000 shares of treasurystock � (600,000 ) �

$ 330,000 $ (270,000 ) $ (270,000 )

Other Considerations. If a buy�sell redemption is funded by life insurance proceeds, the company will record theexcess of the proceeds over the cash value of the policy as a gain for financial reporting purposes, which helpsoffset the charge to retained earnings for the excess of the redemption price over the par value.

If a redemption is accomplished through distribution of property, FASB ASC 845�10�30�2 (formerly APB OpinionNo. 29) generally requires the fair market value of the property transferred to be used as the purchase price of thetreasury stock. If the fair market value differs from the book value, the company would recognize a gain or loss forfinancial statement purposes. The gain or loss recognized in the financial statements may differ from amountsreported in the tax returns. However, that difference would always be a reversal of a temporary difference. (Sincethe difference arises from the distribution of an asset, it can never reverse and, therefore, would not be anoriginating temporary difference.) Thus, the difference could never cause deferred taxes to be set up; it only couldcause them to reverse. The following examples illustrate the accounting issues:

a. No Previous Temporary DifferencesAssume that an asset has a basis of $70,000 for financial statementand income tax reporting purposes.

(1) If its fair market value were $80,000, a $10,000 gain would be reported both in the financial statementsand the tax return on distribution.

(2) If the fair market value were $60,000, a $10,000 loss would be reported in the financial statements butwould not be deducted in the tax returns. The $10,000 difference could never reverse and should,therefore, be treated as a permanent difference.

b. Previous Temporary DifferencesAssume that using different depreciation methods caused the basis ofan asset to be $70,000 for financial statement reporting and $45,000 for tax reporting. As a result, there isa taxable temporary difference of $25,000 prior to the distribution.

(1) If the fair market value were $80,000, a gain of $10,000 would be reported in the financial statements,but the taxable gain would be $35,000. The $25,000 difference is the reversal of the taxable temporarydifference.

(2) If the fair market value were $50,000, a loss of $20,000 would be reported in the financial statements,but a gain of $5,000 would be reported in the tax returns. The $25,000 excess of taxable income overthe amount reported in the financial statements is the reversal of the taxable temporary difference.

(3) If the fair market value were $40,000, the financial statements would report a loss of $30,000, but noloss would be deducted in the tax returns. Because none of the loss is deductible, the differencebetween the $30,000 loss reported in the financial statements and the $25,000 taxable temporarydifference should be treated as a permanent difference.


161

Because of tax attribution rules, buy�out agreements prior to 1987 often included a provision under which theselling stockholder agrees not to have any management influence over the company for 10 years. Disclosure of theagreement in the notes to the financial statements may provide useful information about some companies,particularly when the seller was a key factor in the company's performance.

Covenants Not to Compete

Brief Description. Covenants not to compete are contracts that provide for compensation to be paid by one partyover a specified period for the agreement by another party not to compete in a given geographical area for aspecified time. The consideration for a covenant may be included in the purchase price for the stock or assets of abusiness, it may be paid up�front, or it may be paid in installments.

Tax Attributes. If the covenant is in connection with the purchase of a business or its assets after August 10, 1993,the cost is amortized over 15 years under IRC Section 197. Payments under a pre�August�10, 1993 covenant not tocompete are still generally deductible as an ordinary business expense over the term of the agreement providedthe covenant has economic substance (that is, it is probable that the seller would be a significant competitive threatwithout the covenant). The seller generally reports collections as ordinary income if the covenant has economicsubstance, and capital gain if it does not. Payments under post�August 10, 1993 covenants that are entered intowith a party other than the seller of a business (such as former employees of an acquired business) should continueto be deductible over the term of the agreement, as under pre�Section 197 law. However, the IRS can be expectedto argue that such covenants with non�owners are nevertheless made �in connection with" the purchase of abusiness, and therefore are subject to 15�year amortization.

Uses. Covenants are frequently used in the purchase of a closely held business to protect the new owner'sinvestment from competition.

Accounting under GAAP. Best practices indicate that the accounting considerations for a covenant not to competeare generally the same for GAAP and income tax reporting. No value should be assigned to a covenant unless it haseconomic substance and the purchaser has either made an up�front payment or the cost of the covenant isincluded in the price of the stock or assets acquired by the purchaser.

Illustrations. Assume that on January 1, 20X1, XYZ Corporation purchases all of the assets of C Division of ABCCompany for $1 million with $250,000 allocated to a five�year covenant not to compete in C Division's line ofbusiness and $750,000 allocated to property and equipment. Assume also that XYZ Corporation pays $200,000 atclosing and signs a note for $800,000, which is to be paid in four equal annual installments of principal plus 10%interest with the first payment due one year from closing. If the covenant has economic substance and its value isexpected to decline 40% the first year, 30% the second year, and 10% in each of the final three years, the financialstatements for XYZ Corporation and ABC Company would appear as follows:

ABC COMPANY (Seller)(Balance Sheet Excerpts)

January 1

20X2 20X1

ASSETS

CURRENT ASSETS

Cash (from sales proceeds, excludes interest) $ 400,000 $ 200,000

Current portion of long�term notes receivable 200,000 200,000

OTHER ASSETS

Long�term notes receivable 400,000 600,000

LIABILITIES

Deferred income 150,000 250,000


162

ABC COMPANY (Seller)(Statement of Income Excerpts)

Year Ended December 31

20X2 20X1

OTHER INCOME (EXPENSES)

Revenue from covenant not to compete $ 75,000 $ 100,000

Interest income 60,000 80,000

135,000 180,000

XYZ CORPORATION (Buyer)(Balance Sheet Excerpts)

January 1

20X2 20X1

ASSETS

PROPERTY AND EQUIPMENT (before depreciation) $ 750,000 $ 750,000

OTHER ASSETS

Covenant not to compete 150,000 250,000

CURRENT LIABILITIES


LONG�TERM DEBT 400,000 600,000

XYZ CORPORATION (Buyer)(Statement of Income Excerpts)

Year Ended December 31

20X2 20X1

OTHER INCOME (EXPENSES)

Amortization of covenant not to compete $ (75,000 ) $ (100,000 )

Interest expense (60,000 ) (80,000 )

(135,000 ) (180,000 )


163

SELF�STUDY QUIZ


24. Which of the following is a tax attribute of a stock redemption?

a. When distributing assets having a market value less than tax basis, the loss is deductible by thecorporation.

b. When distributing assets having a market value greater than tax basis, the corporation will recognize again.

c. In a redemption, the stockholder will recognize dividends equal to the amount of assets received.

d. The stockholder never receives capital gain treatment in a stock redemption.

25. Which of the two methods (cost method or par value method) should be used if the company is not planningon reissuing the stock?

a. Cost method.

b. Par value method.

26. Medco Corporation is wholly owned by two stockholders in equal percentages. Each stockholder has a buy�sellagreement with the corporation requiring the corporation to purchase his shares for $450,000 in the event ofhis death. Assume one of the stockholders dies, how much is the retained earnings balance after theredemption using the par value method?


Common stock, $1 par value, 40,000 sharesauthorized and issued $ 40,000

Additional paid�in capital 60,000

Retained earnings 560,000

a. $110,000.

b. $160,000.

c. $280,000.

d. $560,000.

27. If property is distributed in a buy�sell redemption, what effect does the distribution have on temporarydifferences?

a. It does not affect temporary differences.

b. It will cause a temporary difference.

c. It will cause a permanent difference.

d. It may cause a temporary difference to reverse.


164

28. A redemption is accomplished through a distribution of property. The distributed asset has a basis of $4,500for financial statement reporting, $3,000 for tax reporting, and a fair market value of $2,500. What is one effectof the distribution?

a. A $500 taxable loss.

b. A $1,500 temporary difference.

c. A $2,000 reversal of a taxable temporary difference.

d. A permanent difference occurs.


165



24. Which of the following is a tax attribute of a stock redemption? (Page 159)

a. When distributing assets having a market value less than tax basis, the loss is deductible by thecorporation. [This answer is incorrect. In a stock redemption, deducting losses on distribution of assetsis not permitted by tax law.]

b. When distributing assets having a market value greater than tax basis, the corporation will recognizea gain. [This answer is correct. According to tax law, distributions of appreciated assets will resultin the corporation recognizing gains as if the property were sold to the stockholders at its fair marketvalue.]

c. In a redemption, the stockholder will recognize dividends equal to the amount of assets received. [Thisanswer is incorrect. When the transaction meets the tax requirements of a redemption, a stockholdergenerally will not receive the dividend treatment usually applied to corporate distributions. Stockredemptions are taxed differently than dividends.]

d. The stockholder never receives capital gain treatment in a stock redemption. [This answer is incorrect.When the transaction meets the tax requirements of a redemption, a stockholder generally will receivecapital gains treatment on the exchange of his shares per the tax law.]

25. Which of the two methods (cost method or par value method) should be used if the company is not planningon reissuing the stock? (Page 159)

a. Cost method. [This answer is incorrect. Although the cost method is easier to apply, it is not therecommended method in redemptions where the company is not planning on reissuing the stock. Inaddition, this method will prevent the redemption from resulting in a deficit in retained earnings.]

b. Par value method. [This answer is correct. Although the par value method is the more complicatedmethod to apply, this method should be used if the company is not considering reissuing the stock.]

26. Medco Corporation is wholly owned by two stockholders in equal percentages. Each stockholder has a buy�sellagreement with the corporation requiring the corporation to purchase his shares for $450,000 in the event ofhis death. Assume one of the stockholders dies, how much is the retained earnings balance after theredemption using the par value method? (Page 159)





a. $110,000. [This answer is incorrect. All of the $450,000 redemption is not allocated to retained earnings.The common stock and additional paid�in capital accounts must also be adjusted.]

b. $160,000. [This answer is correct. Of the $450,000 redemption price, $20,000 is a reduction incommon stock, $30,000 is a reduction in additional paid�in capital, and the remaining $400,000reduces retained earnings. Therefore, the common stock balance is $20,000, the additional paid�incapital balance is $30,000, and the retained earnings balance is $160,000.]

c. $280,000. [This answer is incorrect. The retained earnings amount is not divided in half to account for thestock redemption. However, using the par value method, common stock and additional paid�in capital aredivided into half.]


166

d. $560,000. [This answer is incorrect. $560,000 is retained earnings amount before the redemption and alsothe retained earnings amount after redemption using the cost method. The par value method adjusts theretained earnings amount.]

27. If property is distributed in a buy�sell redemption, what effect does the distribution have on temporarydifferences? (Page 160)

a. It does not affect temporary differences. [This answer is incorrect. It is possible that a distribution ofproperty will not affect temporary differences if the gain or loss recognized in the financial statements doesnot differ from amounts reported in the tax return. However, this is not always the case.]

b. It will cause a temporary difference. [This answer is incorrect. In this situation, when a gain or lossrecognized in the financial statements differs from amounts reported in the tax returns, a temporarydifference does not occur. A distribution of an asset cannot cause a temporary difference, because thedifference would never reverse.]

c. It will cause a permanent difference. [This answer is incorrect. A property distribution in a buy�sellredemption could, at times, cause a permanent difference. A loss cannot be deducted on the tax return,because deducting losses on distribution of assets is not permitted.]

d. It may cause a temporary difference to reverse. [This answer is correct. The gain or loss recognizedin the financial statements resulting from a distribution of property may differ from amountsreported in the tax return. However, that difference would always be a reversal of a temporarydifference. (Since the difference arises from the distribution of an asset, it can never reverse and,therefore, would not be an originating temporary difference.)]

28. A redemption is accomplished through a distribution of property. The distributed asset has a basis of $4,500for financial statement reporting, $3,000 for tax reporting, and a fair market value of $2,500. What is one effectof the distribution? (Page 160)

a. A $500 taxable loss. [This answer is incorrect. Deducting distribution losses on the tax return is notpermitted.]

b. A $1,500 temporary difference. [This answer is incorrect. Temporary differences to not arise from thedistribution of an asset.]

c. A $2,000 reversal of a taxable temporary difference. [This answer is incorrect. Since the temporarydifference prior to the distribution was $1,500, $1,500 is the amount of the reversal.]

d. A permanent difference occurs. [This answer is correct. Because none of the loss on the asset isdeductible for tax purposes, a permanent difference occurs.]


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HOW TO ACCOUNT FOR PARTNERSHIPS

Accounting for Changes in the Equity Interests of an Entity

The consideration transferred for a change in the equity interests of a small or midsize nonpublic entity, such as thecontribution of capital by a new investor or the purchase of an existing equity interest, typically is based on the fairvalue of the entity. For example, to determine how much a new investor must pay for a small equity interest in theentity, the fair value of the entity may be multiplied by the percentage of ownership conveyed by the interest and bya factor designed to recognize that the interest does not convey control or even the ability to exercise significantinfluence. Does the transfer of consideration for a change in the equity interest mean that appreciation in the fairvalue of the entity's net assets has been realized and should be recognized?

Changes in equity interests may be between equity investors or between equity investors and the entity. Theconsideration transferred for a small or midsize nonpublic entity to acquire a major equity interest often includesenough appreciation in net assets so that the charge to equity to record the purchase reduces the carrying amountof equity below zero. That suggests that at least the appreciation included in the consideration transferred wasrealized and should be recognized through an increase in the carrying amount of the entity's net assets. It alsosuggests that the change was large enough that in effect there is a new entity, and the entity's net assets should berevalued to their fair value at the date of acquisition.

Should the answer for whether the entity should recognize appreciation in the fair value of its net assets depend onthe form of the change? For example, should the answer for the illustration mentioned above be different if theequity interest acquired is relatively small?

Should the answer as to whether the entity should recognize appreciation in the fair value of its net assets dependon the significance of the change? For example, should the answer for the illustration as mentioned above bedifferent if the equity interest acquired is relatively small?

The authoritative accounting literature has not addressed these and related questions. However, accountingtextbooks have addressed them for partnerships. Textbooks typically discuss two methods of accounting forchanges in a partnership's equity intereststhe bonus method and the goodwill method. Generally, no appreci�ation is recognized under the bonus method, but under the goodwill method all the appreciation in the fair value ofthe partnership's net assets is recognized. The EITF discussed, but did not conclude on, a third method, whichresults in recognition of some of the appreciation.

FASB ASC 805 [formerly SFAS No. 141(R), Business Combinations] provides guidance on accounting for theacquisition of a controlling financial interest in another entity. Generally, the acquiring entity should record all of thenet assets of the acquired entity at their fair value. The offsets are the consideration transferred for the acquisitionand the fair value of any noncontrolling interest in the acquired entity. Subsequent unrealized changes in fair valuesshould be recognized only if required by other generally accepted accounting principles, such as for equitysecurities with a readily determinable fair value or for impairment of long�lived assets.

The guidance in FASB ASC 805 suggests that a reasonable framework for small and midsize nonpublic entities touse in deciding whether to recognize appreciation in the fair value of their net assets because of changes in equityinterests would be to push down the values recorded by the acquiring entity in a business combination. Thedecision on whether to apply push�down accounting depends on whether the primary users of the financialstatements of the entity acquired would find the resulting information helpful. However, push�down accounting isnot required.

Guaranteed Payments to Partners

Guaranteed payments to partners are often made as salary payments for services or interest on capital accounts.The conventional method of accounting for such payments to partners is to treat the payments as part of theallocation of partnership net income, rather than as an expense in determining net income. However, in somesituations, e.g., the payments are designed to reflect reasonable compensation for services, it may be moremeaningful to show the payments as expenses of the partnership. Whenever guaranteed payments are material,


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the method of accounting for them should be included in the accounting policies disclosures. An example of sucha disclosure is as follows:


Guaranteed Payments to Partners

Guaranteed payments to partners that are intended as compensation for services rendered areaccounted for as partnership expenses rather than as allocations of partnership net income.Guaranteed payments that are intended as payments of interest on capital accounts are notaccounted for as expenses of the partnership, but rather, as part of the allocation of net income.

Because guaranteed payments are deductible by the partnership and payments in liquidation of a partnershipinterest are not, guaranteed payments are frequently used as a vehicle for purchasing the interest of a partner.Amounts paid in return for the partnership interest should be accounted for following the guidance in �Liquidation(Buy Out) of a Partnership Interest."

Capital Contributions

After a partnership is formed, a partner may contribute assets to it. (For example, a partner may contributeadditional cash to fund cash flow shortages.) A partnership should record such contributions as follows:

� Cash. Cash is the simplest form of capital contribution. The contributing partner's capital account shouldbe increased by the amount of cash contributed.

� Real Estate or Other Assets. In accordance with FASB ASC 845�10�30�1 [(formerly Paragraph 18 of APBOpinion No. 29), which does not apply to companies under common control] the amount recorded for anonmonetary asset received in a nonreciprocal transfer should be the fair value of the asset received.Consequently, the contributing partner's capital account should be increased by the fair value of the assetcontributed. [FASB ASC 970�323�30�3 and 30�4 (formerly SOP 78�9, Accounting for Investments in Real

Estate Ventures) discusses situations in which an investor (a)�contributes real estate, (b) immediatelywithdraws cash or other assets, and (c) has no commitment to reinvest the amount withdrawn. Thestandard states that such transactions more closely resemble sales than capital contributions and shouldbe accounted for by the investor in accordance with FASB ASC 360�20 (formerly SFAS No. 66, Accountingfor Sales of Real Estate).]

CONSIDERATIONS FOR LIMITED LIABILITY COMPANIES

Limited liability companies (LLCs) are a creation of state law. Each state establishes its own LLC rules andcharacteristics. Generally, LLCs are owned by members and combine many of the tax advantages of a partnershipwith the liability protection of a corporation. For example, members are not personally liable for the LLC's debts orliabilities, except to the extent of their investment and any remaining capital commitment to the LLC. However,unlike a limited partner in a partnership, a member of an LLC can participate in management of the entity.

General Tax Treatment

The attractiveness of LLCs depends on their treatment as partnerships for federal income tax purposes. TheInternal Revenue Service has replaced the previous rules that made it difficult to determine whether an LLC shouldbe treated as a partnership or a corporation for federal income tax purposes with �check the box" entity classifica�tion regulations. Under the �check the box" regulations, LLCs with more than one member can elect to be treatedas partnerships for federal income tax purposes, even though they have corporate characteristics. (LLCs also canelect to be treated as corporations; however, that option is attractive only in limited circumstances, such as when Scorporation status is desired to minimize the owners' liability for payroll taxes on their earnings.)

Single�member LLCs. The �check the box" regulations allow single�member LLCs, which are permitted by somestates, to elect to have their existence ignored for federal income tax purposes. For example, an LLC owned by a


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single individual can elect to be treated as a sole proprietorship. An LLC wholly owned by another legal entity, suchas a corporation, can elect to be treated as an unincorporated branch of the parent entity. Alternatively, a single�member LLC can elect to be treated as a corporation in the event that choice is more attractive.

Default Classification Rules. Domestic LLCs in existence before January 1, 1997, generally retain their existing taxstatus by default. However, existing single�member LLCs that claimed partnership status under the former tax rulesare classified by default as sole proprietorships or unincorporated branches of a parent entity, rather than aspartnerships. New domestic LLCs are automatically treated as partnerships if they have more than one member, oras sole proprietorships or unincorporated branches if there is only a single member. Alternatively, LLCs can chooseto be treated as corporations by making an affirmative �check the box" election. An LLC wishing to elect aclassification different from its initial default classification must file an affirmative �check the box" election. The sameis true when an LLC later wishes to change its existing classification.

Conversion of an Existing Entity to an LLC. Internal Revenue Service private letter rulings generally have heldthat the conversion of a partnership to an LLC (whether by merger or otherwise) is treated as a continuation of thepartnership with no tax consequences, unless the conversion causes a shift in the allocation of liabilities among thepartners/members. If a shift in liabilities causes a deemed distribution of cash in excess of a member's basis in theLLC, a gain will be recognized. The conversion of a corporation to an LLC (assuming the LLC is treated as apartnership) will result in the recognized liquidation of the corporation and the formation of a new partnership forfederal income tax purposes, with all of the accompanying tax consequences. Gain or loss will be recognized bythe shareholders, as well as by the corporation on the disposition of its property upon liquidation.

Tax Uncertainties. Despite the issuance of numerous IRS revenue rulings and private letter rulings, certain taxconsequences of operating as an LLC still are uncertain. Some of the tax uncertainties relate to:

� At�risk Rules. A member may deduct LLC losses only to the extent the member is �at risk." Because thedebts of an LLC generally will not increase a member's amount at risk, many LLC members with enoughbasis to deduct their share of LLC losses may be unable to deduct the losses under the limitations imposedby the at�risk rules.

� Passive Activity Rules. Uncertainty exists about whether an LLC member will be treated as a limited partnerfor purposes of determining whether an activity is active or passive to that member. Under the passiveactivity loss rules, limited partners must meet more stringent requirements than general partners todemonstrate material participation.

� Accounting Methods. Although IRS private letter rulings have allowed LLCs to use the cash method inspecific circumstances, it is not clear whether all LLCs are eligible to use the cash method.

� General versus Limited Partner Status. By definition, all LLC members have limited liability, a majorcharacteristic of limited partners. However, while some LLC members do not participate in the company'smanagement (like limited partners), other members do significantly participate in management, which isa characteristic of a general partner. Defining a limited partner for LLC purposes currently varies underdifferent regulations.

Tax Advantages. Despite the tax uncertainties, the following are some of the advantages of LLCs for federal incometax purposes:

� An LLC, classified as a partnership, has the flexibility to make special allocations of income and loss amongits members.

� LLC members can include entity debt, for which they are not liable, in their equity bases for the purposeof deducting entity losses. (The debts of an LLC generally will not increase a member's amount at risk.Therefore, many LLC members with enough basis to deduct their share of LLC losses may be unable todeduct the losses under the limitations imposed by the at�risk rules.)

� An LLC can step up the basis of its assets under IRC Section 754. (The sale of a member's interest to anothermember or to a third party who becomes a member does not result in taxable gain for the LLC.


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Consequently, such a sale generally does not affect the LLC's books. However, IRC Section 754 allows anLLC to elect to adjust the basis of LLC assets to reflect the excess of the price paid by a new member overthat member's proportionate share of the adjusted basis of LLC assets. If such an election is made, thebasis of assets may be different for financial and tax reporting purposes.)

� An LLC generally can distribute appreciated property without the entity�level recognition of gain. [An LLC,classified as a partnership for tax purposes, is required to specifically allocate precontribution gain to themember who contributed the asset under IRC Section 704(c).]

� An LLC member can contribute appreciated property to the LLC without being subject to the 80% controlrequirement of IRC Section 351.

Accounting for LLCs

While LLCs are unique legal entities, they do not give rise to a significant number of accounting or reporting issuesthat differ from those of partnerships. FASB ASC 272�10 (formerly Practice Bulletin No. 14, Accounting and

Reporting by Limited Liability Companies and Limited Liability Partnerships) provides guidance on applying existingaccounting literature to LLCs. Although that literature generally does not impose any new accounting requirements,the paragraphs below discuss some of the unique aspects of preparing LLC financial statements, using thatguidance.

Financial Statement Headings. Practice Bulletin No. 14 requires the headings of an LLC's financial statements toclearly identify the entity as an LLC, even in jurisdictions that do not legally require LLCs to include the LLCdesignation in their names.

Equity Section of the Balance Sheet. Since owners of a limited liability company are referred to as members,FASB ASC 272�10�45�3 (formerly Practice Bulletin No. 14) states that the equity section of the balance sheet shouldbe labeled �Members' Equity." If more than one class of members exists, LLCs are encouraged to report the equityof each class separately within the equity section of the balance sheet. Otherwise, the equity amounts must bedisclosed in the notes to the financial statements. Ownership interests may be represented by membershipcertificates or shares. For example, an LLC may issue Class I shares that have unlimited voting rights and Class IIshares that have only limited rights and privileges. Different classes of shares also may have different rights as tothe distribution of assets upon dissolution of the company. If ownership interests are represented by membershipcertificates or shares, the equity section of the balance sheet will resemble that of a corporation that discloses eachclass of stock on the face of the balance sheet. If ownership interests are not represented by membershipcertificates or shares, the equity section of the balance sheet will resemble that of a partnership. Generally, only asingle amount will be shown. However, if it is desirable to disclose separately the equity accounts of those memberswho have been designated as managers, a presentation such as the following can be made:

MEMBERS' EQUITY

Managing members $ 75,000

Nonmanaging members 25,000

$ 100,000

The operating agreement of some LLCs may provide that unless the transfer (for example, by assignment orinheritance) of a member's interest is approved by the remaining members, the transferee will not be permitted toparticipate in the management of the LLC or become a member. Instead, the transferee is entitled only to receivethe share of profits or other compensation by way of income and return of contributions to which the assigningmember otherwise would be entitled. If desired, the portion of members' capital owned by such non�approvedtransferees also could be disclosed. In addition, FASB ASC 272�10�50�1 (formerly Practice Bulletin No. 14) statesthat if the LLC maintains separate accounts for components of members' equity (such as undistributed earnings,earnings available for withdrawal, or unallocated capital), disclosure of those components is permitted (but notrequired) either on the face of the balance sheet or in the notes.

If a member's equity account is less than zero, FASB ASC 272�10�45�4 (formerly Practice Bulletin No. 14) states thata deficit should be reported even though the member's liability may be limited. In addition, if the LLC records


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amounts due from members for capital contributions, those amounts should be presented as deductions frommembers' equity rather than as assets.

Changes in Members' Equity. FASB ASC 272�10�45�1 (formerly Practice Bulletin No. 14) requires LLCs to presentinformation related to changes in members' equity for the period. The information may be presented as a separatestatement, combined with the statement of income, or in the notes.

Federal Income Taxes. If the LLC is considered a partnership for federal income tax purposes, income is taxed tothe members rather than to the LLC. Like partnerships, the financial statements of an LLC should not include federalincome tax expense or the related liability. If the statement of income presents net income after federal incometaxes, it is not prepared in accordance with GAAP. However, it may be appropriate to record a liability for anysubstantial member withdrawals that are anticipated to pay income taxes and that are formally approved before thebalance sheet date. Although not required by GAAP, it is recommended the financial statements disclose (a) thatthe LLC does not pay income taxes and (b)�any anticipated withdrawals by members to pay income taxes, whetheror not recorded as a liability in the financial statements. With respect to item (b), the accountant should considerdisclosing any withdrawals made since the balance sheet date. An illustrative note follows:


Federal Income Taxes

The Company is not a taxpaying entity for federal income tax purposes, and thus no income taxexpense has been recorded in the statements. Income of the Company is taxed to the membersin their respective returns. The members customarily make substantial capital withdrawals in Aprilof each year to pay their personal income tax liabilities. At December 31, 20X1, $75,000 has beendeposited in a Company savings account in anticipation of member withdrawals.

Even if an LLC is taxed as a partnership, its operating agreement may require a provision for income taxes to becomputed at a specified rate and included as an expense of the LLC. The inclusion of such a tax provision is adeparture from GAAP.

State Income and Franchise Taxes. The tax status of an LLC may not necessarily be the same for both federal andstate tax purposes. In some states, LLCs are subject to state franchise or income tax even if they qualify aspartnerships for federal income tax purposes. Any state income tax should be shown in the financial statements asan expense of the LLC. Also, as specifically addressed in FASB ASC 272�10�60�2 (formerly Practice Bulle�tin�No.�14), deferred taxes should be accounted for and recorded on a jurisdiction�by�jurisdiction basis in accor�dance with GAAP. (In addition, LLCs that are subject to federal income taxes should account for those taxes inaccordance with GAAP.) The nature of any income taxes paid by the LLC also should be disclosed (if material). If theLLC's tax status in a jurisdiction changes from taxable to nontaxable, any deferred tax assets and liabilities relatedto that jurisdiction should be eliminated.

Conversion of an Existing Entity to an LLC. LLCs frequently are formed when an existing entity is converted toLLC status. The converting entity often is a partnership. However, C corporations and S corporations also maymerge with an LLC or convert to LLC status. An LLC formed by the conversion of a partnership generally isconsidered a continuation of the partnership, and no new taxable entity comes into being. However, the conversionof a corporation to LLC status results in the creation of a new entity for tax purposes. (A change in the legal form ofbusiness is not considered a change in reporting entity for financial reporting purposes.)

Comparative Financial Statements. When one or more prior years' financial statements are presented after achange to an LLC, the question arises whether the prior years' statements should be modified. As discussed,changes in the legal form of business, for example, from an S�corporation or partnership to an LLC, are not changesin the reporting entity. Consequently, retrospective application is not appropriate. However, to enhance comparabil�ity, it may be necessary to modify the format of the prior year statements. If that is done, a note such as the followingcan be included to disclose the change:


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NOTE XRECLASSIFICATIONS

Certain accounts in the prior�year financial statements have been reclassified for comparativepurposes to conform with the presentation in the current�year financial statements.

As a practical matter, especially when a corporation is converted to an LLC, the LLC may choose to presentsingle�period statements for the first reporting period following the change.

While changing the legal form of an entity to an LLC does not constitute a change in reporting entity, formation ofan LLC may result in a change in reporting entity in some cases. For example, if commonly�owned companies forwhich combined financial statements had not previously been presented were combined into a single LLC, achange in reporting entity would occur. In that case, the disclosures that are required by FASB ASC 250�10�45�21(formerly SFAS No. 154) should be made and financial statements for all periods presented should reflect the newreporting entity.

Specified LLC Disclosures. According to FASB ASC 272�10�50�1 through 50�5 (formerly Practice Bulletin No. 14),an LLC should disclose the following:

� A description of any limitation of members' liability. (The liability of members in most states is limited to themembers' enforceable obligation to make capital contributions and the members' obligation to return anyprohibited or illegal distributions. The identification of the entity as a limited liability company alerts financialstatement readers to the general limitation of members' liability. Therefore, the requirement to describelimitations relates to special limitations, such as those imposed by some states on the managing member'sliability or the special liability considerations for members of professional limited liability entities.)

� The different classes of members' interests (if more than one class exists), and the respective rights,preferences, and privileges of each class. (If the LLC does not report the equity amount of each classseparately in the equity section of the balance sheet, the equity amounts also must be disclosed in thenotes.)

� The date the LLC will cease to exist if it has a finite life.

� The separate components of members' equity, such as undistributed earnings, earnings available forwithdrawal, or unallocated capital, if the LLC maintains such components. (Such disclosure is permittedbut not required.)

� Any relevant income tax disclosures required by FASB ASC 740�10�50 (formerly SFAS No. 109).

Limited Liability Partnerships

Limited liability partnerships (LLPs) are a special type of partnership allowable under the laws of all states. LLPswere enacted in response to the concern that a partner of a professional firm can be held liable for the malpracticeof another partner in the same firm. The partners in an LLP remain personally liable for the commercial and otherobligations of the entity, their own acts and omissions, and for the acts and omissions of persons under theirsupervision. However, LLP partners are not liable for acts and omissions by the other LLP partners and nonsuper�vised employees. Thus, LLPs generally provide less liability protection than LLCs but more than general partner�ships.

Accounting and Reporting Issues. Similar to LLCs, LLPs do not give rise to a significant number of accounting orreporting issues that differ from those of partnerships. FASB ASC 272�10 (formerly Practice Bulletin No. 14)provides guidance on applying existing accounting literature to LLPs as well as LLCs. In fact, FASB ASC272�10�05�5 (formerly Practice Bulletin No. 14) states in its guidance that the collective term �limited liabilitycompanies" includes both LLCs and LLPs. Therefore, the unique accounting and reporting issues for LLCsdiscussed in the �Accounting for LLCs" section also apply to LLPs.


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SELF�STUDY QUIZ


29. Which of the following partnership transactions is correctly recorded?

a. A nonreciprocal transfer of nonmonetary assets is recorded at fair value.

b. A real estate contribution followed by a cash withdrawal from the partnership with no commitment toreinvest should be recorded as a capital contribution.

c. Guaranteed payments are not deductible by the partnership.

30. Which of the following is a tax disadvantage of a company organizing as an LLC?

a. Appreciated property can be allocated in an LLC without the entity recognizing a gain.

b. The 80% control requirement is not required for members to contribute appreciated property to an LLC.

c. LLC loses can only be deducted by the member to the extent the member is �at risk."

d. Under IRC Section 754, the LLC's assets basis can be stepped up.

31. Which of the following statements applies to accounting for LLCs?

a. Owners of a limited liability company are called partners.

b. Each class of equity can be reported separately on the balance sheet.

c. A member's equity account cannot fall below zero.

d. Amounts due for capital contributions are presented as assets.

32. Forming an LLC by the conversion of what type of entity is considered a continuation of that entity?

a. Partnership.

b. S corporation.

c. C corporation.

33. Which of the following is not a required disclosure for a limited liability company in the financial statements?

a. If the LLC was only set up for a specified time period, the date that it will no longer exist.

b. If the LLC maintains their members' equity in separate components, it must be disclosed.

c. A description of the liability limitations on the members of the LLC.

d. The different classes, rights, preferences and privileges of each class of members' interest in the LLC.


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29. Which of the following partnership transactions is correctly recorded? (Page 168)

a. A nonreciprocal transfer of nonmonetary assets is recorded at fair value. [This answer is correct.In accordance with FASB ASC 845�10�30�1 (formerly Paragraph 18 of APB Opinion No. 29), theamount recorded for a nonmonetary asset received in a nonreciprocal transfer should be the fairvalue of the asset received.]

b. A real estate contribution followed by a cash withdrawal from the partnership with no commitment toreinvest should be recorded as a capital contribution. [This answer is incorrect. If an investor contributesreal estate, then immediately withdraws cash with no commitment to reinvest the amount withdrawn, theStandard states that the transaction more closely resembles a sale than a capital contribution inaccordance with FASB ASC 360�20 (formerly SFAS No. 66).]

c. Guaranteed payments are not deductible by the partnership. [This answer is incorrect. Guaranteedpayments are deductible by the partnership while payments in liquidation of a partnership interest are not.Therefore, guaranteed payments are frequently used as a vehicle for purchasing the interest of a partner.]

30. Which of the following is a tax disadvantage of a company organizing as an LLC? (Page 169)

a. Appreciated property can be allocated in an LLC without the entity recognizing a gain. [This answer isincorrect. If an LLC can distribute appreciated property without an entity�level recognition of a gain, thiswould be a tax advantage, not disadvantage, because it would keep the LLC's taxable income lower andthus, the entity would owe less taxes.]

b. The 80% control requirement is not required for members to contribute appreciated property to an LLC.[This answer is incorrect. Since an LLC member can contribute appreciate property to an LLC withoutbeing subject to the 80% control requirement cited in IRS code, a member can contribute more property,which would be a tax advantage to the LLC member.]

c. LLC loses can only be deducted by the member to the extent the member is �at risk." [This answeris correct. Because the debts of an LLC generally will not increase a member's amount at risk, manyLLC member with enough basis to deduct their share of LLC losses may be unable to deduct thelosses under the limitations imposed by the at�risk rules.]

d. Under IRC Section 754, the LLC's assets basis can be stepped up. [This answer is incorrect. IRC Section754 allows and LLC to elect to the adjust the basis of LLC assets to reflect the excess of the price paid bya new member over that member's proportionate share of the adjusted basis of LLC assets. If such anelection is made, the basis of assets may be different for financial and tax reporting purposes.]

31. Which of the following statements applies to accounting for LLCs? (Page 170)

a. Owners of a limited liability company are called partners. [This answer is incorrect. Owners of a limitedliability company are referred to as members. According to FASB ASC 272�10�45�3 (formerly PracticeBulletin No. 14), the equity section of the balance sheet should be labeled �Members' Equity."]

b. Each class of equity can be reported separately on the balance sheet. [This answer is correct. In fact,FASB ASC 272�10 (formerly Practice Bulletin No. 14) encourages LLCs to report the equity of eachclass separately within the equity section of the balance sheet. Otherwise, the equity amounts mustbe disclosed in the notes to the financial statements.]

c. A member's equity account cannot fall below zero. [This answer is incorrect. If a member's equity accountis less than zero, FASB ASC 272�10�45�4 (formerly Practice Bulletin No. 14) states that a deficit should bereported even though the member's liability may be limited.]


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d. Amounts due for capital contributions are presented as assets. [This answer is incorrect. If the LLC recordsamounts due from members for capital contributions, those amounts should be presented as deductionsfrom members' equity rather than as assets.]

32. Forming an LLC by the conversion of what type of entity is considered a continuation of that entity? (Page 171)

a. Partnership. [This answer is correct. An LLC formed by the conversion of a partnership generallyis considered a continuation of the partnership, and no new taxable entity comes into being understate laws and the Revised Uniform Limited Partnership Act.]

b. S corporation. [This answer is incorrect. S corporations may merge with an LLC or convert to LLC status.However, the conversion of an S corporation to LLC status results in the creation of a new entity for taxpurposes per the IRS.]

c. C corporation. [This answer is incorrect. A new entity is formed when a C corporation converts to an LLC.However, the change in the legal form of business is not considered a change in reporting entity for financialreporting purposes. Conversion of a C corporation into an LLC always involves the liquidation of thecorporation and results in a double tax.]

33. Which of the following is not a required disclosure for a limited liability company in the financial statements?(Page 172)

a. If the LLC was only set up for a specified time period, the date that it will no longer exist. [This answer isincorrect. Per FASB ASC 272�10�50, the date that the LLC will cease to exist, if it has a finite life, must bedisclosed by the LLC.]

b. If the LLC maintains their members' equity in separate components, it must be disclosed. [Thisanswer is correct. Although the disclosure of the separate components of members' equity for theLLC is permitted, it is not required by FASB ASC 272�10�50.]

c. A description of the liability limitations on the members of the LLC. [This answer is incorrect. A requireddisclosure of the LLC per FASB ASC 272�10�50 is a description of any limitation of members' liability. Theliability of members in most states is limited to the members' enforceable obligation to make capitalcontributions and the members' obligation to return any prohibited or illegal distributions.]

d. The different classes, rights, preferences and privileges of each class of members' interest in the LLC. [Thisanswer is incorrect. According to FASB ASC 272�10�50, a disclosure requirement of a LLC is the differentclasses of members' interest and the respective rights, preferences, and privileges of each class. If the LLCdoes not report the equity amount of each class separately in the equity section of the balance sheet, theequity amounts almost must be disclosed in the notes.]


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TAX STATUS CHANGES

General Guidance

A company generally changes its tax status in one of the following ways:

a. A corporation elects or terminates S corporation status.

b. A proprietorship or partnership incorporates.

c. A corporation converts to a partnership, an LLC taxed as a partnership, or a proprietorship.

FASB ASC 740�10�25�32 and 740�10�40�6 (formerly Paragraph 28 of SFAS No. 109) requires a change in acompany's tax status to be accounted for as follows:

a. If the change is from nontaxable to taxable, a deferred tax liability or asset should be recognized at the dateof the change through a charge or credit to income from continuing operations.

b. If the change is from taxable to nontaxable, existing deferred tax assets or liabilities should be eliminatedat the date of the change through a charge or a credit to income from continuing operations.

The remainder of this section explains how to account for specific changes in tax status.

Converting from C to S Corporation

Many C corporations have found it advantageous to convert to S corporation status. In making the conversion, thefollowing accounting issues should be considered:

� How should deferred taxes recorded by a C corporation be accounted for if an S corporation election ismade?

� May comparative financial statements that include years before and after the conversion be issued?

� Should the retained earnings components of the S corporation be segregated in the financial statements?

� How should a stub period that results from adopting a calendar year for a new S corporation be presented?

Deferred Taxes Should Be Eliminated. FASB ASC 740�10�40�6 (formerly SFAS No. 109) requires deferred taxassets and liabilities to be eliminated through a charge or credit to the tax provision for the year the companyceases to be a taxable enterprise. The following summarizes the considerations in calculating the adjustment:

a. Question 12 of the FASB Special Report, A Guide to Implementation of Statement 109 on Accounting for

Income Taxes, requires a company that changes from C corporation status to S corporation status tocontinue to recognize a deferred tax liability to the extent that it would be subject to a corporate level taxon net unrecognized �built�in gains." The deferred tax liability is based on the lesser of an unrecognizedbuilt�in gain as defined by the tax law or an existing temporary difference. However, according to the SpecialReport, since the timing of realization of a built�in gain can determine whether it is taxable, and thussignificantly affect the deferred tax liability to be recognized, actions and elections that are expected to beimplemented should be considered.

b. FASB ASC 740�10�40�6 (formerly SFAS No. 109) requires the adjustment for the change in tax status to becalculated as of the date that the change is approved by the taxing authority or on the date of filing theelection, if approval is not necessary, rather than as of the date that the election actually is effective. SinceIRS approval is rarely required when S corporation status is elected, best practices indicate that, as ageneral rule, the change in tax status occurs when the election is filed. At that date, deferred tax assets andliabilities for temporary differences that will reverse after the effective date of the change in tax status shouldbe eliminated.


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c. S corporation status may be elected either retroactively or prospectively. If the election is filed within 21/2months after the beginning of the fiscal year and the company meets certain eligibility requirements, theelection is effective retroactively to the beginning of the year. The election may be filed at any time duringthe year, however, to be effective prospectively for the following year. The effects of retroactive andprospective election are summarized below.

Retroactive ElectionAssume that a qualified corporation elects S corporation status by filing Form�2553within 21/2 months after its 20X0 year end. The corporation meets all of the eligibility requirements for thepre�election portion of 20X1, and all of the company's stockholders during that portion of the year consentto the election. Under current tax rules in those circumstances, the S�corporation election is effectiveretroactively as of the beginning of 20X1. Even though the change is effective at the beginning of 20X1,however, the company's 20X0 year�end financial statements should continue to report deferred taxes.(Question 11 of the FASB Special Report requires the change in tax status and the effects of the change,if material, to be disclosed in the company's 20X0 financial statements as a subsequent event.) Thecompany's existing deferred tax assets and liabilities at the date that the election is filed should beeliminated through a charge or credit to the income tax provision.

To illustrate the amounts that should be disclosed in the financial statements, assume that the companyfiles its S corporation election on February 28, 20X1. FASB ASC 740�10�40�6 (formerly SFAS No. 109)requires deferred tax assets and liabilities at that date to be calculated. The change in the company'sdeferred tax assets and liabilities from January 1, 20X1, to February 28 would be disclosed as the deferredtax provision for 20X1, and the write off of the deferred tax balance sheet account at February 28 would bethe adjustment caused by the change in tax status. In many instances, best practices indicate that the filingdate and the effective date of retroactive elections are close enough that the adjustment for the change intax status approximates the deferred tax asset or liability at the beginning of the year. In those cases, interimcalculations of deferred taxes need not be made.

Prospective ElectionIf a company elects S corporation status that will be effective prospectively, it alsois necessary to determine the deferred tax asset or liability as of the interim date that the election is filedas explained in the preceding paragraphs for retroactive elections. The deferred tax asset or liability at thefiling date should be adjusted to the amount that represents the tax effect of temporary differences expectedto reverse between the filing date and the beginning of the following year. No provision should be madefor the deferred tax effect of temporary differences expected to originate between the filing date and theeffective date.

To illustrate, assume that a calendar�year company files an election on June 30, 20X1, to elect S�corporationstatus effective January 1, 20X2. At the filing date, deferred taxes that are expected to reverse during theperiod from June 30 to the end of the year should remain in the deferred tax balance sheet account; theremainder should be charged or credited to the tax provision as of the date the election is filed. In manyinstances, the filing date and the effective date of prospective elections are close enough that the changein tax status approximates the balance of the deferred tax asset or liability that would have been calculatedat the end of the year if the tax status had not been changed.

The following illustrates an example of the disclosure that would be made in the year of conversion for a companyeliminating a deferred tax asset in the amount of $110,000:


Income Taxes

The Company has elected S corporation status effective January 1, 20X2 (Note�X). Earnings andlosses after that date will be included in the personal income tax returns of the stockholders andtaxed depending on their personal tax strategies. Accordingly, the Company will not incur addi�tional income tax obligations, and future financial statements will not include a provision forincome taxes. Prior to the change, income taxes currently payable and deferred income taxesrelated primarily to differences between the financial basis of trade accounts receivable and theirtax basis were recorded in the financial statements.


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NOTE XCHANGE IN TAX STATUS

The provision for income taxes consists of the following components:

20X2 20X1

Current $ � $ 30,000

Deferred 110,000 (7,000 )

$ 110,000 $ 23,000

As discussed in Note A, the Company changed its tax status from taxable to nontaxable in 20X2.Substantially all of the deferred tax provision in 20X2 relates to the elimination of the deferred taxasset at the date the election for the change was filed.

Comparative Presentations May Include Periods before and after the Conversion. The effect of a change in taxstatus on the comparability of financial statements is clearly isolated through disclosures such as the onesillustrated in the preceding paragraph. Therefore, comparative financial statements may include periods bothbefore and after the conversion. Some accountants disclose S corporation status in the financial statementheadings. While that approach is acceptable, best practices indicate that the critical disclosure is in the financialaccounting policies note. Additional disclosure in statement headings is optional.

Disclosing Components of S Corporation Retained Earnings Is Optional. A corporation converting from C to Sstatus will segregate its retained earnings into the following components for tax purposes:

� Accumulated Earnings and Profits (AEP)essentially represents undistributed tax basis earnings on the

date of conversion. It differs from retained earnings reported in GAAP financial statements because AEPexcludes cumulative temporary differences. All permanent differences would be included in AEP, since itwould normally be impractical to determine cumulative permanent differences at the date of conversion.(The Small Business Job Protection Act of 1996 requires a corporation that is an S corporation for its firsttax year beginning after 1996 to eliminate any AEP accumulated in S corporation tax years beginningbefore 1983.)

� Accumulated Adjustments Account (AAA)essentially represents undistributed tax basis retainedearnings arising after the date of conversion. It excludes temporary differences that originate or reverse afterthe date of conversion and only includes permanent differences relating to nondeductible expensesincurred after the date of conversion.

� Tax Timing Adjustments (TTA)essentially represents cumulative temporary differences at any balancesheet date. The adjustment to eliminate a deferred tax asset or liability at the date of conversion should berecognized in the tax provision for the year of the conversion and closed to the TTA. Therefore, at the dateof conversion, the TTA represents cumulative temporary differences less the related deferred tax effect.Subsequently, the account is adjusted for temporary differences that originate and reverse after theconversion, but the opening adjustment for the elimination of deferred taxes is frozen.

� Other Retained Earnings (ORE)essentially is a residual amount and consists primarily of tax�exemptincome arising since the date of conversion.

To illustrate the components of retained earnings, assume that at the date a corporation converts to S status, it hasGAAP retained earnings of $500,000, a $100,000 excess of cumulative tax depreciation over GAAP depreciation,and a deferred tax liability of $40,000. Its opening retained earnings would consist of AEP and TTA computed asfollows:

AEP TTA TOTAL

GAAP retained earnings $ 500,000 $ � $ 500,000

Taxable temporary difference (100,000 ) 100,000 �

Deferred tax liability 40,000 (40,000 ) �

$ 440,000 $ 60,000 $ 500,000


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The distinctions among the components of retained earnings are important only because they affect the taxabilityof dividends to shareholders. Generally, dividends are allocated first to AAA, then to AEP, and finally to ORE. Theyare taxed only to the extent that they are allocated to AEP.

Since distinctions among the components of retained earnings deal solely with personal tax consequences to theshareholders and do not affect an evaluation of the company's financial position, results of operations, or cashflows, disclosure of the retained earnings components is optional.

Stub Period Presentations Require Special Disclosures. A company converting from C corporation to Scorporation status is required to adopt a calendar year end unless it can establish a fiscal year as a natural businessyear or pays a deposit. Generally, it is impractical to have different year ends for financial statement and income taxreporting, and this course recommends conforming the year end for both reporting purposes. The notes to thefinancial statements should disclose the change in the year end and the effect it has on the financial statementsincluding the dollar amount if determinable. The stub period presentation may be presented in comparative formwith a full year provided that the change is adequately disclosed and the statements are appropriately captioned.The tax provision for the stub period should consist of a current provision calculated by applying annualized ratesto taxable income for the period and a deferred provision consisting of the difference between the deferred taxasset or liability at the beginning of the period and the deferred tax liability at the end of the period related to built�ingains.

LIFO Reserve Recapture. A corporation electing S corporation status is required to recapture its LIFO inventoryreserve. The amount to be recaptured is the excess of the inventory's value using a first�in, first�out (FIFO) cost flowassumption over its LIFO value at the close of its last C corporation year. The amount recaptured is included inincome on the corporation's final C corporation tax return, and the tax attributable to the recapture is payable in fourequal installments beginning with the final C corporation tax return. [Based on TD 8567, C corporations transferring

inventory to S corporations in a nonrecognition transaction (i.e., in which the transferred assets constitute trans�ferred basis property) must recapture in the year that the inventory is transferred. That year may differ from the Ccorporation's final tax year.] Taxes on the LIFO reserve recapture would be calculated as follows:

Inventory value at 12/31/X1 (last day of final C corporation year):

FIFO $ 1,200,000LIFO 1,000,000

LIFO recapture amount $ 200,000

GAAP Tax

Calculation of income taxes:

GAAP pretax income $ 350,000 $ 350,000

LIFO recapture amount � 200,000

$ 350,000 $ 550,000

Income tax (34% rate) $ 119,000 $ 187,000

Income tax attributable to LIFO recapture ($200,000 � 34% or $187,000 � $119,000) $ 68,000

Schedule of required income tax payments (payments are due by due dates of the returns):

12/31/X1 ($119,000 + 25% of $68,000) $ 136,000

12/31/X2 (25% of $68,000) 17,000

12/31/X3 (25% of $68,000) 17,000

12/31/X4 (25% of $68,000) 17,000

Total $ 187,000


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Under the recapture rules, the tax basis of the inventory is increased by the recapture amount included in incomeso that income from the sale of the inventory is only taxed once at the corporate level. The company, however, is notrequired to change to the FIFO inventory method. Rather, the built�in gain on inventory is includable in income (tothe extent of the difference between LIFO and FIFO) in the last C�corporation year. If the company retains the LIFOmethod for both financial and tax purposes, a temporary difference will be created that will reverse when theinventory is liquidated. Since liquidation will occur when the company is a nontaxable entity, however, the differenceis treated as a permanent difference. If the company changes to the FIFO inventory method for tax purposes,generally it also will adopt FIFO for financial reporting. There would be no temporary difference in that case. Thefollowing journal entry would be appropriate to record income taxes calculated in either circumstance:

Current income tax expense $ 187,000Income taxes payablecurrent portion $ 136,000Income taxes payablenoncurrent

portion 51,000

Terminating S Corporation Status

If S corporation status is terminated, a deferred tax liability and asset should be recognized for the tax effects oftemporary differences that exist at the date that the termination election is filed. The procedures for determining theeffect of the change at the date of termination are similar to those for determining the effect of an S corporationelection. However, similar to Section 351 incorporations, there are certain limitations on recognizing deferred taxassets.

Section 351 Incorporation

Brief Description. In a Section 351 transaction, the assets of a proprietorship or partnership are transferred to acorporation (generally newly formed) in exchange for stock. After the exchange, the former proprietor or partnerscontrol the corporation.

Tax Attributes. The exchange, if properly constituted under Section 351, is tax free to all parties, i.e., the proprietor�ship or partnership, the corporation, and the stockholders. The basis of the assets of the proprietorship orpartnership carries over to the corporation.

Uses. A Section 351 incorporation is generally used when a small business desires the legal or tax benefits of thecorporate form.

Accounting under GAAP. The assets and liabilities received by the corporation should be recorded on the booksof the corporation at their historical costs. Thus, the GAAP basis of the assets and liabilities to the former proprietor�ship or partnership would become their GAAP basis to the corporation. Capital stock (and frequently notespayable) in amounts equal to the net historical cost value of the assets and liabilities transferred is issued to thestockholders.

Illustration. Assume ABC Proprietorship is incorporated on July 1, 20X2, and that 1,000 shares of $1 par valuecommon stock are issued in exchange for all assets and liabilities of the proprietorship except cash. Assume ABCProprietorship has the following assets and liabilities at June 30, 20X2:

HistoricalCost Basis Tax Basis

MarketValue

ASSETS

CURRENT ASSETS

Cash $ 40,000 $ 40,000 $ 40,000

Accounts receivable 100,000 100,000 100,000

TOTAL CURRENT ASSETS 140,000 140,000 140,000

PROPERTY AND EQUIPMENT 250,000 250,000 200,000

Less accumulated depreciation 75,000 150,000 �

$ 315,000 $ 240,000 $ 340,000


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LIABILITIES

CURRENT LIABILITIES

Accounts payable $ 50,000 $ 50,000 $ 50,000

LONG�TERM DEBT 150,000 150,000 150,000

200,000 200,000 200,000

PROPRIETOR'S NET WORTH $ 115,000 $ 40,000 $ 140,000

The initial balance sheet of ABC Incorporated on July 1, 20X2, would appear as follows:

ASSETS

Accounts receivable $ 100,000

PROPERTY AND EQUIPMENT 250,000

Less accumulated depreciation 75,000

$ 275,000

LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES

Accounts payable $ 50,000

LONG�TERM DEBT 150,000

200,000


Common Stock 1,000


75,000

$ 275,000

Other Considerations

Because both the tax basis of assets and the GAAP basis carry over to the corporation, temporary differences ariseif the former proprietorship used different book and tax accounting methods, e.g., different depreciation methodsas in the preceding illustration. GAAP requires recognizing a deferred tax asset and liability for temporary differ�ences that exist at the date an entity's tax status changes from nontaxable to taxable and requires them to beestablished through a charge or credit to earnings in the period that the tax status changes. However, any lossesand tax credits incurred by a proprietorship are passed through to the proprietor and cannot be carried forward toa C corporation. Thus, deferred tax assets should not be recognized for unused losses or tax credits. Furthermore,when determining the need for a valuation allowance for a deferred tax asset, income from carryback years beforeincorporation should not be considered as a source of future income because losses of the C corporation cannotbe carried back to years when the entity was a proprietorship.

In a Section 351 incorporation, best practices indicate that the financial statements before and after the incorpora�tion are comparable with the exception of the provision for income taxes. Therefore, comparative statements mayinclude periods before and after the incorporation, provided the incorporation and the change in tax status aredisclosed. The following is an example of appropriate disclosure using the facts in the previous illustration andassuming a 30% tax rate:


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Income Taxes

Effective with the incorporation discussed in Note X, the Company became a taxable entity. Priorto incorporation, no provision was made for income taxes because earnings and losses wereincluded in the personal tax return of the proprietor, and were taxed based on his personal taxstrategies. As discussed in Note X, a deferred tax liability was provided for the cumulative excessof depreciation for tax reporting over depreciation for financial statement reporting at the date ofincorporation. After incorporation, provision has been made for the tax effects of transactionsreported in the financial statements, and consists of taxes currently due plus deferred taxesrelated to the difference between the basis of property and equipment for financial and incometax reporting.

NOTE XINCORPORATION AND CHANGE IN TAX STATUS

Effective July 1, 20X2, the Company was incorporated by issuing 1,000 shares of $1 par valuecommon stock in exchange for all assets and liabilities of ABC Proprietorship except cash. Thoseassets and liabilities were recorded in the accompanying financial statements at the proprietor�ship's historical cost basis as summarized below:

Accounts receivable $ 100,000Property and equipment 175,000Accounts payable (50,000)Long�term debt (150,000)

$ 75,000

Common stock of $1,000 and additional paid�in capital of $74,000 were recorded.

The 20X2 provision for income taxes consists of the following components:

Current $ 15,000Deferred 25,000

$ 40,000

The deferred tax liability related to temporary differences at the date of incorporation was estab�lished through a charge of $22,500 to the 20X2 tax provision.

If the tax basis of accounting was used by the proprietorship for financial reporting and GAAP will be used forfinancial reporting by the corporation, opening balances of the current�period financial statements should beadjusted to conform with generally accepted accounting principles.

Converting from Corporation to Partnership

Some corporations may convert to a partnership. In making the conversion, the following accounting issues shouldbe considered:

� How should deferred taxes recorded by a corporation be accounted for if a partnership election is made?

� Should the corporation's basis in assets and liabilities be carried over to the partnership?

� May comparative financial statements that include years before and after the conversion be issued?

� How should a stub period that results from adopting a calendar year be presented?

Deferred Taxes Should Be Eliminated. When a corporation converts to partnership status, any deferred tax assetsand liabilities at the date of the change should be eliminated through a charge or credit to the tax provision for the


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year the company ceases to be a taxable enterprise. The procedures for determining the effect of the change at thedate of conversion are similar to those for determining the effect of an S�corporation election.

Assets and Liabilities Distributed to the Partnership Normally Should Be Valued at the Predecessor Corpo�ration's GAAP Values. TRA's repeal of the General Utilities doctrine imposes corporate taxes on the appreciationof net corporate assets distributed to the partnership. For tax reporting, the appreciated values may be the openingvalues for the partnership. Authoritative accounting literature does not address partnership accounting. However,current thinking generally precludes establishing a new GAAP basis unless there has been a change in control.Therefore, in a true conversion, there is no change in control, and best practices indicate that the corporation'sGAAP basis should carry forward to the partnership. If the partners elect to reflect the appreciated values at thepartnership level for tax reporting, a difference in basis for income tax and financial statement reporting will arise.

Although partnerships are not subject to income taxes, best practices indicate that the notes to the partnership'sfinancial statements should disclose any differences between the basis of assets and liabilities for financial state�ment and income tax reporting. The following illustrates appropriate disclosure:


Income Taxes

The financial statements do not include a provision for income taxes, because the partnershipdoes not incur federal or state income taxes. Instead, its earnings and losses are included in thepartners' personal income tax returns and are taxed based on their personal tax strategies. Thetax basis of assets transferred from the predecessor corporation differs from their basis forfinancial reporting.

Comparative Presentations May Include Periods before and after the Conversion. In a true conversion,financial statements before and after the conversion are comparable with the exception of the absence of aprovision for income taxes. Therefore, comparative statements may include periods before and after the conversionprovided the conversion and the change in tax status are disclosed. The following is an example of appropriatedisclosure:


Income Taxes

The Partnership was formed through the conversion of ABC Company effective January 1, 20X2(Note X). Earnings and losses after that date will be included in the personal income tax returnsof the partners and taxed depending on their personal tax strategies. Accordingly, the Partnershipwill not incur additional income tax obligations, and future financial statements will not include aprovision for income taxes. Prior to the change, income taxes currently payable and deferredincome taxes based on differences between the financial basis of assets and liabilities and theirtax basis were recorded in the financial statements.

NOTE XFORMATION OF THE PARTNERSHIP AND CHANGE IN TAX STATUS

Effective January 1, 20X2, ABC Company was converted to ABC Partnership through anexchange of Company shares for Partnership units. For financial statement reporting, assets andliabilities transferred to the Partnership were recorded at the predecessor corporation's historicalcost basis. However, for income tax reporting, the partners elected to record the assets at theirappreciated values at the date of distribution. As a result, the basis of property and equipmentwas approximately $175,000 higher for income tax reporting than for financial statement report�ing.


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The provision for income taxes consists of the following components:

20X2 20X1

Current $ � $ 30,000

Deferred 110,000 (7,000 )

$ 110,000 $ 23,000

As a result of the conversion, the Company's deferred tax asset in the amount of $110,000 atDecember 31, 20X1, was eliminated through a charge to the 20X2 tax provision.

Stub Period Presentations Require Special Disclosures. Current tax law requires a corporation converting to apartnership to adopt a calendar year end unless it can establish a fiscal year as a natural business year or pays adeposit. Generally, it is impractical to have different year ends for financial statement and income tax reporting, andit is recommended conforming the year end for both reporting purposes. As discussed, the notes to the financialstatements should disclose the change in the year end and the effect it has on the financial statements including thedollar amount, if determinable. The stub period presentation may be presented in comparative form with a full yearprovided that the change is adequately disclosed and the statements are appropriately captioned.

The tax provision for the stub period should consist of a current provision calculated by applying annualized ratesto taxable income for the period and a deferred provision that will eliminate the deferred tax asset or liability at thebeginning of the period.

OWNERS' TRANSACTIONS

Equity Interests for Services

For both corporations and partnerships, equity interests are sometimes given for services associated with thestarting of a business. As an example, attorneys are sometimes given equity interests as consideration for legalservices in setting up the entity, in obtaining patents, or in arranging financing. For financial reporting, it isrecommended expensing the fair value of services related to setting up the entity as organization costs [FASB ASC720�15�25�1 (formerly SOP 98�5, Reporting on the Costs of Start�Up Activities)] requires organization costs to beexpensed as incurred) and charging the fair value of other services to an amortizable asset, e.g., patents orfinancing costs. The offsetting credits would be to capital stock for the par value of the stock and to additionalpaid�in capital for the difference (or to partners' capital as appropriate). As an example, if a lawyer receives 100shares of $50 par value common stock in exchange for setting up a company and the fee at standard billing rateswould be $10,000, the company would expense the organization costs for $10,000 and credit common stock for$5,000 and additional paid�in capital for $5,000. For tax reporting, a prescribed maximum amount of the costs canbe deducted in the year incurred, with the remaining costs amortized over 15 years. A phaseout threshold isprescribed, beyond which there is a dollar�for�dollar reduction in the first�year deduction. For the tax year beginningin 2010, the Small Business Jobs Act of 2010, signed into law September 27, 2010, increases the maximumfirst�year deduction from $5,000 to $10,000 and increases the phaseout threshold from $50,000 to $60,000.

Receivables from Stockholders

Stockholders of closely held businesses sometimes borrow from the corporation under informal arrangements asa means of acquiring �tax free" cash. Such receivables from owners of closely held businesses are frequent targetsof the IRS. The IRS often asserts that the stockholder does not intend to repay the receivable and that thereceivable, therefore, should be included in the stockholder's personal tax return as a dividend. While mostaccountants recognize the tax dangers of large receivables from stockholders, many overlook the GAAP measure�ment problems also associated with such receivables.

Under GAAP, stockholder receivables are subject to the same measurement principles as other receivables, andaccordingly, consideration should be given to providing an allowance for amounts considered uncollectible and toreclassify the amount as a noncurrent asset. A large stockholder receivable with no formal repayment plan may


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place accountants in a difficult situation with their clients. If the stockholder either cannot or does not intend torepay such loans, the working capital and net worth of the company may be grossly overstated. But, if thereceivable is removed by recording dividends or additional compensation to the stockholder, the stockholder mayincur a large tax liability. For financial statement reporting, forgiveness of a related party receivable should typicallybe recorded as a charge to equity. If the accountant determines that a portion of the stockholder receivable shouldbe written off in the financial statements because the stockholder cannot or does not intend to repay the receivable,he also should determine what he believes the appropriate tax treatment of the offsetting debit will be, e.g., baddebt deduction (although the deduction would be subject to close scrutiny by the IRS to determine if there is a validdebtor�creditor relationship), dividends, or compensation. If the reporting entity is subject to income taxes, deferredtaxes should be provided for differences between the book and tax treatment.

Stockholder Agreements to Reimburse Corporations for Excessive Compensation or DisallowedExpenses

Some corporations have agreements with their stockholders under which the stockholders agree to reimburse thecorporation for excess compensation and certain other expenses that may be disallowed as a deduction. If thetypes of expenses covered by the agreements are disallowed, they usually are required to be treated as dividends.Thus, the stockholder reimbursement agreements are an attempt to avoid the associated double taxation. How�ever, some court cases have held that the existence of the agreements was evidence that the corporations believedthe expenses were questionable deductions and have found adversely. If they exist, best practices indicate thatthey are a gain contingency and should, therefore, be disclosed.

When expenses or compensation are disallowed by the IRS, the corporation should record the additional taxassessment. If an agreement to reimburse disallowed deductions exists between the stockholder and the corpora�tion, the corporation also should record a receivable and a reduction to the appropriate expense categories in theyear that the amount of the RAR and resulting reimbursement can be reasonably estimated. Best practices indicatethat the reimbursement does not qualify as a prior�period adjustment.

Accrued Liabilities to Stockholders and Partners

Accrual basis taxpayers may not deduct accrued expenses payable to cash basis stockholders and partners untilpaid. Generally accepted accounting principles, however, require recognizing expenses in the period incurredwithout regard to whether the creditor is related. Common examples of such transactions are rent for buildings andequipment owned by a stockholder and leased to the company and interest on obligations due to a stockholder.Similar situations also could exist for accrued bonuses. Since the expenses would be recognized in the statementswhen incurred and deducted in the returns when paid, a temporary difference would arise, and if the reporting entityis subject to income taxes, deferred taxes should be provided.

ACCOUNTING FOR LEASING TRANSACTIONS

Accounting for Bargain Rentals

For tax reporting, accrual basis lessors usually recognize rent income under operating leases when earned, andaccrual basis lessees recognize rent expense under operating leases when payments are due. (Exceptions occurin certain deferred rental agreements of over $250,000.) To illustrate, assume a three�year lease requires a tenantto pay monthly rentals of $1,000, but waives the requirements for the first six months to provide an incentive for thetenant to take the space. For tax reporting the lessor would report no income from the lease for the first six months,and the lessee would deduct no rent expense during the period.

GAAP requires lessors and lessees to recognize rent under noncancelable operating leases on a straight�linemethod over the period the lessee controls the use of the leased property. Accordingly, rent expected under thenoncancelable period is computed and recognized evenly over the lease term. In the preceding example, pay�ments actually due under the lease total $30,000, which averages $833 per month (or $30,000 � 36). Rent for thefirst six months would, therefore, be $5,000 (or $833 � 6).


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Accounting for Other Lease Incentives

Other lease incentives can consist of incentive payments by lessors or the lessor's assumption of a lessee's lease.The following summarizes differences in accounting for those incentives for financial and income tax reporting:

a. Incentive payments include up�front payments to the lessee and payments to reimburse the lessee forspecific costs such as moving costs or abandoned leasehold improvements. The lessor and the lesseeshould amortize incentive payments against rental income or expense over the term of the lease forfinancial reporting. Since the incentive payment is taxable or deductible when due, a temporary differencearises between income for financial and income tax reporting.

b. Best practices indicate that a temporary difference arises if a lessor makes leasehold improvements for alessee and then bills the lessee for its cost less an allowance. For financial reporting, the lessee shouldrecord the leasehold improvements at the full cost, and record an offsetting credit to the deferred leaseincentive account for the allowance. Both the lessor and the lessee should amortize the deferred leaseincentive against rental income or rental expense over the term of the lease. For tax reporting, the leaseholdimprovements would be recorded at their net cost, and rental income and payments would be includedin taxable income when due.

c. If the lessor assumes a pre�existing lease of the lessee, the related loss incurred by the lessor is a rentincentive by both the lessor and the lessee that is amortized against rental income and expense over thelease term. Since rental income and payments are included in taxable income when due, a temporarydifference arises.

Leases with Scheduled Increases

Tax rules for leases with scheduled annual increases are similar to those described in �Accounting for BargainRentals." To illustrate, assume a three�year lease provides for an annual base rent of $10,000 with increases duringthe second two years of at least 5% (that is, to at least $10,500 in the second year and $11,025 in the third year). Fortax purposes, the lessor would report income of $10,000 during the first year, and the lessee would report rentexpense of $10,000. However, since minimum payments of $31,525 are scheduled over the lease term, GAAPrequires recognizing rent expense of $10,508 (or $31,525 � 3) on a straight�line basis during each of the threeyears.

Differences between rent income and rent expense recognized for financial statement and income tax reporting aretemporary differences, and deferred taxes should be provided accordingly.

Tax Indemnifications in Lease Agreements

Some leases include indemnification clauses that protect lessors from the loss of any tax benefits as a result of taxlaw changes. For example, some equipment lessors wrote agreements that provided for an additional paymentupon repeal of investment tax credits. FASB ASC 840�10�25�10 and 25�11 (formerly Issue No. 86�33, Tax Indemnifi�

cations in Lease Agreements) provides the following guidance on accounting for such payments:

Accounting by the lessor

1. The payments should be allocated into two parts: the part resulting from lost ITC and the partrelated to all other tax effects.

2. The portion of the payments that relates to ITC should be recognized in earnings followingthe lessor's normal policy for accounting for ITC. Therefore, if the flow�through method wasnormally used, the portion of the payment related to indemnification for lost ITC would becredited to the tax provision in the period earned.

3. The portion of the payment that related to the other tax issues should be considered as a leasepayment and accounted for according to the classification of the lease. Therefore, if the leasewere classified as a sales type or a direct financing lease, the payment would be accounted


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for as an adjustment of the lessor's investment in the lease. If the lease were classified as anoperating lease, the payment would be recognized over the remaining lease term as anadjustment of rent income using the straight�line method.

Accounting by the lesseeThe payments should be considered as a lease payment andaccounted for according to the classification of the lease. Therefore, if the lease were classified asa capital lease, the payment would be recorded as an adjustment of the basis of the leased asset.If the lease were classified as an operating lease, the payment would be recognized over theremaining lease term as an adjustment of rent expense using the straight�line method.

ACCOUNTING FOR OTHER TAX TRANSACTIONS

Vacation Pay

GAAP requires recognizing vacation pay on an accrual basis. Generally an accrual basis taxpayer may elect todeduct accrued vacation pay provided it is actually paid within a prescribed period after the close of the tax year. Tobe currently deductible the vacation pay must be paid within the tax year or paid within two and one�half monthsfollowing the end of the tax year. Amounts paid after two and one�half months following the end of the tax year aredeductible in the tax year that they are actually paid. The amount of the accrued vacation pay not deductible in thecurrent tax year is a temporary difference that will reverse as the accrued vacation pay is disbursed in future taxyears.

Simplified LIFO

Current tax law allows businesses to use a simplified LIFO method that provides them with the option of dividingtheir inventory into pools for each major category of inventory items and applying a single published index for eachpool. Best practices indicate that using externally published indexes usually provides a reasonable approximationof the company's own experience and that simplified LIFO usually is acceptable for GAAP reporting.

Generally, changes from a non�LIFO approach of accounting for inventories to a LIFO approach are appliedsimultaneously for financial statement and income tax reporting. If a company changes its method of accounting forinventories, either from a non�LIFO approach to a LIFO approach or from a LIFO method based on actual results tosimplified LIFO, the change should be accounted for as a change in accounting principle.

Limits on Deductible Expenses

Current tax law limits the deductibility of certain expenses, e.g., interest expense on life insurance loans, club dues,and business meals and entertainment. The excess of expenses incurred above the deductible amount should berecognized in the financial statements in the year that they are incurred but would never be deducted for income taxreporting and should, therefore, be accounted for as a permanent difference for which no deferred tax benefit isrecognized.


188


189

SELF�STUDY QUIZ


34. Which of the following is accurate concerning conversion from a C corporation to S corporation status?

a. By the end of the tax year, the S corporation must make the adjustment for the change in tax status.

b. Retroactive election must be made by February 15 for a calendar year corporation.

c. Prospective election for the following year may be made anytime during the year.

d. Retained earnings components must be disclosed in the financial statements.

35. A requirement of a C corporation to elect S corporation status is to recapture its LIFO inventory reserve. Whichof the following is true in relation to a LIFO reserve recapture?

a. The built�in gain on inventory from changing from LIFO to FIFO is included in income on the first Scorporation return.

b. In a nonrecognition transaction between a C corporation and a S corporation, inventory must berecaptured in the year of transfer.

c. The tax attributable to the LIFO recapture must be paid in full on the final return.

d. A S corporations creates a double taxation effect when the inventory is recaptured using the LIFO inventoryreserve.

36. Stanley Furnishings has decided to change their election from a C corporation to a S corporation. The last dayof the final C corporation year will be 12/31/X6. The inventory values at that date are:

FIFO $ 2,500,000

LIFO 2,000,000


Stanley's GAAP pretax income at 12/31/X6 is $600,000. Based on a tax rate of 34%, what is the income taxattributable to the LIFO recapture?

a. $42,500.

b. $170,000.

c. $246,500.

d. $374,000.

37. The definition of a Section 351 Incorporation is when the assets of a proprietorship or partnership are allocatedto a corporation in exchange for stock. Which of the following is an attribute of a Section 351 transaction?

a. Financial statements before and after a Section 351 incorporation are equivalent, excluding the provisionfor income taxes.

b. A Section 351 incorporation is tax free to the corporation, but not to the stockholders.

c. Assets and liabilities contributed to a corporation in a Section 351 exchange are recorded at market value.

d. The corporation is controlled by the board of directors after Section 351 incorporation.


190

38. Occasionally, equity interests may be given in exchange for services. How might this be recorded?

a. An attorney is given equity interest in exchange for legal services to set up an entity. The entity willautomatically deduct the expense for tax reporting.

b. An attorney is given equity interest in exchange for legal services to arrange financing. The entity willautomatically deduct the expense for financial reporting.

c. An attorney is given equity interest in exchange for legal services to set up an entity. The entity will capitalizethe expense for financial reporting.

d. An attorney is given equity interest in exchange for legal services to obtain patents. The entity will creditcapital stock and additional paid�in capital or partners' capital, if appropriate.

39. Robert is a stockholder in PKU Imports, Inc. Robert owns many businesses, one of which rents warehousespace to PKU Imports. The rent expense for the warehouse space is an example of which of the following?

a. Stockholder agreement to reimburse corporation for disallowed expenses.

b. Receivable from stockholder.

c. Accrued liability to stockholder.

40. On July 1, Alligator Corp. leases equipment to Crocodile Corp. for a term of five years. Both corporations havecalendar year ends. The lease is a noncancelable operating lease that requires Crocodile Corp. to pay monthlyrentals of $1,000, but waives the requirements for the first eight months. Which of the following choices correctlyreports this transaction?

a. For tax reporting purposes, Alligator Corp. will record rental income of $6,000 for months one through six.

b. For financial reporting purposes, Crocodile Corp. will record rental expense of $1,000 for month twelve.

c. For tax reporting purposes, Crocodile Corp. will record rental expense of $12,000 for year two (monthsseven through eighteen).

d. For financial reporting purposes, Alligator Corp. will record rental income of $5,200 for the first calendaryear.


191



34. Which of the following is accurate concerning conversion from a C corporation to S corporation status?(Page 176)

a. By the end of the tax year, the S corporation must make the adjustment for the change in tax status. [Thisanswer is incorrect. FASB ASC 740�40�10�6 (formerly SFAS No. 109) requires the adjustment for thechange in tax status to be calculated as of the date that the change is approved by the taxing authority oron the date of filing the election , if approval is not necessary, rather than as of the date that the electionactually is effective.]

b. Retroactive election must be made by February 15 for a calendar year corporation. [This answer isincorrect. If the election is filed within 2½ months after the beginning of the fiscal year and the companymeets certain eligibility requirements, the election is effective retroactively to the beginning of the year.February 15 is roughly 1½ months for a calendar year corporation.]

c. Prospective election for the following year may be made anytime during the year. [This answer iscorrect. The election may be filed at any time during the year to be effective prospectively for thefollowing year according to the Form 2553 instructions.]

d. Retained earnings components must be disclosed in the financial statements. [This answer is incorrect.A corporation converting from C to S status will segregate its retained earnings into the followingcomponents for tax purposes: accumulated earnings and profits (AEP), accumulated adjustmentsaccount (AAA), tax timing adjustments (TTA), and other retained earnings (ORE). Since distinctions amongthe components of retained earnings deal solely with personal tax consequences to the shareholders anddo not affect an evaluation of the company's financial position, results of operations, or cash flows,disclosure of the retained earnings components is optional.]

35. A requirement of a C corporation to elect S corporation status is to recapture its LIFO inventory reserve. Whichof the following is true in relation to a LIFO reserve recapture? (Page 179)

a. The built�in gain on inventory from changing from LIFO to FIFO is included in income on the first Scorporation return. [This answer is incorrect. Under the LIFO recapture rules, the built�in gain on inventoryis included in income (to the extent of the difference between LIFO and FIFO) in the last C corporation year.]

b. In a nonrecognition transaction between a C corporation and a S corporation, inventory must berecaptured in the year of transfer. [This answer is correct. Based on IRS regulation TD 8567, Ccorporations transferring inventory to S corporations in a nonrecognition transaction (i.e., in whichthe transferred assets constitute transferred basis property) must recapture in the year that theinventory is transferred. That year may differ from the C corporation's final tax year.]

c. The tax attributable to the LIFO recapture must be paid in full on the final return. [This answer is incorrect.Per IRS code, the tax attributable to the recapture is payable in four equal installments.]

d. A S corporations creates a double taxation effect when the inventory is recaptured using the LIFO inventoryreserve. [This answer is incorrect. Under the recapture rules, the tax basis of the inventory is increased bythe recapture amount included in income so that income from the sale of the inventory is only taxed onceat the corporate level.]


192


FIFO $ 2,500,000

LIFO 2,000,000


Stanley's GAAP pretax income at 12/31/X6 is $600,000. Based on a tax rate of 34%, what is the income taxattributable to the LIFO recapture? (Page 179)

a. $42,500. [This answer is incorrect. This is the amount of the quarterly payment that would be due on theLIFO recapture.]

b. $170,000. [This answer is correct. The amount attributable to the LIFO recapture is the 34% incometax rate multiplied by the LIFO recapture amount.]

c. $246,500. [This answer is incorrect. This would be the amount due on the first installment of the incometax.]

d. $374,000. [This answer is incorrect. This amount is the total income tax due from Stanley Furnishings forthe entire year for 12/31/X6.]

37. The definition of a Section 351 incorporation is when the assets of a proprietorship or partnership are allocatedto a corporation in exchange for stock. Which of the following is an attribute of a Section 351 transaction?(Page 181)

a. Financial statements before and after a Section 351 incorporation are equivalent, excluding theprovision for income taxes. [This answer is correct. In a Section 351 incorporation, the financialstatements before and after the incorporation are comparable with the exception of the provisionfor income taxes. This is because any losses and tax credits incurred by the proprietorship arepassed through to the proprietor and cannot be carried forward to the new corporation and theassets and liabilities are recorded at historical cost.]

b. A Section 351 incorporation is tax free to the corporation, but not to the stockholders. [This is incorrect.The exchange, if properly constituted under Section 351, is tax free to all parties, i.e., the proprietorshipor partnership, the corporation and the stockholders per IRS code.]

c. Assets and liabilities contributed to a corporation in a Section 351 exchange are recorded at market value.[This answer is incorrect. The assets and liabilities received by the corporation should be recorded on thebooks of the corporation at their historical costs according to the rules of a Section 351 transaction.]

d. The corporation is controlled by the board of directors after Section 351 incorporation. [This answer isincorrect. After a Section 351 transaction, the former proprietor or partners control the corporation, not aboard of directions.]

38. Occasionally, equity interests may be given in exchange for services. How might this be recorded? (Page 184)

a. An attorney is given equity interest in exchange for legal services to set up an entity. The entity willautomatically deduct the expense for tax reporting. [This answer is incorrect. For tax reporting,organization costs associated with forming a new company are not deductible when paid or incurred. Suchcosts must be capitalized unless the company makes an election to amortize them.]

b. An attorney is given equity interest in exchange for legal services to arrange financing. The entity willautomatically deduct the expense for financial reporting. [This answer is incorrect. When an attorney isgiven equity interests as consideration for legal services in arranging financing, the fair value of serviceswill be charged to an amortizable asset, such as financing costs, for financial reporting.]


193

c. An attorney is given equity interest in exchange for legal services to set up an entity. The entity will capitalizethe expense for financial reporting. [This answer is incorrect. For financial reporting, the company willexpense the fair value of services related to setting up the entity as organization costs. FASB ASC720�15�25�1 (formerly SOP 98�5, Reporting on the Costs of Start�Up Activities) requires organization coststo be expensed as incurred.]

d. An attorney is given equity interest in exchange for legal services to obtain patents. The entity willcredit capital stock and additional paid�in capital or partners' capital, if appropriate. [This answeris correct. For financial reporting, the entity will charge the fair value of services to patents, anamortizable asset. The offsetting credits would be to capital stock for the par value of the stock andto additional paid�in capital for the difference (or to partners' capital as appropriate).]

39. Robert is a stockholder in PKU Imports, Inc. Robert owns many businesses, one of which rents warehousespace to PKU Imports. The rent expense for the warehouse space is an example of which of the following?(Page 185)

a. Stockholder agreement to reimburse corporation for disallowed expenses. [This answer is incorrect. Acorporation may have an agreement with their stockholder for which the stockholder agrees to reimbursethe corporation for certain expenses that may be disallowed and should be treated as dividends for thestockholder. The rent expense for the warehouse is not a disallowed expense for PKU Imports and is alegitimate business expense for the corporation.]

b. Receivable from stockholder. [This answer is incorrect. Stockholders of closely held businessessometimes borrow from the corporation under informal arrangements as a means of acquiring �tax free"cash. The rental of the warehouse space by PKU Imports from the stockholder does not qualify as areceivable from the stockholder.]

c. Accrued liability to stockholder. [This answer is correct. When a stockholder owns a building andleases it to the company, this is an example of an accrued liability to stockholder. Accrual basistaxpayers may not deduct accrued expenses payable to cash basis stockholders and partners untilpaid and GAAP required recognized expenses in the period incurred without regard to whether thecreditor is related, for example, a current stockholder.]

40. On July 1, Alligator Corp. leases equipment to Crocodile Corp. for a term of five years. Both corporations havecalendar year ends. The lease is a noncancelable operating lease that requires Crocodile Corp. to pay monthlyrentals of $1,000, but waives the requirements for the first eight months. Which of the following choices correctlyreports this transaction? (Page 185)

a. For tax reporting purposes, Alligator Corp. will record rental income of $6,000 for months one through six.[This answer is incorrect. For tax reporting the lessor would report no income from the lease for the firsteight months, and the lessee would deduct no rent expense during the period.]

b. For financial reporting purposes, Crocodile Corp. will record rental expense of $1,000 for month twelve.[This answer is incorrect. For financial reporting purposes, GAAP requires lessors and lessees to recognizerent under noncancelable operating leases on a straight�line method over the period the lessee controlsthe use of the leased property.]

c. For tax reporting purposes, Crocodile Corp. will record rental expense of $12,000 for year two (monthsseven through eighteen). [This answer is incorrect. For tax reporting, accrual basis lessors usuallyrecognize rent income under operating leases when earned, and accrual basis lessees recognize rentexpense under operating leases when payments are due. Therefore, Crocodile Corp. will recognize rentexpense of $10,000 for year two ($0 for months seven through eight and $1,000 each month for monthsnine through eighteen).]


194

d. For financial reporting purposes, Alligator Corp. will record rental income of $5,200 for the firstcalendar year. [This answer is correct. For financial reporting purposes, lessors and lessees willrecognize rent on a straight�line method over the five years. Alligator Corp. will record $5,200 rentalincome for the first calendar year. The lease began on July 1, therefore, six months' of income willbe recognized. Each month, Alligator Corp. will recognize $866.67 rental income ($52,000 totalrents/60 months).]


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Lesson 2 (PFSTG102)


25. When a stock redemption is used to buy out a stockholder, it is in effect a treasury stock purchase.

a. True.

b. False.

c. Do not choose this answer choice.

d. Do not choose this answer choice.

26. Artco Corporation is wholly owned by two stockholders in equal percentages. Each stockholder has a buy�sellagreement with the corporation requiring the corporation to purchase his shares for $500,000 in the event ofhis death. Assume one of the stockholders dies, how much is the retained earnings balance after theredemption using the cost method?





a. $(100,000).

b. $(85,000).

c. $200,000.

d. $400,000.

27. Assume the same facts as the previous example. How much is the retained earnings balance after theredemption using the par value method?

a. $(100,000).

b. $(85,000).

c. $200,000.

d. $400,000.

28. A redemption is accomplished through a distribution of property. The distributed asset has a basis of $8,000for financial statement reporting, $3,000 for tax reporting, and a fair market value of $5,000. What is one effectof the distribution?

a. A $5,000 taxable gain results from the distribution.

b. A $5,000 temporary difference results from the distribution.

c. A $5,000 temporary difference reverses due to the distribution.

d. A $5,000 permanent difference occurs due to the distribution.


196

29. How is the cost of a covenant not to compete (entered into in connection with the purchase of a business onJuly 1, 2009) recorded on the tax return?

a. It is written off if impaired.

b. It is depreciated over 5 years.

c. It is amortized over 15 years.

d. It is amortized over the term of the agreement.

30. Push�down accounting is a framework for small and midsize nonpublic entities to use to recognize appreciationin the fair value of net assets due to changes in equity interests. Which of the following statements about pushdown accounting is correct?

a. Push�down accounting is required.

b. If the users of the financial statements of the entity acquired would find the information helpful, then itshould be used.

c. Push�down accounting is applied to the appreciation in the fair value of net assets of the company beingacquired.


31. Which of the following is correct regarding guaranteed payments to partners?

a. Guaranteed payments that are payments of interest on capital accounts should always be treated as asalary expense when determining net income.

b. A disclosure about the accounting method used should be included in the accounting policies if theguaranteed payments are material.

c. If the guaranteed payment is interest on capital accounts, then the payment should be treated as anallocation of partnership net income.


32. What is the default classification of a new domestic LLC for federal income tax purposes if the LLC has twomembers?

a. Sole proprietorship.

b. Partnership.

c. An unincorporated branch of a parent entity.

d. Corporation.

33. Which of the following is a GAAP departure when reported for an LLC?

a. Recording a liability for anticipated substantial member withdrawals to pay income taxes.

b. Not including federal income tax expense on the financial statements of an LLC.

c. The statement of income should present net income after federal income taxes.

d. Not reporting a liability for federal income tax expense.


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34. LLPs follow the same guidance for reporting purposes as LLCs.

a. True.

b. False.



35. Which of the following changes in tax status would cause recognition of a deferred tax liability or asset?

a. A corporation terminates its S corporation status.

b. A corporation converts to a proprietorship.

c. A corporation elects S corporation status.

d. A corporation converts to a partnership.

36. Match the following components of retained earnings with their description.

a. Accumulated Earnings and Profits (AEP)

b. Accumulated Adjustments Account (AAA)

c. Tax Timing Adjustments (TTA)

d. Other Retained Earnings (ORE)

i. Essentially is a residual amount and consists primarily of tax�exempt income arising since the dateof conversion.

ii. Essentially represents undistributed tax basis earnings on the date of conversion.

iii. Essentially represents cumulative temporary differences at any balance sheet date.

iv. Essentially represents undistributed tax basis retained earnings arising after the date of conversion.

a. a.iv., b.ii., c.iii., d.i.

b. a.iv., b.ii., c.i., d.iii.

c. a.i., b.iii., c.iv., d.ii.

d. a.ii., b.iv., c.iii., d.i.


198


FIFO $ 2,500,000

LIFO 2,000,000


Stanley's GAAP pretax income at 12/31/X6 is $340,000. Based on a tax rate of 34%, what is the income tax duein the first installment of required income tax payments?

a. $42,500.

b. $115,600.

c. $158,100.

d. $170,000.

38. If a corporation converts to a partnership, it must adopt a calendar year end or pay a deposit per the currenttax laws.

a. True.

b. False.



39. Which of the following choices accurately accounts for leasing transactions?

a. Lease incentives may cause temporary differences.

b. Leases with scheduled increases cause permanent differences.

c. Tax indemnifications do not affect reporting for lease agreements.

d. Tax and financial statement reporting are essentially the same.

40. Parish Manufacturing pays out any remaining vacation pay to their employees after year end and after thecompany income taxes are paid for the year. Employees accrued vacation for the 2009 calendar year in 2008.Parish paid out the accrued vacation pay on March 10, 2010. Parish Manufacturing follows a calendar tax year.In what year would the vacation pay be deductible to the company?

a. 2008.

b. 2009.

c. 2010.



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GLOSSARY

Accounting Period: The period which a taxpayer uses to determine federal income tax liabilities. Absent a choiceto the contrary, individuals and entities are automatically relegated to the calendar year (§441). Taxpayers maygenerally select other periods, in particular fiscal years, such as June 1 to May 30, or in special circumstances,fifty�two, fifty�three week taxable years, and shorter periods, in cases of changes of accounting periods and taxpayersin existence for less than a 12�month period [§441(f), 443]. Partnerships and S corporations' taxable years arestatutorily controlled and generally preclude adoption of a taxable year for the enterprise different from that of itsmajority partners, or a noncalendar year, respectively [§706, 1378(b)]. Changes in the accounting period call for theIRS approval.

Basis in Partnership Interest: A partner's basis in his or her share of a partnership, a dynamic account that beginswith the amount of money plus the adjusted basis of property contributed to a partnership (§722). The partner's shareof the partnership's liabilities for which the partner is liable and those that no partner is liable for are deemed to bea contribution of money and increase the partner's basis (§752). Liabilities of the partnership are generally allocatedamong the partners according to loss�sharing ratios, except for nonrecourse liabilities of limited partnerships, whichallocate partnership debt according to profit�sharing ratios [Reg. §1.752�1(e)]. Direct assumption of the partnership'sliabilities increases a partner's basis in the partnership interest. Basis is also increased by the partner's share ofpartnership income and the excess of depletion deductions over the basis of the depletable property; however, basisis reduced by partnership distributions and losses, nondeductible, noncapitalized expenditures, and limited oil andgas depletion (see §705, 722, 742 and 752). Reductions in a partner's share of liabilities are treated as distributionsof money to the partner, and correspondingly reduce basis [§752(b)]. The partner's basis in the partnership interestserves to limit loss deductions [§704(d)], and to determine gain or loss on sale or liquidation of the interest or ondistributions of money in excess of basis (§731 and 732).

Change of Accounting Method: A switch by the taxpayer from one overall method of accounting to a differentmethod or the alteration in the treatment of a material item (basically, any regularly recurring incidence of incomeor expense which involves the time when it is reported) [Reg. §1.446�1(e)(2)(i)]. The term includes the following: aswitch from the cash method to the accrual method or vice versa; a switch from cash or accrual method to one ofthe long�term contract methods or vice versa; a switch to a depreciation method other than straight�line depreciation;a switch from one inventory valuation method to another; and a switch to or from a specialized basis method (e.g.,crop method by farmers) [Reg. §1.446�1(e)(2)(ii)]. The term can also encompass a change in accounting methodsfrom an incorrect method to a correct method unless the erroneous method was not used consistently.

Complete Liquidation, Corporate: A transfer by all shareholders of their stock to the corporation that issued thestock in exchange for the corporation's property (§331). A status of complete liquidation exists when the corporationceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts,and distributing any remaining balance to its shareholders. A complete liquidation may be completed prior to theactual dissolution of the liquidating corporation, and in any event a legal dissolution of the corporation is not required.


Deferred Income Tax Liability: Excess of income tax amount shown on an income statement over the actual taxamount, which occurs when book�income exceeds taxable income. This excess is recognized as a liability in thetaxpayer's balance sheet, and is written of the following accounting period.

Like�kind Exchange: An exchange of business or investment property pursuant to §1031. Recognition of gains andlosses on such exchanges is tax�deferred, except to the extent of nonqualifying property (boot) received or paid over(to the extent of any built�in gain or loss). For example, if a taxpayer exchanges investment land with an adjusted basisof $10,000 and worth $100,000 for an apartment (business) worth $100,000, the transaction will result in noimmediate taxation. However, the apartment will have a basis of $10,000. Such exchanges may be simultaneous ordeferred, but if the exchange was with a related taxpayer, it generally does not qualify for nonrecognition of gain orloss if either party disposes of the property within two years, or longer if and to the extent there is a diminution of riskof loss with respect to the property [§1031(f)]. The extent of delay permissible in deferred exchanges is generallylimited to 180 days [§1031(a)(3)]. Section 1031 is mandatory, and that the price exacted is a basis in the acquired


200

property which is reduced to the extent of any deferred gain. The exchange is evaluated property�by�property; forexample, an exchange of assets of a business for the assets of a similar business does not qualify (Rev. Rul. 89�121,1989�2 CB 203).

Limited Liability Company: An organization no member of which is personally liable for the debts of the enterprise,often formed under foreign law [see, e.g., PLR 8317018 (January 21, 1983)], and that may have the characteristicsof partnerships and corporations under United States law. The IRS used to maintain that a limited liability companycould not be a partnership but has withdrawn that position, which interpreted [§7701(a)(3)]. The current rules giveLLCs with two or more owners to elect to be treated either as a partnership or as a corporation for taxation purposes[§301.7701�3(a)]. Single�member LLCs may choose to be taxed as a corporation or disregarded as an entityseparate from their owner.

Liquidation, Partnership Interest: The redemption of a partner's interest in the partnership by the partnership . Itcan occur at once or in stages [see Reg. §1.761�1(d)]. It is sometimes difficult to distinguish a liquidation from a saleof a partnership interest; the key issue is who is primarily responsible for paying the retiring partner or his or her estate.Section 736 controls the taxation of liquidating distributions.

Partnership Liquidation: In general, an event which occurs when no part of any business, financial operation orventure of a partnership continues to be carried on by any of the partners [§708(b)(1)(A)]. It also occurs for technicaltax purposes if 50 percent of the interests in capital and profits of the partnership are transferred by sale or exchangein any 12�month period, such that there is a termination [Reg. §1.708�1(b)(1)(iv)].

Stock Redemption: A transaction in which a corporation acquires its stock from a shareholder in exchange forproperty other than the corporation's stock, or rights to acquire such stock. Once the stock is acquired by thecorporation, it may cancel or retire the stock, or hold it as treasury stock [§317(b)]. A corporate distribution inredemption of its stock is treated as a §301 distribution of property if the distribution does not fit into any one of fourspecific categories. If a distribution does fall within a special category, the distribution is treated as an exchange,hence potentially taxable as a long�term capital gain [§302(a) and (d)]. The four categories in which a redemptionis treated as a sale of stock are: (1) redemption not essentially equivalent to a dividends [§302(b)(1)]; (2) asubstantially disproportionate redemption of stock [§302(b)(2)]`; (3) a redemption in complete termination of theshareholder interest [§302(b)(3)]; and (4) a redemption in partial liquidation of the corporation [§302(b)(4), a ruleapplicable only to noncorporate shareholders].

Tax Attributes, Bankruptcy Tax Act: A series of tax characteristics that may be reduced in bankruptcy or outsideof bankruptcy as a result of not recognizing discharge of indebtedness income. These characteristics include: (1)net operating losses and their carryovers; (2) carryovers of general business credits; (3) capital losses and theircarryovers; (4) the basis of the taxpayer's assets (both depreciable and nondepreciable ); and (5) carryovers of theforeign tax credit; minimum tax credits; passive losses and credits; passive loss and credit carryovers [§108(b)(2)].The provisions calling for application of the reductions are intricate.


201

INDEX

A

ACCOUNTING CHANGE� Change in basis of accounting 111. . . . . . . . . . . . . . . . . . . . . . . . . � Change in depreciation method 113. . . . . . . . . . . . . . . . . . . . . . . . � Change in estimate 113. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in fiscal year 112. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in principle

�� For tax purposes 111. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Correction of an error 118. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cumulative effects of adjustment 113. . . . . . . . . . . . . . . . . . . . . . . � Disclosures 113. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Inventory pricing method 187. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Prospective application 113, 118. . . . . . . . . . . . . . . . . . . . . . . . . . .

ASSETS� Capitalization and valuation for certain tax transactions 118. . . .

B

BANKRUPTCY� Chapter 11 proceedings

�� Balance sheet considerations 122. . . . . . . . . . . . . . . . . . . . . . . �� Consolidated financial statements 125. . . . . . . . . . . . . . . . . . . �� Disclosures 125. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� General financial statement considerations 122. . . . . . . . . . . �� Income statement considerations 123. . . . . . . . . . . . . . . . . . . �� Statement of cash flows considerations 124. . . . . . . . . . . . . .

� Emergence from reorganization proceedings 125. . . . . . . . . . . .

BUSINESS COMBINATIONS� Covenants not to compete 161. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Tax basis 127. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Transfer of assets from proprietorship or partnership to

corporation 180. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

C

CASUALTY GAINS 143. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONSOLIDATED OR COMBINED FINANCIAL STATEMENTS� Investments in partnerships 136. . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONSTRUCTION CONTRACTORS� Income tax considerations 119. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interest

�� Capitalized 119. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONTINGENCIES AND COMMITMENTS� Agreements to reimburse disallowed deductions 185. . . . . . . . .

D

DEPRECIATION� ACRS 139. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Basis reduction 139. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Departures from GAAP 140. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated useful life 113. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax considerations 139. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Luxury autos 140. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Section 179 deduction and bonus depreciation 140. . . . . . . . . . .

DISCLOSURES� Bankruptcy proceedings 125. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Comparative financial statements 171. . . . . . . . . . . . . . . . . . . . . . . � Guaranteed payments to partners 167. . . . . . . . . . . . . . . . . . . . . . � Income taxes

�� Change in tax status 177, 181, 183. . . . . . . . . . . . . . . . . . . . . . �� Examination by a taxing authority 109. . . . . . . . . . . . . . . . . . . . �� Limited liability company tax status 171. . . . . . . . . . . . . . . . . . �� Partnership tax status 183. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stub period presentations 184. . . . . . . . . . . . . . . . . . . . . . . . . .

� Limited liability companies 172. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Liquidating companies 120. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � S corporations 177. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock redemptions 161. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

E

EXPENSES� Casualty gains 143. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Limits on deductibility 187. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

G

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES� Departures from 140. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

I

INCOME TAXES� Accrued liabilities to related parties 185. . . . . . . . . . . . . . . . . . . . . � Deferred, liability method

�� Change in tax status 176. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Depreciation of luxury autos 140. . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures

�� Change in tax status 177, 181, 183. . . . . . . . . . . . . . . . . . . . . . �� Limited liability company tax status 171. . . . . . . . . . . . . . . . . . �� Partnership tax status 183. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stub period presentations 184. . . . . . . . . . . . . . . . . . . . . . . . . .

� Examination by a taxing authority 109. . . . . . . . . . . . . . . . . . . . . . . � Like�kind exchanges 141. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Limited liability companies 168, 171. . . . . . . . . . . . . . . . . . . . . . . . . � Loss carryforwards 137. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Permanent differences 160, 187. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stockholder agreements to reimburse disallowed

deductions 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Temporary differences, examples of

�� Casualty gains 143. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Construction period interest 119. . . . . . . . . . . . . . . . . . . . . . . . �� Deferred condemnations 143. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Depreciation and Section 179 deductions 139. . . . . . . . . . . . �� Inventories 179. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Investments in partnerships 137, 139. . . . . . . . . . . . . . . . . . . . �� Leases 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Liabilities to owners 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Like�kind exchanges 142. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Liquidations 120, 121. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Long�term contracts 120. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Partnership conversions 183. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Passive losses 137. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� S corporations 180. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Section 351 incorporation 181. . . . . . . . . . . . . . . . . . . . . . . . . . �� Stockholder receivables 184. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stock redemptions 160. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Vacation pay 187. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTANGIBLE ASSETS� Covenants not to compete 161. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTEREST� Capitalization

�� Income tax considerations 119. . . . . . . . . . . . . . . . . . . . . . . . . .

INVENTORIES� Accounting changes 187. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Costs 118. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax considerations 118. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � LIFO

�� Recapture 179. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Simplified 187. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Uniform capitalization rules 118. . . . . . . . . . . . . . . . . . . . . . . . . . . .

INVESTMENTS� Partnerships 135. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Passive losses from partnerships and S corporations 135. . . . . .


202

L

LEASES� Bargain rentals 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Incentives 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Indemnification clauses 186. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Leasehold improvements 186. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Operating leases

�� Assumption of lease 186. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Incentive payments 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Scheduled rent increases 186. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Tax indemnification in lease agreements 186. . . . . . . . . . . . . . . . .

LIABILITIES� Accrued liabilities

�� Vacation and sick pay 187. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Noncompete agreements 161. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIMITED LIABILITY COMPANIES OR PARTNERSHIPS� Accounting for LLCs 170. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Changes in members' equity 171. . . . . . . . . . . . . . . . . . . . . . . �� Comparative financial statements 171. . . . . . . . . . . . . . . . . . . �� Conversion of an existing entity to an LLC 171. . . . . . . . . . . . �� Disclosures 172. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Equity section of the balance sheet 170. . . . . . . . . . . . . . . . . . �� Financial statement headings 170. . . . . . . . . . . . . . . . . . . . . . . �� Income taxes 171. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Limited liability partnerships 172. . . . . . . . . . . . . . . . . . . . . . . . . . . � Tax treatment 168. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIQUIDATION� Accounting for gains and losses 120. . . . . . . . . . . . . . . . . . . . . . . . � Tax accounting 120. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

M

MATERIALITY� ACRS 140. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Investments in partnerships 138. . . . . . . . . . . . . . . . . . . . . . . . . . . .

N

NONMONETARY TRANSACTIONS� Like�kind exchanges 141. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

O

OTHER COMPREHENSIVE BASIS OF ACCOUNTING� Change in basis of accounting 111, 182. . . . . . . . . . . . . . . . . . . . .

P

PARTNERSHIPS� Accounting under GAAP 135. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � At�risk rules 135. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Capital contributions 168. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Converting from corporation to partnership 182. . . . . . . . . . . . . . � Deferred taxes eliminated 182, 184. . . . . . . . . . . . . . . . . . . . . . . . . � Earnings on partnership investments 135. . . . . . . . . . . . . . . . . . . . � Guaranteed payments to partners 167. . . . . . . . . . . . . . . . . . . . . . � Interest in exchange for services 184. . . . . . . . . . . . . . . . . . . . . . . � Investment in partnerships 135. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Passive losses 135. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Transfer of assets to corporation 180. . . . . . . . . . . . . . . . . . . . . . . .

PROPERTY AND EQUIPMENT� Condemnation 143. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Distributions 160. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated useful life 139. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanges 141. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax considerations 139. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Section 179 deduction and bonus depreciation 140. . . . . . . . . . .

PROPRIETORSHIPS� Transfer of assets to corporation 180. . . . . . . . . . . . . . . . . . . . . . . .

R

RECEIVABLES� Income tax considerations 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stockholder 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RELATED PARTY TRANSACTIONS� Deductibility of accrued liabilities 185. . . . . . . . . . . . . . . . . . . . . . .

RETAINED EARNINGS� Restrictions 159. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

S

S CORPORATION� Calendar year 179. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Converting from C to S corporation 176. . . . . . . . . . . . . . . . . . . . . � Disclosures 176. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � LIFO reserve recapture 179. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Passive losses 135. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Terminating election 180. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

STOCKHOLDERS' EQUITY� Stock issued in exchange for services 184. . . . . . . . . . . . . . . . . . . � Stock redemptions 159. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Treasury stock 159. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


203


COURSE 3

THE STATEMENT OF CASH FLOWS AND NOTES TO FINANCIAL STATEMENTS(PFSTG103)

OVERVIEW

COURSE DESCRIPTION: This interactive self�study course addresses various aspects of financial statementpreparation. Lesson 1 discusses the cash flow statement requirements whenpresented as a part of a full set of financial statements. Lesson 2 explainsdisclosures for nonpublic companies commonly made in the notes to the financialstatements.


November 2010



Basic knowledge of financial statements







Lesson 1The Statement of Cash Flows

Completion of this lesson will enable you to:� Identify the authoritative literature and form and style considerations that are significant to an organization's

notes to the financial statements.� Summarize cash flows from operating activities, investing activities, financing activities, and noncash investing

and financing activities that are presented as a part of the financial statements.

Lesson 2Notes to Financial Statements


notes to the financial statements and determine which significant accounting policies should be disclosed.� Recognize the common problems in preparing frequent disclosures, general disclosures, and other disclosures

related to inventory, debt, income taxes, related parties, going concerns, and lawsuits.� Describe how to disclose information about financial instruments in an organization's financial statement notes.� Summarize issues that organizations might encounter with disclosing information about risks and uncertainties

in the notes to their financial statements.


204








205

Lesson 1:�The Statement of Cash Flows

INTRODUCTION

Authoritative Basis for Statements of Cash Flows

FASB ASC 230�10�15�3 (formerly SFAS No. 95, Statement of Cash Flows) requires a cash flow statement to bepresented as part of a full set of financial statements. This lesson discusses those requirements, including thepresentation of specific types of transactions in cash flow statements and the disclosure of noncash transactions.The lesson also illustrates alternative formats for presenting cash flow statements that are permitted.



notes to the financial statements.� Summarize cash flows from operating activities, investing activities, financing activities, and noncash investing

and financing activities that are presented as a part of the financial statements.

When to Present the Statement

FASB ASC 230�10�15�3 (formerly SFAS No. 95) requires a statement that shows a company's cash receipts andpayments during a period, classified by principal sources and uses, to be presented as a basic financial statementwhen each of the following conditions is met:

a. The Company Is a Profit�oriented Business Enterprise or Nonprofit Organization. Cash flow statementrequirements do not apply to financial statements of individuals.

b. The Financial Statements Are Prepared in Accordance with Generally Accepted Accounting Principles. Astatement of cash flows is not required if the financial statements are prepared on a basis of accountingother than GAAP, e.g., cash basis or income tax basis.

c. Both a Balance Sheet and an Income Statement Are Presented. If a balance sheet or an income statementis presented separately, a statement of cash flows is not required.

All companies meeting the preceding criteria, except certain employee benefit plans and investment enterprises asprovided in FASB ASC 230�10�15�4 (formerly SFAS No. 102), are required to present a statement of cash flowsregardless of their legal form, e.g., proprietorships, partnerships, S corporations, or regular corporations, orwhether they normally classify their assets and liabilities as current and noncurrent. The requirement applies toboth interim and annual financial statements.

How Cash Is Defined

A statement of cash flows shows the change in cash and cash equivalents during the period. Cash and cashequivalents are defined as shown in Exhibit 1�1.


206

Exhibit 1�1

SFAS No. 95 Definitions of Cash and Cash Equivalents

CASH CASH EQUIVALENTS

Definition [FASB ASC 230�10�20 (formerly SFASNo. 95, footnote 1)]

Definition [FASB ASC 230�10�20 (formerly SFASNo. 95, Paragraph 8)]

. . . cash includes not only currency on hand butdemand deposits with banks or other financialinstitutions. Cash also includes other kinds ofaccounts that have the general characteristics ofdemand deposits in that the customer maydeposit additional funds at any time and alsoeffectively may withdraw funds at any time withoutprior notice or penalty. . . .

. . . short�term, highly liquid investments that (a)are readily convertible to known amounts of cashand (b) are so near their maturity that theypresent insignificant risk of changes in valuebecause of changes in interest rates.

ExamplesCertificates of deposit,a money marketaccounts, and repurchase agreements that havethe characteristics described above.

ExamplesTreasury bills, commercial paper,money market accounts that are not classified ascash, and other short�term investments whoseoriginal maturity is three months or less.b (Notethat equity securities never meet the definition ofcash equivalents.)

Notes:

a If penalties associated with certificates of deposit or money market accounts are material or if statedterms effectively restrict withdrawal of funds, the funds should be classified as cash equivalents orinvestments, depending on their maturities.

b Only those investments that mature three months or less from the date they were purchased qualify ascash equivalents. For example, a three�month Treasury bill and a three�year Treasury note purchasedthree months from maturity both qualify as cash equivalents. A Treasury note purchased three yearsago does not become a cash equivalent when its remaining maturity is three months, however.

* * *

Some companies do not include cash overdrafts in the definition of cash. Instead, they consider overdrafts to becurrent liabilities similar to accounts payable. Thus, they present cash overdrafts as an operating activity in thestatement of cash flows. Best practices indicate that a cash overdraft should be included in the definition of cash,however. Although there is a financing element to a cash overdraft, the time required for the overdraft to beeliminated is insignificant. FASB ASC 230�10�45�4 (formerly Paragraph 7 of SFAS No. 95) requires that the totalamounts of cash and cash equivalents at the beginning and end of the period agree with similarly titled line itemsor subtotals shown in the balance sheets. If the balance sheet reports a single net negative cash balance in itsliabilities, the captions in the statement of cash flows should be revised accordingly [for example, Cash (cashoverdraft) at end of year]. If the balance sheet for a single year reports both a positive balance in its assets and anegative balance in its liabilities, best practices indicate a reconciliation should be provided.

Cash restricted for special purposes should be segregated from cash available for general operations and,normally, should be excluded from current assets. Accordingly, best practices indicate that restricted cash shouldbe excluded from the definition of cash and cash equivalents. The classification of changes within the balanceshould be consistent with the classification in the balance sheet. To illustrate, assume net cash of $1,000,000 isreceived from the issuance of industrial development bonds. At the end of the year, $700,000 has been disbursedfor property and equipment, leaving a balance of $300,000 in the restricted cash account. Best practices indicatethat the cash should be included in construction�in�progress. Therefore, the entire amount of the proceeds wouldbe reported as a noncash financing and investing activity.


207

Throughout this lesson, the term cash is used to include cash equivalents.

Basic Elements

As discussed more fully later in this lesson, a statement of cash flows has five basic elements:

� Cash flows from operating activities

� Cash flows from investing activities

� Cash flows from financing activities

� Net change in cash during the period

� Supplemental disclosure of noncash investing and financing activities

Accordingly, all cash receipts and payments should be classified as operating, investing, or financing activities, andnoncash transactions involving investing and financing activities, such as acquiring assets by assuming liabilities,should be disclosed separately rather than within the body of the statement.

Types of Cash Flows. Exhibit 1�2 shows how a typical company's transactions would be classified into operating,investing, and financing activities according to the GAAP criteria.

Gross and Net Cash Flows

Gross cash flows from investing and financing activities are generally required to be reported rather than netamounts. Thus, for example, cash flow statements would show the following amounts:

Investing Activities

� Proceeds from sales of assets and cash payments for capital expenditures rather than the net change inproperty and equipment.

� Proceeds from sales and maturities of securities and purchases of, rather than the net change in, thoseinvestments.

� Loans made and collections on loans rather than the net change in notes and loans receivable.

Financing Activities

� Proceeds from long�term borrowings and repayments of long�term obligations (including capital leaseobligations) rather than the net change in long�term debt.

� Proceeds from short�term debt and payments to settle short�term debt rather than the net change inshort�term debt when the debt term exceeds three months.

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Exhibit 1�2

Types of Cash Flows

STATEMENT OF CASH FLOWS NONCASH INVESTING AND

OPERATING INVESTING FINANCING

NONCASH INVESTING ANDFINANCING TRANSACTIONS

CASH RECEIPTS FROM:� Sale of goods and services� Short�term and long�term

notes receivable from cus�tomers arising from sales ofgoods or services

� Interest and dividends� Other cash receipts not aris�

ing from investing or financ�ing activities, such asamounts received to settlelawsuits or refunds fromsuppliers

CASH RECEIPTS FROM:� Sale of property and equip�

ment� Sale of certain securities� Collections on loans� Insurance proceeds relating

to transactions classified asinvesting

CASH RECEIPTS FROM:� Short�term borrowings� Long�term borrowings� Issuance of stock

� Acquiring nonoperating assets, e.g.,property and equipment or a subsid�iary, by assuming liabilities orexchanging assets

� Issuing stock in exchange for sub�scriptions receivable or other noncashconsideration

� Converting debt to equity or one classof stock to another, e.g., common topreferred

� Stock dividends or distributions ofproperty as dividends

� Converting notes receivable to invest�tCASH PAYMENTS FOR:

� Inventory� Short�term and long�term

notes payable to suppliersfor materials or goods

� Wages� Other operating expenses� General and administrative

expenses� Interest (excluding

amounts capitalized)� Settlement of an asset

retirement obligation� Taxes� Other cash payments not

related to investing orfinancing activities, such ascash contributions andcash refunds to customers

CASH PAYMENTS FOR:� Property and equipment

(including capitalized inter�est)

� Certain securities� Loans to others

CASH PAYMENTS FOR:� Dividends� Repayment of amounts bor�

rowed, e.g., short�term debt,long�term debt, and capitallease obligations

� Treasury stock

gments


209

While the general rule calls for reporting gross cash flows, reporting net cash flows from the following activities ispermitted:

a. Cash receipts and payments from purchasing and selling cash equivalents.

b. Cash receipts and payments related to investments (other than cash equivalents), loans receivable, anddebt when the original maturity of the asset or liability is three months or less.

c. Cash receipts and payments from agency transactions (that is, transactions for which the company isholding or disbursing cash on behalf of its customers).

d. For certain financial institutions, cash receipts and payments related to:

(1) Deposits placed with other financial institutions

(2) Customer time deposits

(3) Loans made to customers

Although reporting net cash flows from the preceding activities is permitted, netting is not required. Presentinggross cash flows for those activities may be preferable in some instances. For example, it may create an unneces�sary recordkeeping burden to segregate cash flows from investments with a maturity of three months or less fromthose of investments with longer maturities.

Should cash flows from revolving lines of credit be presented on a gross or net basis? A difference of opinion existsamong CPAs in practice. Some firms have taken the position that there must be a series of 90�day notes for the cashflows to be presented net. If the borrower signs a single note with a term of more than three months for themaximum amount of the line of credit, they believe that gross amounts are required to be presented. Others,however, present all cash flows related to revolving lines of credit net. Best practices indicate that either method isacceptable.

FORM AND STYLE

Required Format

Cash flow statements should report the total amounts of cash and cash equivalents at the beginning and end of theperiod, and those amounts should be the same as similarly titled line items or subtotals in the balance sheet as ofthose dates. In other words, the net change in cash during the period should be added to cash at the beginning ofthe period to obtain cash at the end of the period. While it is anticipated that most preparers will follow the endingcash format, they may revise the format of the statement to begin with �cash at beginning of year."

Title

GAAP does not specify a title for statements of cash flows. However, best practices indicate that the title �Statementof Cash Flows" should be used.

Order of Presentation

The order for presenting operating, investing, and financing activities in statements of cash flows is not addressedin GAAP. Best practices indicate, however, that most companies report cash flows from operations first.

Captions

Because cash flow statements are classified according to cash flows from operating, investing, and financingactivities, captions are used to identify each section. Some typical examples are as follows:

� Cash Flows from Operating Activities, Cash Flows from Investing Activities, Cash Flows from FinancingActivities


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� Cash Provided by (Used by) Operations, Cash Provided by (Used by) Investments, Cash Provided by(Used by) Financing

� Operations, Investments (or Investment Activities), Financing (or Financing Activities)

This Lesson's Policy. Throughout this lesson, the captions �Cash Flows from Operating Activities," �Cash Flowsfrom Investing Activities," and �Cash Flows from Financing Activities" are used to identify each section becausethose captions are used by many companies and are used in the illustrative cash flow statements in FASB ASC230�10�55 (formerly Appendix C to SFAS No. 95). In addition, for each classification of cash flows, i.e., operating,investing, and financing, a captioned subtotal shows the net cash flow provided or used by that classification. Thecaption �Net Increase (Decrease) in Cash" is used to identify the change in cash during the period.

Comparative Presentations. Captions used within the cash flow statement should be modified when comparativefinancial statements are presented and the net results in each period are not the same, such as net income in oneperiod and a net loss in another or an increase in cash in one period and a decrease in cash in another. Thefollowing comparative statement illustrates captions that may be used.

20X2 20X1


Net income (loss) $ (38,000 ) $ 20,000

Adjustments to reconcile net income (loss) to net cash provided(used) by operating activitiesDepreciation 12,100 14,100

(Gain) loss on the sale of equipment 2,000 (3,300 )

(Increase) decrease in:

Trade accounts receivable (7,500 ) 1,500

Inventories 2,000 3,400

Increase (decrease) in:

Trade accounts payable 8,000 (6,300 )

Accrued liabilities (7,200 ) 2,650

NET CASH PROVIDED (USED)BY OPERATING ACTIVITIES (28,600 ) 32,050


Purchase of equipment (6,000 ) (18,700 )

Proceeds from sale of equipment 16,800 14,000

NET CASH PROVIDED (USED)BY INVESTING ACTIVITIES 10,800 (4,700 )


Long�term borrowings 7,500 �

Reduction of long�term debt (4,500 ) (6,900 )

Dividends paid � (8,600 )

NET CASH PROVIDED (USED)BY FINANCING ACTIVITIES 3,000 (15,500 )

NET INCREASE (DECREASE) IN CASH (14,800 ) 11,850

CASH AT BEGINNING OF YEAR 39,150 27,300

CASH AT END OF YEAR $ 24,350 $ 39,150


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Making the Statement Understandable

The following matters also should be considered when preparing cash flow statements:

� Except for requiring that the operating activities section start with net income when the indirect method isused, GAAP does not address the order in which items should appear within the operating, investing, andfinancing sections of the statement of cash flows. The operating activities section under the indirect methodusually first adjusts net income for noncash income and expenses, then for changes in operating assets,and finally for changes in operating liabilities. While there is more variety in the presentation of cash flowsfrom investing and financing activities, three approaches are common in practice(a) presenting thechanges in the order in which the assets and liabilities appear in the statement of financial position, (b)presenting items in the order of significance, and (c) presenting payments together and receipts together.The method used should be the one that is likely to be the easiest for the primary users to understand.

� Related or immaterial items should be grouped. Certain items may be shown separately when material andcombined in an �other" caption when not material.

� Subtotals should be used to show cash flows from operating, investing, and financing activities exceptwhen a category consists of a single item.

� Preferably, the entire statement should be presented on one page. If more detail is required for adequatedisclosure, it may be included in the notes to the financial statements or in a separate schedule.

� Disclosures made in other financial statements or in the notes need not be repeated. Similarly, disclosuresmade on the face of the cash flow statement, for example, depreciation for the period, need not be repeated.

Reclassification and Restatements

Reclassifications of amounts between current and noncurrent assets and liabilities, either because of changes inconditions or because of classification errors in prior years, may affect the statement of cash flows. The followingparagraphs present recommendations for handling reclassifications.

Reclassifications Resulting from Changed Conditions. Reclassifications resulting from changed conditionsrepresent the effects of noncash activities and, thus, would not affect statements of cash flows. For example,reclassifying a long�term liability to current liabilities as a result of a violation of restrictive covenants does not affectcash and, accordingly, would not be shown in the cash flow statement.

Classification Errors in Prior Years. Prior�period financial statements presented for comparative purposes shouldbe restated when reclassifications are made to correct errors in prior years. For example, if a demand notepreviously classified as long�term were reclassified because it is callable at the option of the creditor, prior�periodstatements (balance sheet and statement of cash flows) should treat the amount as a current liability. Thus, thecash flow statement as originally presented would have shown cash flows from long�term borrowings, and therestated financial statements would show the cash flows from short�term borrowings. (The reclassification alsoshould be disclosed in the notes to the financial statements, if material.)


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SELF�STUDY QUIZ


1. When is a statement of cash flows not required?

a. When the financial statements are prepared on an income tax basis.

b. When an income statement and balance sheet are presented together.

c. When an organization is a nonprofit organization.

2. Which of the following items is not considered cash or a cash equivalent?

a. Treasury note purchased three years ago with remaining maturity of two months.

b. Three�year treasury note purchased two months from maturity.

c. Three�month treasury bill purchased three months from maturity.

d. Three month certificate of deposit with a material penalty.

3. GAAP lists four types of cash flows: investing, operating, financing, and noncash investing and financing. Whichtype of cash flow would the following example be?

Louis and Clark Inc. a manufacturing organization, collected $125,000 on loans over the course of the year.

a. Noncash Investing.

b. Financing.

c. Investing.

d. Operating.

4. Cash flows from financing and investing generally should be reported in which of the following amounts?

a. Net cash flows.

b. Gross cash flows.

5. Which of the following examples are most accurate regarding preparing cash flow statements?

a. Organization A should refer to GAAP to determine the order in which items should appear in the operating,investing, and financing sections of its statement of cash flows.

b. Organization B has its disclosures listed in the notes, other financial statements, and the cash flowstatement as stated in GAAP.

c. Organization C is preparing its cash flow statement. It uses a separate schedule to present more detail,which is required for adequate disclosure.

d. Organization D uses subtotals to present cash flows from operating activities when categories consist ofa single item.


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1. When is a statement of cash flows not required? (Page 205)

a. When the financial statements are prepared on an income tax basis. [This answer is correct. If astatement is prepared on a basis other than GAAP (e.g., income tax or cash basis), a statement ofcash flows is not required per FASB ASC 230�10�15�3. If the financial statements are prepared inaccordance with GAAP, then a cash flow statement is required.]

b. When an income statement and balance sheet are presented together. [This answer is incorrect. Thebalance sheet and the income statement must be presented together a cash flow statement is requiredby FASB ASC 230�10�15�3. If a balance sheet or an income statement is presented separately, a statementof cash flows is not required as stated in GAAP.]

c. When an organization is a nonprofit organization. [This answer is incorrect. Cash flow statementrequirements do not apply to financial statements of individuals. According to FASB ASC 230�10�15�3, anorganization must be a profit�oriented business enterprise or a nonprofit organization for cash flowstatement requirements to apply.]

2. Which of the following items is not considered cash or a cash equivalent? (Exhibit 1�1)

a. Treasury note purchased three years ago with remaining maturity of two months. [This answer iscorrect. To qualify as a cash equivalent, an investment must mature three months or less from thedate it was purchased. Even though this investment is going to mature within the three months, itwas not purchased within the previous three months.]

b. Three�year treasury note purchased two months from maturity. [This answer is incorrect. Even though theTreasury note has a three year maturity, it was purchased within the three month requirement to meet thedefinition of a cash equivalent per FASB ASC 230.]

c. Three�month treasury bill purchased three months from maturity. [This answer is incorrect. Because theTreasury bill matures within three months or less of when it was purchased, it is considered a cashequivalent per FASB ASC 230.]

d. Three month certificate of deposit with a material penalty. [This answer is incorrect. According to FASB ASC230, due to the penalties, this certificate of deposit would not be considered cash, but it would beconsidered a cash equivalent.]

3. GAAP lists four types of cash flows: investing, operating, financing, and noncash investing and financing. Whichtype of cash flow would the following example be? (Exhibit 1�2)

Louis and Clark Inc. a manufacturing organization, collected $125,000 on loans over the course of the year.

a. Noncash Investing. [This answer is incorrect. The $120,000 was a cash inflow. An example of noncashinvesting cash flow would be acquiring nonoperating property by assuming a loan.]

b. Financing. [This answer is incorrect. Financing types of cash flows would come from short or long�termborrowings, not loan collections.]

c. Investing. [This answer is correct. Collections on loans are considered an investing type of cashflow because the loan was an investment that earned interest.]

d. Operating. [This answer is incorrect. Operating types of cash flows might include sale of goods andservices as well as interest and dividends. Loan receipts are not part of the operations of Louis and ClarkInc, a manufacturing organization.]


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4. Cash flows from financing and investing generally should be reported in which of the following amounts?(Page 207)

a. Net cash flows. [This answer is incorrect. According to GAAP criteria, there is more relevancy in gross cashreceipts and disbursements than net amounts thus, cash flows from investing and financing activitiesshould generally be reported in gross cash flow amounts. An example would be both proceeds from salesof assets and cash payments for capital expenditures should be shown in the cash flows statement ratherthan just the net change in property and equipment.]

b. Gross cash flows. [This answer is correct. According to GAAP criteria, the gross cash gross cashflows from investing and financing activities are generally required to be reported rather than netamounts.]

5. Which of the following examples are most accurate regarding preparing cash flow statements? (Page 211)

a. Organization A should refer to GAAP to determine the order in which items should appear in the operating,investing, and financing sections of its statement of cash flows. [This answer is incorrect. GAAP does notaddress the order in which items should appear within the operating, investing, and financing section ofthe statement of cash flows. However, GAAP does require that the operating activities section begin withnet income when the indirect method is used.]

b. Organization B has its disclosures listed in the notes, other financial statements, and the cash flowstatement as stated in GAAP. [This answer is incorrect. According to GAAP, disclosures listed on the faceof the cash flow statement and disclosures listed in other financial statements or in the notes do not needto be repeated.]

c. Organization C is preparing its cash flow statement. It uses a separate schedule to present moredetail, which is required for adequate disclosure. [This answer is correct. GAAP prefers the entirecash flow statement be presented on one page. If additional specifications are required for adequatedisclosure, it may be included in the notes to the financial statements or in a separate schedule.]

d. Organization D uses subtotals to present cash flows from operating activities when categories consist ofa single item. [This answer is incorrect. As stated in GAAP, subtotals should be used to present cash flowsfrom operating, investing, and financing activities except when a category consists of a single item. In thatcase, a subtotal is not necessary.]


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What Is Included?

FASB ASC 230�10�20 (formerly SFAS No. 95) defines cash flows from operating activities by exception; operatingactivities include all transactions and events that are not investing or financing activities. Generally, however,operating activities meet the following three criteria:

a. The amounts represent the cash effects of transactions or events.

b. The amounts result from a company's normal operations for delivering or producing goods for sale andproviding services.

c. The amounts are derived from activities that enter into the determination of net income.

Thus, cash flows from operating activities include cash received from sales of goods or services and cash used ingenerating the goods or services such as for inventory, personnel, and administrative and other operating costs.Accordingly, cash receipts from both short�term and long�term notes receivables from customers arising from salesof goods or services are required to be classified as operating activities. Similarly, principal payments on custom�ers' accounts and both short�term and long�term notes payable to suppliers for materials or goods also should beclassified as operating activities. In addition, interest and dividend income, interest expense, and cash payments tosettle an asset retirement obligation are considered to be operating activities even though they are not preciselyconsistent with the preceding criteria. According to an AICPA Technical Practice Aid at TIS 5600.17, landlordincentive allowances in an operating lease should also be presented in the operating activities section of thelessee's statement of cash flows. The cash allowances from the lessor are treated for accounting purposes asadjustments of rent. (Exhibit 1�2 lists some typical examples of cash flows from operating activities.)

What Is Excluded?

Cash flows from operating activities exclude (a) amounts that are not derived from cash receipts and cashpayments, such as accruals, deferrals, and allocations such as depreciation, and (b) amounts that are consideredto be derived from investing or financing activities rather than from operations, such as cash receipts and paymentsrelated to property and equipment and dividends paid.

Basic Format

Cash flows from operations may be presented in either of two basic formats: the direct method or the indirectmethod. Most preparers use the indirect method. (See the Trends volume.) The following paragraphs describe bothmethods and explain their advantages and disadvantages.

Direct Method. The direct method begins with cash receipts and deducts cash payments for operating costs andexpenses, individually listing the cash effects of each major type of revenue and expense. At a minimum, thefollowing categories of cash receipts and cash payments are required to be presented:

� Cash collected from customers, including lessees and licensees

� Interest and dividends received

� Other operating cash receipts, if any

� Cash paid to employees and other suppliers of goods or services, including suppliers of insurance andadvertising

� Interest paid

� Income taxes paid

� Other operating cash payments, if any


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Because the direct method explicitly shows only cash receipts and payments, no adjustments are necessary fornoncash expenses such as depreciation or deferred income taxes. An example of the direct method is as follows:


Cash received from customers $ 348,000

Interest received 1,950

349,950

Cash paid to suppliers and employees 273,000

Cash paid to settle lawsuit 11,700

Interest paid 5,600

Income taxes paid 11,000

301,300

NET CASH PROVIDED BYOPERATING ACTIVITIES 48,650

If the direct method is used, a reconciliation of net income to cash flows from operating activities is required to bepresented in a separate schedule showing all major classes of operating items, including, at a minimum, changesin receivables and payables related to operating activities and changes in inventory.

Proponents of the direct method believe it is preferable because it shows the actual sources and uses of cash fromoperations. In addition, some accountants believe the statement of cash flows is easier to understand becausethere is no need to adjust for noncash items such as depreciation. The direct method may be preferable to theindirect method in the following circumstances:

� Information required for the direct method is readily available or can be obtained without significant cost.

� There are numerous reconciling items between net income and cash flows from operations making theindirect presentation cluttered and cumbersome to analyze.

� Management or banks with which the company obtains financing find the relationship of specific cashreceipts and payments to cash flows from operations useful for making decisions.

The direct method is not used by many companies, however, best practices indicate that it generally will take moretime to prepare a statement using the direct method than using the indirect method. Additional time is necessarybecause a separate reconciliation of net income to operating cash flows is required, thus presenting operating cashflows both directly and indirectly. Nevertheless, best practices indicate that some clients may find cash flowstatements that use the direct method easier to understand and, in those cases, recommend its use.

Indirect Method. The indirect method starts with net income and adjusts for (a) noncash items such as depreci�ation and deferred income taxes and (b) changes during the period in operating current assets and liabilities. [Asexplained earlier, the reconciliation should show all major classes of operating items, including, at a minimum,changes in receivables and payables related to operating activities and changes in inventory. Although FASB ASC230�10�45�29 (formerly SFAS No. 95) literally requires presenting changes in receivables, payables, and inventoryseparately in the reconciliation, some firms believe that amounts could be combined if they would affect a singleline item under the direct method, such as increase in accounts payable and accrued expenses.] Note that netincome should only be adjusted for changes in operating current assets and liabilities. Changes in current assetsand liabilities that arise from investing or financing activities (for example, short�term loans or notes receivable orpayable not related to sales of goods or services) should be shown as investing or financing activities, asappropriate. In addition, accounts payable may have aspects of financing or investing activities, for example,dividends payable or equipment purchased on account. In those cases, it would not be appropriate to include thenet change in payables as an adjustment in arriving at cash flows from operations. An example of the indirectmethod is as follows:


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Net income $ 223,000

Adjustments to reconcile net income to net cash provided by operatingactivitiesDepreciation 29,400

Gain on the sale of equipment (6,700 )


Trade accounts receivable (10,200 )

Inventories 26,450

Prepaid expenses 4,100


Trade accounts payable 37,250

Accrued liabilities (9,500 )

Income taxes payable 4,300


Items that reconcile net income to net cash flows from operating activities are allowed to be presented in thestatement of cash flows itself, as illustrated in the preceding paragraph, or in a separate schedule. If the reconcilingitems were presented in a separate schedule, the cash flow statement would show a single line item for cash flowsfrom operations such as the following:

Net Cash Flows from Operating Activities $ 298,100

In that case, a separate schedule would present a reconciliation of net income with net operating cash flows suchas:

RECONCILIATION OF NET INCOME TO NET CASHFLOWS FROM OPERATING ACTIVITIES



Gain on the sale of equipment (6,700 )



Inventories 26,450






NET CASH PROVIDED BYOPERATING ACTIVITIES $ 298,100

If the indirect method is used, interest and income taxes paid are required to be disclosed. Best practices indicatethat following recommendations for those disclosures be followed:

a. Interest payments generally can be derived by adjusting interest charged to operations by the change inaccrued interest expense.

b. FASB ASC 230�10�50�2 (formerly SFAS No. 95) requires interest paid, net of amounts capitalized, to bedisclosed. Since interest paid is classified as an operating activity, the objective of the disclosure is to allowfinancial statement users to consider interest paid as a financing cash outflow if that better suits their


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purposes. Thus, the amount to be disclosed is the amount of interest reflected in operating cash outflows.If interest is capitalized as part of the cost of property and equipment, the amount capitalized should besubtracted in calculating the interest payments to disclose. The resulting amount is the interest paymentsthat are classified as an operating cash disbursement. However, interest paid and capitalized as part of aninventory type item is considered an operating cash outflow, and, accordingly, total payments need not bereduced for amounts capitalized.

The following examples illustrate how to calculate the amount of interest to disclose:

(1) Assume that a homebuilder pays interest of $130,000, the amount of interest capitalized as cost ofhomes under construction increases by $20,000, accrued interest expense decreases by $30,000,and interest charged to operations is $80,000. Interest payments of $130,000 are reflected in cashoutflows from operations ($80,000 charged to operations plus the total of $20,000 increase incapitalized interest and $30,000 decrease in accrued interest), and $130,000 should be disclosed asinterest paid. It is not necessary to reduce that amount by the amount of interest capitalized since itis an inventory type item.

(2) If interest payments total $75,000 and interest of $30,000 is capitalized as a cost of constructing abuilding, cash flows from operations reflect interest payments of $45,000. Thus, $45,000 should bedisclosed as interest paid. (Normally, the amount of interest capitalized is calculated using interestcosts determined on the accrual basis; it is not based on payments, and accrued interest is notallocated between capitalized amounts and amounts charged to earnings. Therefore, best practicesindicate that it is appropriate to determine the amount to disclose by subtracting the amount of interestcapitalized from total interest payments. Disclosing the amount of interest payments capitalized is notrequired.)

c. The disclosure of income taxes paid should include all taxes that are included in the company's incometax provision. Since financial statements for partnerships and, generally, S corporations do not includeincome tax provisions, no disclosure is usually required for those entities. Accordingly, tax deposits paidby partnerships or S corporations to retain a fiscal year under IRC Sec. 444 should not be disclosed asincome taxes paid.

d. GAAP does not address how income tax refunds affect disclosure of income taxes paid. Best practicesindicate that the amount disclosed should be net of receipts of income tax refunds. (In some years, thatmight result in disclosing net receipts.) Best practices also indicate that it is unnecessary to disclose either(1) the gross amount of receipts and payments or (2) that a net amount is presented.

The disclosures may be made on the face of the statement or in the notes. Illustrations of disclosures presented inthe notes are as follows:

a. Interest paid during 20X2 and 20X1 (net of capitalized interest of $2,800 in 20X1) amounted to $15,300 and$13,100, respectively.

Income taxes paid amounted to $25,900 and $24,100 during 20X2 and 20X1, respectively.

b. Cash flows from operating activities reflect interest payments of $75,300 in 20X1 and $69,400 in 20X0,income tax payments of $26,300 in 20X1, and receipts of $14,200 in 20X0 from income tax refunds.

The disclosures could be added to the existing long�term debt and income tax notes or disclosed in a separate noteof supplemental cash flow disclosures.

Best practices indicate that it is generally easier and takes less time to prepare a cash flow statement using theindirect method. Thus, that method is recommended.

Agency Transactions. Changes in certain current assets and liabilities do not flow through net income and,therefore, theoretically do not affect cash provided from operations. For example, some companies collect fundssuch as sales tax from third parties and remit them to a separate entity or otherwise hold or disburse cash on behalf


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of a customer. Best practices indicate, however, that changes in sales tax liability and changes in other agencyaccounts could be reported as operating activities if the changes are not material. In addition, FASB ASC230�10�45�8 (formerly SFAS No. 95) states that it is generally acceptable to report only the net changes in thoseassets and liabilities because knowledge of gross amounts generally is not essential to understanding the compa�ny's operating, investing, and financing activities.

Extraordinary Items, Cumulative Accounting Adjustments, and Discontinued Operations

GAAP does not require extraordinary items, cumulative accounting adjustments, or discontinued operations to beseparately disclosed in cash flow statements. Thus, the criteria for classifying transactions and events as operating,investing, or financing also would apply to extraordinary items, cumulative accounting adjustments, and discontin�ued operations. The Industry's specific recommendations are presented in the following paragraphs.

Noncash Extraordinary Items. Extraordinary items generally consist of gains or losses or write�offs of assets and,thus, are noncash items. Because GAAP does not require extraordinary items to be separately identified in thestatement of cash flows, best practices indicate that they be treated in the same manner as other noncash items.Under the direct method of reporting cash flows from operations, the approach is simple; since cash flows fromoperations consist only of cash receipts and payments, noncash extraordinary items would be excluded. Under theindirect method, however, net income should be adjusted to arrive at the cash effects of operating activities byadding the noncash elements of extraordinary losses to net income and subtracting the noncash elements ofextraordinary gains from net income. To illustrate, assume that a company's income statement included thefollowing amounts:

INCOME BEFORE INCOME TAXES ANDEXTRAORDINARY ITEM 305,000

INCOME TAXES 91,500

INCOME BEFORE EXTRAORDINARY ITEM 213,500

EXTRAORDINARY ITEMSettlement of class action customer suit, net ofestimated insurance proceeds (less applicable income tax benefit of$30,600) 71,400

NET INCOME $ 142,100

To simplify the illustration, assume the following additional facts:

a. Payment to the customers occurred after the balance sheet date.

b. The class action suit was covered by the company's general liability insurance. Thus, the recordedextraordinary item is net of projected insurance proceeds of $102,000 ($71,400 + $30,600).

c. Income before income taxes and extraordinary items in the amount of $305,000 has been received in cash.

Cash flows from operations would be presented as follows:



Adjustments to reconcile net income to net cash provided by operatingactivitiesSettlement of class action customer suit net of estimated insurance

proceeds 102,000

Increase in income taxes payable 60,900



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Note that the increase in income taxes payable consists of total income taxes shown in the income statement($91,500 � $30,600 benefit).

If an extraordinary item affects both operating current assets and noncurrent assets, best practices indicate that thenoncash effects related to operating current assets are required to be shown separately from the change in currentassets resulting from operating cash receipts and payments. Thus, the noncash effects of the extraordinary itemgenerally would be shown as a single amount. To illustrate, assume that an extraordinary loss resulting from ahurricane included a $62,000 loss of inventory and a $40,000 write�off of undepreciated cost of a warehouse thatwas destroyed. Best practices indicate that cash flows from operating activities should be presented by using asingle caption such as �Inventory and undepreciated cost of building and equipment destroyed by hurricane." Inother words, the decrease in inventory in the amount of $62,000 would be included in the noncash adjustment forthe loss and generally would not be included with the change in inventory resulting from purchases and sales. If thenoncash effects attributable to operating current assets are material, best practices indicate that GAAP does notpermit combining the noncash effects with the change attributable to operating cash receipts and payments, anda presentation such as the following would not be acceptable:



Adjustments to reconcile net income to net cash provided by operatingactivitiesUndepreciated cost of warehouse destroyed by hurricane 40,000

Decrease in inventory 62,000



If a company experiences both an extraordinary loss and an ordinary loss, best practices indicate that the noncasheffects of the losses could be shown as a single amount in the cash flow statement. For example, an extraordinaryloss of property and equipment and a loss of property and equipment that was not extraordinary could be reportedas a single line item with a caption such as �Undepreciated cost of property and equipment destroyed."

Extraordinary ItemsCash. Although extraordinary items are not required to be separately disclosed in cash flowstatements, cash flows related to extraordinary items are required to be appropriately classified as operating,investing, or financing activities. Thus, for example, cash payments to settle a lawsuit probably would be classifiedas an operating activity, while cash paid to extinguish debt probably would be classified as a financing activity. Toillustrate, assume that a company's creditors agreed to accept $100,000 in settlement of debt in the amount of$130,000 and the debt extinguishment met the FASB ASC 225�20�45�2 (formerly APB Opinion No. 30), criteria forclassification as an extraordinary item. The company reported the transaction in its income statement as follows:

INCOME BEFORE INCOME TAXES ANDEXTRAORDINARY ITEM 200,000

INCOME TAXES 60,000

INCOME BEFORE EXTRAORDINARY ITEM 140,000

EXTRAORDINARY ITEMgain on extinguishment of debt (less applicableincome taxes of $9,000) 21,000

NET INCOME $ 161,000

Assuming that income before income taxes and extraordinary item in the amount of $200,000 had been received incash and that there were no other transactions, the company's cash flow statement under the indirect methodwould be presented as follows:


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Adjustments to reconcile net income to net cash provided by operatingactivitiesGain on extinguishment of debt (30,000 )




Cash paid to extinguish debt (100,000 )

NET INCREASE IN CASH 100,000

CASH AT BEGINNING OF YEAR �

CASH AT END OF YEAR $ 100,000

Under the direct method, only the cash actually received or paid would be reflected in the cash flow statement. Inthe preceding example, the $100,000 paid to extinguish the debt would be included, and the gain on extinguish�ment of debt and the increase in income taxes payable would be excluded. Note that cash outflows for incometaxes are required to be classified as an operating activity. Thus, the income tax effects related to an extraordinaryitem should not be allocated to investing or financing activities even though the extraordinary item may appropri�ately be classified as an investing or financing activity.

Cumulative Accounting Adjustments. Like most extraordinary items, cumulative accounting adjustments arenoncash items. Accordingly, under the direct method of reporting cash flows from operations, which only presentscash receipts and payments, cumulative accounting adjustments would be excluded. When the indirect method isused, however, net income should be adjusted to arrive at cash flows from operations by adding the noncashelements of expense amounts to net income and subtracting the noncash elements of income amounts from netincome. Similar to extraordinary items, GAAP does not require cumulative accounting adjustments to be presentedseparately in the statement of cash flows. According to best practices, the adjustment can be classified accordingto the nature of the change.

Cumulative effect adjustments that affect operating current assets and liabilities are rare and normally relate to achange from the FIFO method of valuing inventories to another method or arise through special transition provi�sions of new accounting pronouncements. If it were not practical to restate prior�period financial statements,however, including the cumulative effect of the change in net income was permitted. In that type of situation, bestpractices indicate that GAAP could require the noncash effects of the cumulative adjustment to be shown sepa�rately from the change in the operating current asset or liability attributable to operating cash receipts andpayments.

Discontinued Operations. Cash inflows and outflows are required to be reported according to whether they relateto operating, investing, or financing activities. FASB ASC 230�10�45�24 (formerly SFAS No. 95, Paragraph 26,footnote 10) states that separate disclosure of cash flows from discontinued operations is not required. Companiesmay decide, however, to report operating cash flows of discontinued operations separately. A company thatchooses to report separately operating cash flows of discontinued operations should do so consistently for allperiods affected, which may include periods long after sale or liquidation of the operation. Some of the disclosurevariations that an accountant may choose include:

� Combining the cash flows from discontinued operations with the cash flows from continuing operationswithin each of the three categories.

� Separately identifying the cash flows related to discontinued operations within each of the three categories.


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� Displaying the cash flows related to discontinued operations separately for each of the three categoriesnear the bottom of the statement, just before �net increase or decrease in cash and cash equivalents."

In a December 2005 speech at the AICPA Annual Conference on SEC and PCAOB Current Developments, an SECrepresentative stated that the SEC staff did not support aggregating operating, investing, and financing cash flowsfrom discontinued operations into a single line item. (Because discontinued operations of a component of an entityare segregated in the income statement and assets and liabilities of the component at the balance sheet date aredisclosed, information to present cash flows from both continuing and discontinued operations generally is readilyavailable.) An example of cash flows from operating activities classified by continuing and discontinued operationsis as follows:


Continuing operations

Income before income taxes $ 84,000

Adjustments to reconcile income to net cash provided by continuing operations

Depreciation 23,000

Loss on sale of property and equipment 12,000

Deferred taxes 9,000


Trade accounts receivable 11,200

Inventories (17,700 )




Accrued liabilities 17,250

CASH PROVIDED BY CONTINUINGOPERATIONS BEFORE INCOME TAXES 152,100

Discontinued operations

Loss before income tax benefits (40,000 )

Adjustments to reconcile loss to net cash used by discontinued operations

Depreciation 16,000

Gain on disposal of property and equipment (3,000 )

Provision for loss on disposal of other noncurrent assets 22,000



Inventories 16,450


Trade accounts payable (15,200 )

Accrued liabilities 13,800

CASH USED BY DISCONTINUEDOPERATIONS BEFORE INCOME TAX BENEFITS (20,000 )

Decrease in income taxes payable (5,600 )

NET CASH PROVIDED BY OPERATING ACTIVITIES 126,500

Although also not required, cash flows from investing and financing activities may be allocated to continuing anddiscontinued operations if that information were relevant. The information may be presented (a) in a separateschedule, (b) on the face of the cash flow statement under captions such as �Continuing Operations" and�Discontinued Operations," or (c) on the face of the cash flow statement identified by a caption such as �Proceedsfrom disposal of property and equipmentdiscontinued operations."


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Other Adjustments to Arrive at Net Cash Flows from Operating Activities

The following paragraphs discuss other adjustments to arrive at net cash flows from operating activities when theindirect method is used to present cash flows from operations. The objective of the adjustments is to present netcash flows generated by operating activities by adding noncash expenses to and subtracting noncash revenuesfrom net income. The adjustments should be reflected either in the statement itself or in a separate schedule.Except as noted below, when the direct method is used, the following items should be excluded from the statementof cash flows because the direct approach only reflects cash receipts and payments. (However, the items would beshown in the reconciliation of net income to net cash provided by operating activities.)

Current Operating Assets and Liabilities. Noncash entries to current operating assets and liabilities generallyshould be presented as separate adjustments to net income in arriving at cash flows from operations. Commonexamples of noncash transactions affecting current operating assets and liabilities include recording a provision forbad debts and providing a reserve for inventory obsolescence.

AccountsReceivable

Allowancefor

DoubtfulAccounts

Balance 1/1/X1 $ 50,000 $ 10,000

Sales 300,000 �

Cash collected (250,000 ) �

Bad debt provision � 25,000

Write�offs (20,000 ) (20,000 )

Balance 12/31/X1 $ 80,000 $ 15,000

The operations section of the cash flow statement would be presented as follows:


Net income $ 50,000

Adjustments to reconcile net income to net cash provided by operatingactivitiesProvision for losses on accounts receivable 25,000

Increase in accounts receivable (50,000 )


If noncash entries are not material, however, best practices indicate that it is appropriate to present only the netchange in current assets and liabilities.

Amortization of Intangible Assets and Deferred Charges. Intangible assets and deferred charges (expendituresexpected to yield benefits for several accounting periods) are classified as noncurrent assets and may be periodi�cally charged to expense over some period of time. Some examples of intangible assets are goodwill, copyrights,franchises, licenses, trademarks, formulas, mailing lists, and film rights. The amortization or impairment of intangi�ble assets and deferred charges do not use cash, and any amortization expense or impairment loss recognizedshould be added back to income to arrive at cash flows provided by operations.

Cash Value of Life Insurance. Cash value of life insurance is reported in the balance sheet as a noncurrent asset,and increases in cash value that are allowed to accumulate are included in net income as a reduction of insuranceexpense. Since the increases do not provide cash, however, they should be subtracted from net income to arrive atcash flows from operations. Life insurance that accumulates value has both operating and investing characteristics.However, the primary reason for life insurance is to reduce the risk of operating losses resulting from the death ofa key employee. Consistent with the requirement of FASB ASC 230�10�45�22 (formerly Paragraph 24 of SFAS No.95) to classify a transaction based on the nature of the activity that is likely to be predominate, best practices


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indicate that all life insurance transactions should be classified as an operating activity. An example of the opera�tions section of the cash flows statement in those circumstances follows:


Net income $ 38,000

Adjustments to reconcile net income to net cash provided by operatingactivitiesIncrease in cash value of life insurance (2,000 )


Increases in cash value that are used to reduce payments of insurance premiums (instead of accumulating) reducea liability (for premium obligations) rather than increase a noncurrent asset (cash value of life insurance). In thatcase, the guidance in the table above applies. In most circumstances, best practices indicate that the noncashaspects of the change in trade payables attributable to the increase in cash value would not be material. Accord�ingly, the adjustment to net income would be included in the net change in trade payables, and the increase in cashvalue would not be disclosed as a separate item.

Deferred Income Taxes. Deferred income taxes (both current and noncurrent) are noncash expenses. Thus,increases in deferred tax liabilities and decreases in deferred tax assets should be added back to net income toarrive at net cash flows from operations, and increases in deferred tax assets and decreases in deferred taxliabilities should be subtracted from net income. Only the changes in deferred tax assets and liabilities that wereincluded in net income should be added back to or subtracted from net income, however. Changes allocated tocomponents of other comprehensive income (e.g., the deferred taxes on unrealized gains/losses on available�for�sale marketable securities) should not be added to or subtracted from net income since they were not included innet income.

Deferred Revenue. Deferred revenue represents revenue that has been received or is receivable before it isearned, i.e., before the related goods are delivered or services are performed. In most companies, deferredrevenue is not material. In those instances, deferred revenue and the related receivable, if any, should be presentedin a manner similar to other operating assets and liabilities on the cash flow statement. The deferred revenuebalance should be added to net income and the receivable balance, if any, should be deducted from net income inarriving at cash flows from operations.

Depletion. Depletion is the allocation of the cost of natural resources to expense as units are removed. Becausedepletion does not affect cash, it should be added back to net income to arrive at cash flows from operations.

Depreciation. Productive assets that are economically useful for longer than one year are capitalized and chargedto operations as depreciation over their estimated useful lives. Since depreciation is a noncash expense, it shouldbe added back to net income in arriving at cash flows provided from operations.

Disposal, Sale, and Retirement of Property and Other Noncurrent Assets. When noncurrent assets are sold orretired, the cash effects of the transaction are equal to the proceeds received. Thus, any gain or loss associatedwith the disposal of noncurrent assets should be subtracted from or added back to net income in arriving at netcash flows from operations, and proceeds from the sale should be shown as cash inflows from investing activities.Any expenses incident to the sale also should be added back to net income and shown as an investing activity. Thatapproach should be followed regardless of whether there is a gain or loss on the disposal or whether assets aresold or retired, i.e., no proceeds are received.

Purchase (Sale) of a Business. When a company is purchased or sold, the cash paid to acquire the company (orcash proceeds from sale of the company) should be shown as cash used (or provided) by investing activities.Usually a purchase (or sale) of a business will�include the exchange of operating items, such as receivables andpayables. The cash activity for the purchase of those operating items is included in investing activities. As a result,it is necessary to show the�changes in operating assets and liabilities net of the effects of the purchase (or sale).

To illustrate, assume that XYZ Company purchased ABC Company in 20X4. The following are assets obtained andliabilities assumed in the purchase:


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Accounts receivable $ 17,000

Equipment and leasehold improvements 120,000

Accounts payable (10,000 )

Long�term debt assumed (90,000 )

Cash paid to acquire ABC Company $ 37,000

In addition, XYZ's accounts receivable and accounts payable increased by $23,000 and $12,000, respectively, forthe year ended December 31, 20X4 (including the results of the acquisition). Net income was $155,000 anddepreciation was $22,000. Cash flows from the transactions would be presented as follows:



Adjustments to reconcile net income to net cash provided by operatingactivities:Depreciation 22,000

Changes in assets and liabilities, net of effects of acquisition of ABCCompany:

Accounts receivable��($23,000�$17,000) (6,000 )

Accounts payable�($12,000�$10,000) 2,000

NET CASH PROVIDED BYOPERATING ACTIVITIES $ 173,000


Acquisition of ABC Company (37,000 )

The changes in operating assets and liabilities resulting from the purchase transaction are not considered indetermining net cash provided from operating activities; instead, they are shown as cash outflows from investingactivities. In this example, the majority of the changes in accounts receivable and payable resulted from theacquisition of ABC Company, not from operating activities, and the acquisition�related changes are reflected ascash flows from the acquisition of ABC Company. If the acquisition�related changes were presented simply aschanges in operating assets and liabilities, net cash provided by operating activities would be misstated.

Installment Sales. When sales of goods or services are made on an installment basis, a receivable is created thatis reduced as principal payments are collected. In addition to principal payments, cash receipts representinginterest income generally would be collected, and the installment transaction also might be accompanied by a cashdown payment. Cash flows from a transaction that relates to operating activities should be classified as operatingcash flows regardless of the time at which the cash flows occur. (Note that it is only acceptable to disregard thetiming of payments when a transaction relates to operating activities. The timing should be considered in classify�ing amounts when a transaction has both investing and financing aspects. Thus, if goods or services are sold inexchange for a down payment and a note receivable, the down payment and subsequent principal and interestpayments all would be considered as cash receipts from operating activities. The long�term receivable is a noncashamount included in net income in the year of sale and, thus, should be subtracted from income in arriving at cashflows from operations.

To illustrate, assume that merchandise with a cost of $28,000 was sold on December 31, 20X1, for a cash downpayment of $20,000 and a $50,000 note to be paid in 60 monthly installments of $1,112, including interest at therate of 12%. Relevant balances at the end of the first two years would be as follows:

20X2 20X1

Current portion of receivable $ 8,749 $ 7,765

Noncurrent portion of receivable 33,486 42,235

Principal collected 7,765 20,000

Interest collected 5,579 �

Total cash collected 13,344 20,000


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The $42,000 gross profit recognized in the 20X1 income statement represents the $70,000 sales price less the$28,000 cost of the merchandise sold. The effect of income taxes has been ignored to simplify the illustration. Cashflows from the transaction would be presented as follows:

20X2 20X1


Net income $ 5,579 $ 42,000

Adjustment to reconcile net income to net cashprovided by operating activities(Increase) decrease in installment receivable 7,765 (50,000 )

Net decrease in inventory � 28,000

NET CASH PROVIDED BYOPERATING ACTIVITIES 13,344 20,000

Note that in 20X1 the installment receivable is subtracted from net income in arriving at cash flows from operationsbecause it represents a noncash item that is included in net income, and the net decrease in inventory in theamount of $28,000 is added to net income. The resulting net increase in cash of $20,000 results from receipt of thecash down payment. In 20X2, interest and principal collected account for the cash inflow from operating activities.

Long�term Investments in Common Stock. Under the equity method of accounting for investments in commonstock, investment earnings are recognized in income when they accrue rather than when they are distributed asdividends. Thus, the investor's share of undistributed earnings or loss of an investee, i.e., equity pick up lessdividends, should be subtracted from or added back to net income to arrive at cash flows from operations.Assuming a company's share of earnings in 20X2 was $40,000, its share of net loss in 20X1 was $15,000, anddividends of $5,000 were received in both years, cash flows from operations would be presented as follows:

20X2 20X1


Net income $ 63,000 $ 42,000

Adjustment to reconcile net income to net cashprovided by operating activities(Equity in earnings) share of loss of joint venture,

net of dividends received of $5,000 in 20X2 and20X1 (35,000 ) 20,000


If investments are accounted for by the cost method, dividends received are generally recorded as investmentearnings and are, therefore, considered to be cash inflows from operating activities. Accordingly, no adjustment tonet income is required to arrive at cash flows from operating activities.

Noncontrolling Interests. The consolidated income statement presents the consolidated net income followed byseparate amounts of net income attributable to the parent and the noncontrolling interest. Because the noncontrol�ling interest is not reported as an expense in the consolidated financial statements, no adjustment to reconcile netincome to net cash provided by operating activities is needed for the net income attributable to noncontrollinginterest. Rather, the cash flow statement begins with the consolidated net income.

Unrealized Gains and Losses on Marketable Equity Securities. Unrealized gains and losses on trading securi�ties, as well as nontemporary unrealized losses on held�to�maturity debt securities and available�for�sale securities,are recognized in income in the period in which they occur. Because unrealized gains and losses are noncashitems, net income should be adjusted for their effect by adding back unrealized losses and subtracting unrealizedgains to arrive at cash flows from operations.

Premium Amortization and Discount Accretion. Depending on market conditions, bonds and notes may bepurchased at par, above par (at a premium), or below par (at a discount). Bonds and notes classified as held�to�


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maturity should be recorded at cost with any discount or premium amortized to income over the life of thesecurities. Since the amortization of premiums and discounts are noncash items, net income should be adjustedfor their effect to arrive at cash flows from operations. The amortization of a premium results in recording interestincome at an amount less than the amount of cash received. Accordingly, premium amortization should be addedback to net income. Conversely, the amortization of a discount results in recording interest income at an amountgreater than the amount of cash received. Thus, discount amortization should be reflected as a decrease to netincome.


According to FASB ASC 230�10�20; 230�10�45�12 and 45�13 (formerly SFAS No. 95), investing activities include thefollowing:

� Lending money and collecting on loans

� Acquiring and selling or disposing of securities

� Acquiring and selling or disposing of productive assets that are expected to generate revenue over a longperiod of time

Exhibit 1�2 lists some typical examples of cash flows provided by and used in investing activities. The followingparagraphs discuss how to present cash flows from investing activities in statements of cash flows.

Format Considerations

Netting Certain Cash Flows. While FASB ASC 230�10�45�7 through 45�9 (formerly SFAS No. 95) sets a generalrule that cash receipts and payments should be reported on a gross rather than a net basis, cash flows related toloans and short�term investments with original maturities of three months or less may be reported net rather thangross. Certain financial institutions may also report cash flows related to customer loans and deposits placed withother financial institutions on a net basis.) However, all other cash receipts and payments from investing activitiesshould be reported on a gross basis.

Noncash Investing Activities. Certain investing activities, such as acquiring assets by assuming liabilities orexchanging assets, are noncash transactions that do not involve cash receipts or payments. (Exhibit 1�2 lists othertypical examples of noncash investing activities.) Nevertheless, investing activities that do not involve cash arerequired to be reported separately so that information is provided on all investing activities.

Capital Expenditures

Purchases. Cash outlays for acquiring long�lived assets (including capitalized interest, if any) should be reportedas a cash outflow from investing activities. The amount to be reported in a statement of cash flows generally shouldconsist of (a) assets purchased for cash and (b) downpayments for assets purchased by assuming liabilities.Payments of liabilities, including capital lease obligations, and trade�in allowance and other noncash aspects of thetransaction should be excluded from the amounts reported as investing activities. The following example illustrateshow to report a typical capital expenditure assuming the following facts:

� Net income and depreciation for the year amounted to $12,000 and $3,000, respectively.

� On January 1, the company purchased a new machine with a list price of $74,000.

� A used machine with an undepreciated cost of $5,000 was traded in on the purchase. The trade�inallowance on the used machine was $4,000. Thus, the loss was $1,000.

� The company made a down payment of $10,000 and financed the balance of the purchase with aninstallment loan in the amount of $60,000 to be paid in six annual installments of $10,000 plus interest atthe rate of 14%.


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A cash flow statement such as the following would be presented:


Net income $ 12,000

Adjustment to reconcile net income to net cash provided by operatingactivitiesDepreciation 3,000

Loss on disposal of equipment 1,000



Purchase of equipment (10,000 )


Debt reduction (10,000 )

NET DECREASE IN CASH (4,000 )

CASH AT BEGINNING OF YEAR 24,000


Investing cash flows only include advance payments, the down payment, or other amounts paid at the timeproductive assets are purchased or shortly before or after. Thus, in the preceding example, cash flows used byinvesting activities consist solely of the $10,000 cash down payment. Subsequent principal payments on theinstallment loan are classified as financing activities. The noncash aspects of the transaction (equipment acquiredby assuming liabilities, net of the trade�in allowance) should be disclosed separately.

Sales. Proceeds from sales of long�lived assets should be shown as cash inflows from investing activities.Accordingly, if the facts in the �Purchases" paragraph were changed to assume that a used machine with anundepreciated cost of $5,000 was sold for $6,500 (rather than traded in on the new equipment), a cash flowstatement such as the following would be presented:


Net income $ 14,500

Adjustment to reconcile net income to net cash provided by operatingactivitiesDepreciation 3,000

Gain on sale of equipment (1,500 )



Proceeds from sale of equipment 6,500


NET CASH USED BYINVESTING ACTIVITIES (3,500 )


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Debt reduction (10,000 )




Installment Sales

Installment sales of long�lived assets are considered to be investing activities. Accordingly, cash receipts in theform of cash down payments and collections of principal should be classified as cash provided by investingactivities. (Interest collected should be classified as cash flows from operating activities, however.) For example, abuilding with an undepreciated cost of $60,000 (cost $100,000; accumulated depreciation $40,000) that is sold for$70,000 with terms of sale requiring a cash down payment of $20,000 and payment of the balance in five annualinstallments of $10,000 plus interest at the rate of 16% would result in the following amounts at the end of the firsttwo years (assuming no other transactions):

20X2 20X1

Net incomegain on sale of $10,000 in 20X1 and $8,000interest income in 20X2 $ 8,000 $ 10,000

Building � 100,000

Accumulated depreciation � 40,000

Sales price � 70,000

Cash down payment � 20,000

Current portion of receivable 10,000 10,000

Long�term portion of receivable 30,000 40,000

Principal collected 10,000 �

The following example illustrates how the transaction would be presented in cash flow statements:

20X2 20X1


Net income $ 8,000 $ 10,000

Adjustment to reconcile net income to net cashprovided by operating activitiesGain on sale of building � (10,000 )

NET CASH PROVIDED BYOPERATING ACTIVITIES 8,000 �


Collection on installment sales 10,000 20,000

Certain types of installment sales have both operating and investing aspects, for example, when inventory is soldon an installment basis.

Investments

Short�term Investments vs. Cash Equivalents. If a company has amounts that do not meet the definition of cash,it must decide whether to account for such amounts as cash equivalents or as other short�term investments. [Cashequivalents are defined as �short�term, highly liquid investments that (a) are readily convertible to known amountsof cash and (b) are so near their maturity that they present insignificant risk of changes in value because of changesin interest rates."] In distinguishing between short�term investments that are classified as cash equivalents and


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those that are not, FASB ASC 230�10�45�6 and 50�1 (formerly SFAS No. 95) (a) permit all companies to establish apolicy concerning which short�term, highly liquid investments with original maturities of three months or less areconsidered cash equivalents and which are to be reported as short�term investments and (b) requires companiesto disclose the policy in their financial statements. An illustrative disclosure would be as follows:


Cash Equivalents and Short�term Investments

Cash equivalents consist primarily of Treasury bills, repurchase agreements, and commercialpaper with original maturities of three months or less. Certificates of deposit with original maturi�ties over three months are classified as short�term investments. Cash equivalents and short�terminvestments are stated at cost because that approximates market value. At December 31, 20X2and 20X1, cash equivalents amounted to $40,900 and $31,800, respectively.

Once a policy is established, it should be consistently followed. A change in the type of investments that areclassified as cash equivalents is a change in accounting principle.

Purchases and sales of investments that are classified as cash equivalents are considered to be a part of compa�nies' cash management rather than part of their operating, investing, and financing activities. Thus, the net changein cash equivalents should be included in the net change in cash and cash equivalents shown in the statement ofcash flows, but purchases and sales of cash equivalents would not be reported separately.

Investments That Are Not Cash Equivalents. Purchases and sales of investments in debt or equity securities thatare not cash equivalents should be classified as operating or investing activities based on the nature and purposefor which the related securities were acquired. The following illustrates how investments that are not cash equiva�lents should be presented in cash flow statements. The illustrations assume that classifying transactions in tradingsecurities as operating activities and classifying transactions in available�for�sale securities as investing activities isappropriate based on the nature and purpose for which the related securities were acquired.


Net income $ 39,000




Trading securities 18,000




Trade accounts payable (25,000 )





Proceeds from sales of available�for�sale securities 17,600

Purchases of available�for�sale securities (21,600 )



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Interest and Dividend Income. Receipts from interest and dividends should be classified as cash flows fromoperating activities rather than cash flows from investing activities. In many cases, interest and dividend income oninvestments held by outside custodians is automatically reinvested to principal. Best practices indicate that suchinterest and dividend proceeds should be treated as �constructively received" and presented as a cash activity inthe statement of cash flows. The interest or dividend income should be reflected as a cash flow from operatingactivities, while the reinvestment should be reflected as an investing activity. Even though the proceeds are notphysically transferred from the custodian and reinvested in separate transactions, the substance of the transactionis that cash proceeds have been used to increase an investment. Accordingly, best practices indicate that present�ing the transaction as a cash activity is more appropriate than presenting it as a noncash activity. If presented as anoncash activity, interest or dividend income would be subtracted from net income in arriving at cash flows fromoperations and the reinvestment would be separately reported as a noncash investing and financing activity.

Making Loans

Making loans (notes and loans receivable) is an investment activity. Accordingly, the principal amount of the loanshould be shown as cash used for investing activities, and principal collected on the loan should be shown as cashprovided by investing activities. (However, cash flows relating to investments or loans receivable with originalmaturities of three months or less may be reported net.) Interest collected on the loans should be shown as anoperating activity. For example:


Net income $ 31,300




Loans made (27,700 )

Collections on loans 8,500


Purchase (Sale) of a Business

When a company is purchased or sold, cash flow statements should report the cash paid to acquire the company(or cash proceeds from sale) as an investing activity. For example, if a company pays $90,000 to acquire anotherbusiness with working capital (other than cash) of $30,000 and net noncurrent assets of $60,000, cash flows frominvesting activities would be presented as follows:


Acquisition of ABC Company (net of cash acquired) 90,000

The major categories of assets obtained and liabilities assumed would be disclosed as noncash investing andfinancing activities.

Federal Tax Deposit to Retain Fiscal Year

Best practices indicate that a payment by an S corporation or partnership of a federal tax deposit to retain its fiscalyear or the collection of a refund of a prior payment, should be reported as an investing activity. The deposit is, insubstance, an interest�free loan to the IRS of the tax benefits to the owners of reporting on a fiscal year basis.

Since FASB ASC 230�10�20 (formerly SFAS No. 95, Paragraph 21), defines operating activities as those that are notdefined as investing or financing activities, and the definition of investing activities does not include fiscal yeardeposits, some accountants question whether such deposits should be viewed as operating activities instead of


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investing activities. Best practices indicate that it is unreasonable to assume that all investing and financingactivities could be addressed in the Standard. Furthermore, that guidance notes that operating activities generallyshould report the cash effects of events that enter into the determination of net income. Tax deposits only affectcash; they never enter into the determination of net income.


FASB ASC 230�10�20 (formerly SFAS No. 95) states that financing activities include the following:

� Obtaining resources from owners and providing them with a return on, and a return of, their investment

� Borrowing money and repaying amounts borrowed, or otherwise settling the obligation

� Obtaining and paying for other resources from creditors on long�term credit

Exhibit 1�2 lists some typical examples of cash flows provided by financing activities. The following paragraphsdiscuss how to present cash flows from financing activities in statements of cash flows.


Netting Certain Cash Flows. Cash receipts and payments are generally required to be reported on a gross ratherthan a net basis. However, loans with original maturities of three months or less may be reported net rather thangross. (Certain financial institutions are permitted to also report cash flows related to customer deposits on a netbasis.) All other financing activities should be reported gross.

Noncash Financing Activities. Certain financing activities, such as issuing stock in exchange for noncash consid�eration such as property and equipment, do not involve cash receipts or payments. (Exhibit 1�2 lists other typicalexamples of noncash financing activities.) Nevertheless, financing activities that do not involve cash are required tobe reported separately so that information is provided on all financing activities.

Cash Dividends

Financing activities include providing owners with a return on their investment, and, thus, cash dividends paidshould be shown as a cash outflow from financing activities, as illustrated below:


Dividends paid (6,000 )

Dividends declared but not paid and stock dividends are noncash transactions. Accordingly, they should not beshown in the cash flow statement itself. Rather, they should be disclosed as noncash investing and financingactivities.

Stockholders often borrow funds from closely held corporations to avoid the taxation associated with dividenddistributions. The corporation records the borrowings as stockholder loans receivable and may offset dividenddistributions against the loan receivable. (The IRS may consider the �loans" as �constructive dividends" to thestockholder, thus making the distribution taxable to the stockholder.) To the extent that dividends are offset in theyear the stockholder loan is made, best practices indicate that the statement of cash flows should reflect theamount paid to the stockholder as a financing activity, rather than an investing activity. In subsequent years,however, offsetting the stockholder loan against dividend distributions should be reported as a noncash financingactivity.

Issuing Stock

Proceeds from issuing stock should be reported as cash inflows from financing activities. Although cash flows aregenerally required to be reported on a gross basis, best practices indicate that it would be acceptable to showproceeds from issuing stock, net of stock issue costs, as cash received from financing activities provided theamount of stock issue cost is disclosed as follows:


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Proceeds from issuing common stock (net of stock issue costs of$3,000) 27,000

The following transactions relating to issuing stock do not affect cash flows and should be disclosed as noncashinvesting and financing activities:

� Stock issued for receivables or other noncash consideration such as property and equipment

� Stock issued to settle debt

� Stock issue costs that have not been paid in cash during the period

Short�term and Long�term Debt

Cash receipts from both short�term and long�term borrowings should be shown as cash inflows from financingactivities. The reduction of short�term and long�term obligations should be reported as a separate cash outflowfrom financing activities, except for cash flows related to loans with original maturities of three months or less, whichmay be reported net. To illustrate, assume that a company's activities related to borrowings are summarized asfollows:

� Equipment is acquired in a capital lease transaction; the capital lease obligation was $84,000.

� Cash borrowed consisted of $10,000 of short�term debt payable in less than three months, $40,000 of othershort�term debt, and $125,000 of long�term debt.

� Cash paid on borrowings consisted of $8,100 on the capital lease obligation, $5,000 on short�term debtpayable in less than three months, $15,000 on other short�term debt, and $12,000 on long�term debt.

Cash flows from financing activities would be presented as follows:


New borrowings:

Short�term 45,000

Long�term 125,000

Debt reduction:

Short�term (15,000 )

Long�term (20,100 )

NET CASH PROVIDED BYFINANCING ACTIVITIES 134,900

New borrowings of short�term debt consist of the net cash flows from loans with original maturities of less than threemonths in the amount of $5,000 ($10,000 borrowed less $5,000 repaid) plus $40,000 from other short�term debt.Because payments on debt with original maturities of three months or less are netted with new borrowings,reduction of short�term debt consists solely of payments of other short�term debt in the amount of $15,000.Payments on long�term debt consist of $8,100 paid on capital lease obligations and $12,000 paid on otherlong�term debt. Note, however, that incurring the capital lease obligation does not affect cash and, thus, would bedisclosed as a noncash investing and financing activity rather than as a cash inflow from financing activities.

Debt Issue Costs. Best practices indicate that bank fees and other costs incurred in obtaining financing orrefinancing should be offset against the debt and charged to interest expense over the life of the debt, generallyusing the interest method. All of the costs are therefore accounted for as discount on the debt. FASB ASC230�10�45�15 (formerly EITF Issue No. 95�13, �Classification of Debt Issue Costs in the Statement of Cash Flows")states that cash payments for debt issue costs should be classified as a financing activity. Accordingly, the amountsreported as a financing activity are the proceeds (the face amount of the debt), less the bank fees and other costsincurred, and repayment of that amount (the reduction in the net liability reported in the financial statements). No


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adjustment is needed to reconcile net income with net cash provided by operating activities. To illustrate, assumecosts of $40,000 are incurred in obtaining a loan of $1,000,000. The loan is to be repaid in 36 monthly installmentsof $33,000 including interest at 11.55%. A rate of 14.41% discounts the payments to the net proceeds of $960,000(calculated as principal less the issuance costs of $40,000). That is the effective rate. At the end of the first year,payments of $396,000 have been made. Based on the stated rate, those payments have been allocated approxi�mately $295,800 to principal and $100,200 to interest, and the principal balance outstanding is $704,200. However,based on the effective rate, the payments have been allocated approximately $275,400 to principal and $120,600to interest, and the principal balance outstanding is $684,600. Assuming those are the only transactions for theyear, cash of $564,000 has been provided (that is, the proceeds of $960,000 less the payments of $396,000), andthe statement of cash flows would be as follows:


Net loss and net cash used in operating activities $ (120,600 )


Proceeds of long�term debt 1,000,000

Payments for debt issue costs (40,000 )

Principal payments (275,400 )

684,600

NET INCREASE IN CASH $ 564,000

Life Insurance Policies. Loans against life insurance policies should be treated as long�term borrowings if theloans will be repaid following the guidance in the previous paragraph regarding short�term and long�term debt.Generally, however, the loans are considered to be permanent and, in those cases, best practices suggest treatingthem as distributions rather than loans. For example, assume that a company acquires an insurance policy thataccumulates cash value of $9,000 over two years, borrows $2,000 against the cash value as a long�term liability(which is offset against cash value in the company's financial statements), and cancels the policy. If the loan weretreated as a distribution, the following amounts would be reported in the cash flow statement assuming no othertransactions:

20X2 20X1


Net income $ 5,000 $ 4,000

Adjustments to reconcile net income to net cashprovided by operating activities(Increase) decrease in cash value of life insurance 2,000 (2,000 )


Upon the death of an insured individual, the face amount of the policy less any outstanding loans against the cashvalue is distributed. An example of a cash flow statement is presented below assuming a $250,000 policy on the lifeof a stockholder had accumulated cash value of $20,000 at the date of death and that outstanding loans against thecash value amounted to $10,000. Net income reported in the statement amounts to income from the life insurancepolicy of $230,000 ($250,000 face value less $20,000 cash value previously recognized in earnings).



Adjustments to reconcile net income to net cash provided by operatingactivitiesDecrease in cash value of life insurance 10,000



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The cash provided by operating activities in the preceding example equals the net cash distribution received by thecompany and is composed of $250,000 face value of the policy less outstanding policy loans of $10,000.

Treasury Stock

The amount paid to acquire a company's own stock should be reported as a cash outflow from financing activitiesin the amount of the cash disbursed to acquire the stock. Subsequent reissuance of treasury stock for cash shouldbe reported as a cash inflow from financing activities. The following cash flow statement would be appropriateassuming 200 shares of common stock were acquired in 20X1 for $2,500 and reissued in 20X2 for $2,700:

20X2 20X1


Purchase of treasury stock $ � $ (2,500 )

Proceeds from reissuance of treasury stock 2,700 �

NET CASH PROVIDED (USED)BY FINANCING ACTIVITIES 2,700 (2,500 )

NONCASH INVESTING AND FINANCING ACTIVITIES

FASB ASC 230�10�50�3 (formerly SFAS No. 95) requires investing and financing activities that do not involve cashreceipts and payments during the period to be excluded from the cash flow statement and reported separately. Forexample, FASB ASC 230�10�55�11 includes the following illustrative schedule of noncash investing and financingactivities:

Supplemental schedule of noncash investing and financing activities:

The Company purchased all of the capital stock of Company S for $950. In conjunction with theacquisition, liabilities were assumed as follows:

Fair value of assets acquired $ 1,580

Cash paid for the capital stock (950 )

Liabilities assumed $ 630

A capital lease obligation of $850 was incurred when the Company entered into a lease for newequipment.

Additional common stock was issued upon the conversion of $500 of long�term debt.

Because the disclosure of noncash investing and financing transactions is not self�balancing, it is possible toinadvertently omit a noncash transaction from the schedule. Thus, all investing and financing transactions shouldbe carefully reviewed to ensure that all noncash transactions are included. This course recommends accountantsuse a worksheet that reconciles noncash investing and financing transactions. As previously mentioned, investingand financing transactions involve the following activities:

Investing Activities

� Lending money and collecting on loans

� Acquiring and selling or disposing of certain securities (other than cash equivalents)

� Acquiring and selling or disposing of productive assets that are expected to generate revenue over a longperiod of time

Financing Activities

� Obtaining resources from owners and providing them with a return on, and a return of, their investment


237

� Borrowing money and repaying amounts borrowed, or otherwise settling the obligation

� Obtaining and paying for other resources from creditors on long�term credit

Although the supplemental disclosure of noncash investing and financing transactions is not self�balancing,transactions having both cash and noncash aspects, for example, purchase of equipment in exchange for a cashdown payment and an equipment loan, reconcile to the cash received or disbursed as shown within the cash flowstatement.


The supplemental disclosure of noncash investing and financing transactions may be presented either in narrativeform (for example, in the notes to the financial statements) or summarized in a schedule. If the supplementaldisclosure is made in a schedule, best practices indicate that it be presented at the bottom of the cash flowstatement. An example is as follows:


Net income $ 67,100




Inventories 21,850










Proceeds of long�term borrowings 25,000

Repayment of long�term borrowings (5,000 )

NET CASH PROVIDED BYFINANCING ACTIVITIES 20,000




SUPPLEMENTAL DISCLOSURES

Schedule of Noncash Investing and Financing Transactions

Capital lease obligation incurred for use of equipment $ 15,600

Alternatively, companies may disclose noncash investing and financing transactions in the notes to the financialstatements in a separate note.


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Assets Acquired by Assuming Liabilities

Assets acquired by assuming liabilities, including capital lease obligations, are noncash transactions that shouldbe disclosed separately. Assume the following facts:

� Net income and depreciation for the year amounted to $12,000 and $3,000, respectively.

� On January 1, the company purchased a new machine with a list price of $74,000.

� A used machine with an undepreciated cost of $5,000 was traded in on the purchase. The trade�inallowance on the used machine was $4,000.

� The company made a down payment of $10,000 and financed the balance of the purchase with aninstallment loan in the amount of $60,000 to be paid in six annual installments of $10,000 plus interest atthe rate of 14%.

The noncash aspects of the preceding transaction should be disclosed separately, for example, in a schedule ofnoncash investing and financing transactions such as follows:

Acquisition of equipment

Cost of equipment, net of trade�in $ 69,000

Loss on trade�in 1,000

Equipment loan (60,000 )

Cash down payment for equipment $ 10,000

The $10,000 cash down payment should be shown as cash used by investing activities.

The traditional form of this transaction is for the lender to send a check to the seller or for the buyer to assume debt.In some situations, the form of the transaction is such that the buyer actually receives the proceeds of the borrowingand then sends those proceeds to the seller. The following are common examples:

� The lender deposits the proceeds of the loan into the company's checking account, and the companydrafts a check to the vendor.

� The company drafts restricted cash accounts to pay the vendor, for example, cash restricted under theterms of an industrial development bond or cash restricted under a construction draw arrangement.

� The company draws against a pre�established line of credit to pay the vendor.

The substance of each of those situations is the same; the company acquires an asset by incurring a liability. Thecompany is in the same position as if the lender sent a check to the vendor. Accordingly, best practices indicate thateach should be reported as a noncash investing and financing activity.

In addition to acquiring equipment via long�term debt, companies sometimes finance the acquisition of equipmentthrough a short�term trade account. To illustrate, assume that:

� A wholesale distributor buys three trucks from a local dealer for $110,000 in December 20X0. The distributorpays the dealer $10,000 cash at that time and agrees to pay the remaining $100,000 in sixty days uponreceipt of the vendor's invoice. The distributor records the $100,000 liability in trade accounts payable.

� The trade accounts payable balance increased by $300,000 during 20X0, including the $100,000 for thetrucks.

� The trade accounts payable balance increased $350,000 during 20X1, after payment of the $100,000payable to the dealer.


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Although the $100,000 liability is included in trade accounts payable on the distributor's balance sheet as ofDecember 31, 20X0, that amount should not be reflected as an increase in accounts payable in the company'sstatement of cash flows when reconciling net income to cash flows from operating activities. Therefore, operatingactivities in 20X0 should reflect only a $200,000 increase in trade accounts payable. The remaining $100,000increase in trade accounts payable should be disclosed as a noncash investing and financing activity, and the$10,000 cash down payment should be reflected as cash used by investing activities. In 20X1, the $100,000payment to the dealer should not be reflected as a decrease in trade accounts payable when reconciling netincome to cash flows from operating activities. Instead, the payment should be reflected as a financing activity, andoperating activities should reflect a $450,000 increase in trade accounts payable. The applicable portions of thestatements of cash flows for 20X1 and 20X0 should reflect the following:

20X1 20X0


Net income

Adjustments to reconcile net income to net cashprovided by operating activitiesIncrease in trade accounts payable 450,000 200,000

CASH FLOWS USED BY INVESTING ACTIVITIES

Purchase of equipment � (10,000)


Payment of short�term trade account used to financeequipment acquisition (100,000 ) �

In addition, the noncash aspects of the preceding transaction should be disclosed separately, for example, in aschedule of noncash investing and financing transactions such as follows:

Acquisition of equipment

Cost of equipment $ 110,000

Trade account payable (100,000 )

Cash down payment for equipment $ 10,000

The disclosure also could be made in a note to the financial statements, such as:

Noncash investing and financing activities in 20X0 consist of financing the purchase of equipmentthrough a $100,000 trade account.

Best practices indicate that if the amount of change in the accounts payable balance related to nonoperating itemsis immaterial, the statements of cash flows for both the year of purchase and the year of payment could reflect theamount as an increase (decrease) in accounts payable.

Converting Debt to Equity

Converting debt to equity is a financing transaction since long�term financing is capitalized; however, the transac�tion does not involve cash. Thus, the debt reduction should be disclosed in the financial statements in a separateschedule or otherwise. If a separate schedule were presented, appropriate captions, depending on the specificcircumstances, would be as follows:

� Stock issued in exchange for long�term debt

� Long�term debt converted to common stock

Converting Stock

Converting one class of stock to another, such as preferred to common, is treated in a manner similar to convertingdebt to equity. An amount equal to the par value of the preferred stock and any related additional paid�in capital that


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is converted should be disclosed. For example, assume that 1,000 shares of $100 par value preferred stock($100,000) is converted to 9,000 shares of $10 par value common stock. A schedule of noncash investing andfinancing transactions would report the transaction in a manner such as the following:

Preferred Stock Converted to Common Stock

Common stock $ 90,000


$ 100,000

Noncash Dividends

The fair value of property that is distributed as a dividend is required to be charged to retained earnings. At the datethat property dividends are declared, the company should recognize a gain or loss for the difference between thecarrying value and the fair value of the assets that are distributed. For example, if property with an undepreciatedcost of $85,000 and a fair value of $150,000 is distributed as a dividend, the company would recognize a gain of$65,000 ($150,000 � $85,000) when the dividend is declared. The gain should be subtracted from net income toarrive at cash flows from operations as follows:




Gain on distribution of property (65,000 )




Prepaid expenses (500 )


Trade accounts payable (750 )




The transaction also would be shown in the schedule of noncash investing and financing transactions as follows:

Property dividends

Fair value of property distributed as dividends $ 150,000

Undepreciated cost (85,000 )

Gain on distribution $ 65,000

For stock dividends, best practices indicate that an amount equal to the fair value of the shares issued should beseparately disclosed as a noncash transaction. For example, if 100 shares of common stock ($10 par value) with afair value of $1,200 are distributed as a dividend, a schedule of noncash investing and financing transactions wouldreport the transaction in a manner such as the following:

Common stock distributed as a dividend

Common stock $ 1,000

Additional paid�in capital 200

Fair value of stock dividend $ 1,200

If a sufficient number of shares are issued so that the transaction would be classified as a stock split, best practicesindicate that whether the transaction should be separately disclosed as a noncash transaction would depend on


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the legal requirements of the state of incorporation of the company. For example, some states require an amountequal to the par value of the shares issued to be capitalized to retained earnings. In those circumstances, theauthors believe that the stock split should be disclosed as described in the preceding paragraph. However, if stateregulations require the transaction to be accounted for by increasing the number of shares outstanding anddecreasing the par value per share, there would be no formal entry to record the transaction, and thus, the authorsbelieve it need not be disclosed as a noncash transaction. (The transaction would be disclosed in the notes to thefinancial statements, however.)

Purchase (Sale) of a Business

When a company is purchased or sold, the cash paid to acquire the company (or cash proceeds from sale of thecompany) should be shown as cash used (or provided) by investing activities. FASB ASC 230�10�50�3 through 50�5(formerly SFAS No. 95) requires only the fair value of assets acquired and the fair value of liabilities assumed to bedisclosed as a noncash transaction. It does not require the major categories of assets obtained and liabilitiesassumed to be disclosed. The major categories of assets obtained and liabilities assumed, however, often areseparately disclosed as a noncash transaction, for example, in a separate schedule, as follows:

Acquisition of ABC Company

Working capital other than cash $ 30,000


Intangibles and other assets 30,000



When less than 100% of a subsidiary is acquired, noncontrolling interests in the subsidiary at the date of acquisitiongenerally are shown as follows:

Acquisition of ABC Company

Working capital other than cash $ 30,000


Intangibles and other assets 30,000


Noncontrolling interests (20,000 )


Increases in the parent company's investment in a subsidiary as a result of issuing additional common stock alsoshould be disclosed, for example, in a schedule of noncash investing and financing transactions, as follows:

Issuance of common stock to reduce noncontrolling interests in ABCCompany $ 10,000

Unrealized Gains and Losses on Marketable Securities

Net unrealized gains and losses on some marketable equity securities are recognized in income in the period inwhich they occur. Net income should be adjusted for the effect of those unrealized gains and losses by adding backunrealized losses and subtracting unrealized gains to arrive at cash flows from operations. Conversely, unrealizedgains and losses on other debt and equity securities do not affect net income. They are recorded by adjusting thecarrying amount of the securities and adjusting other comprehensive income for a similar amount. Unrealized gainsand losses on those securities need not be added to or subtracted from net income to arrive at cash flows fromoperations. Best practices indicate that since those changes are internal accounting adjustments, they are notinvesting activities and, therefore, disclosure of them as a noncash investing transaction is unnecessary.

Accrued Interest on Stockholder Loans

Stockholders often borrow funds from or loan funds to closely held corporations. In some instances, the interestaccrued on loans receivable from or payable to stockholders is added to the principal balance of the loan. Best


242

practices indicate that the increase in the loan balance should be reported as a noncash investing and financingactivity. The accrued interest income (or expense) should be subtracted from (or added to) net income in arrivingat cash flows from operating activities, since the interest is derived from a noncash transaction.

CASH FLOW PER SHARE

FASB ASC 230�10�45�3 (formerly SFAS No. 95) prohibits reporting an amount that represents cash flow per share,a practice followed in the past primarily by some publicly held companies. In making that decision, the FASBconcluded that cash flow per share data was susceptible to misinterpretation. For example, it may imply that cashflow is equivalent or superior to earnings as a measure of performance or that an amount representing cash flowper share is available for distribution to stockholders.

PREPARING CASH FLOW STATEMENTS

The information needed to prepare a cash flow statement usually is obtained from comparative balance sheets andadditional information about changes in accounts in sufficient detail to identify (a) the nature of cash flows(operating, investing, or financing), (b) gross cash receipts and payments, and (c) any noncash transactions.

This section illustrates how to prepare a statement of cash flows for Big Time Company. The balance sheets andstatement of income and retained earnings for Big Time Company follow:

BIG TIME COMPANYBALANCE SHEETSDecember 31

20X2 20X1

ASSETS

CURRENT ASSETS

Cash $ 32,450 $ 56,250

Accounts receivable 112,800 121,600

Notes receivablestockholder 27,800 11,400

Accrued interest receivable 1,450 800

Inventory 149,500 183,300


PROPERTY AND EQUIPMENT

Land 60,000 60,000

Building 320,000 320,000

Shop equipment 55,000 40,000

Furniture 18,500 18,500

Autos and trucks 11,000 23,500

464,500 462,000

Accumulated depreciation (195,850 ) (185,000 )

268,650 277,000

OTHER ASSETS

Cash value of life insurance 22,950 19,350

Deferred charges 1,350 2,700

24,300 22,050

TOTAL ASSETS $ 616,950 $ 672,400


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LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES

Notes payable $ 40,000 $ 50,000



Accrued compensation expense 11,000 8,150

Interest payable 1,850 1,400

Payroll taxes payable 1,300 950

Income taxes payable 4,350 2,250




Common stock 20,000 20,000


TOTAL STOCKHOLDERS' EQUITY 135,100 120,250

TOTAL LIABILITIES ANDSTOCKHOLDERS' EQUITY $ 616,950 $ 672,400

BIG TIME COMPANYSTATEMENT OF INCOME AND RETAINED EARNINGSYear Ended December 31, 20X2

REVENUE

Sales $ 737,200

Gain on sale of truck 250

Interest income 2,400

739,850

COST OF SALES

Raw materials 315,200

Direct labor 32,900

Freight 16,700

364,800

GROSS PROFIT 375,050


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SELLING AND ADMINISTRATIVE EXPENSES

Officers' salaries 89,600

Sales salaries 48,400

Office salaries 51,600

Payroll taxes 18,650

Rent 25,850

Office expense 10,800

Officers' life insurance 4,200

Professional fees 5,900

Telephone 4,700

Utilities 9,350

Repairs and maintenance 6,700

Insurance 14,300

Provision for bad debts 20,000

Depreciation 18,850

Amortization 1,350

Other taxes 3,200

Interest expense 14,650

348,100

INCOME BEFORE INCOME TAXES 26,950

INCOME TAXES 8,100

NET INCOME 18,850

BEGINNING RETAINED EARNINGS 100,250

Dividends paid (4,000 )

ENDING RETAINED EARNINGS $ 115,100

Additional financial information for Big Time Company is as follows:

� The company's principal stockholder repaid $3,600 of his $11,400 receivable during the year. At December31, 20X2, the stockholder borrowed an additional $20,000.

� The company purchased machinery in exchange for a $5,000 down payment and a $10,000 equipmentnote. The first payment on the equipment note is due in 20X3.

� A truck with an original cost of $12,500 and accumulated depreciation of $8,000 was sold for $4,750.

� Notes payable shown as a current liability have original maturities of three months or less.


245

SELF�STUDY QUIZ


6. Ben has made his decision to use the indirect method in preparing the statement of cash flows for Saddles `nSuch, Inc. Which of the following is an advantage to using this method over the direct method?

a. Showing the actual sources and uses of cash from operating activities.

b. Less time and easier to prepare.

c. More useful for making decisions.

d. Does not have to show noncash items.

7. SFAS No. 95 requires disclosure of interest paid regardless of whether the direct or indirect method is used.Based on the following facts, calculate the amount of interest paid to be disclosed.

Interest Payments $75,000

Capitalized Interest for inventory $10,000

Capitalized Interest for equipment $30,000

a. $45,000 should be disclosed as interest paid and $40,000 should be disclosed as interest paymentscapitalized.

b. $35,000 should be disclosed as interest paid.

c. $75,000 should be disclosed as interest paid.

d. $45,000 should be disclosed as interest paid.

8. Tuesday's Child Organization (TCO) must report the effect of its adoption of a new accounting principle as itrelates to unrealized gains. TCO uses the indirect method to prepare their statement of cash flows. What is theproper treatment of the cumulative accounting adjustment?

a. Because TCO uses the indirect method of reporting cash flows from operating activities, cumulativeaccounting adjustments would be excluded.

b. Due to the requirements of GAAP, TCO presents the cumulative accounting adjustment separately in thestatement of cash flows.

c. TCO should combine the total cumulative effect of adopting the new accounting principle with totalunrealized gains and report it as a single adjustment on the statement of cash flows.

9. How should receipts from dividends and interest be classified in the cash flow statement?

a. As cash flows from operating activities.

b. As cash flows from investing activities.


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10. How should the interest collected on a loan be presented on the statement of cash flows?

a. As an operating activity.

b. As an investment activity.

c. As a financing activity.

d. As a noncash investing.

11. Which of the following is an example of a financing activity?

a. The Cut `N Dry purchased 10 barber chairs with dryer attachments for $2,500 for their newly renovatedbarber shop.

b. Sunshine Cleaners cleans homes in the Detroit metroplex. Sunshine has decided to sell its old vacuumcleaners for $25 each.

c. Universal Bowling Lanes is purchasing 250 bowling shoes to replace the shoes that are worn out. The totalcost for the shoes is $7,500.

d. The owner of Heartland Inc. received a cash dividend from the company.


247



6. Ben has made his decision to use the indirect method in preparing the statement of cash flows for Saddles `nSuch, Inc. Which of the following is an advantage to using this method over the direct method? (Page 219)

a. Showing the actual sources and uses of cash from operating activities. [This answer is incorrect. If Benwants to show this detail, he should choose the direct method.]

b. Less time and easier to prepare. [This answer is correct. Predominantly, the indirect method is usedin the preparation of the statement of cash flows for this exact reason. The direct method shows thedetail of operating cash receipts and payments, while the indirect method only highlights thedifference between reported profit and net cash flow from operating activities. This process makesthe direct method have a significant cost and time to prepare the information.]

c. More useful for making decisions. [This answer is incorrect. This is an advantage of the direct method.Management may find the relationship of specific cash receipts and payments to cash flows from operatingactivities more useful for purposes of making decisions. The indirect presentation is often considered toocluttered and cumbersome for easy analysis. The direct method provides more detailed information to thereader of the cash flows.]

d. Does not have to show noncash items. [This answer is incorrect. Noncash items are shown as adjustmentsto the change in net assets using the indirect method.]

7. SFAS No. 95 requires disclosure of interest paid regardless of whether the direct or indirect method is used.Based on the following facts, calculate the amount of interest paid to be disclosed. (Page 218)

Interest Payments $75,000

Capitalized Interest for inventory $10,000

Capitalized Interest for equipment $30,000

a. $45,000 should be disclosed as interest paid and $40,000 should be disclosed as interest paymentscapitalized. [This answer is incorrect. According to FASB ASC 230�10�50�2 (formerly SFAS No. 95),disclosing the amount of interest payments capitalized is not required.]

b. $35,000 should be disclosed as interest paid. [This answer is incorrect. According to FASB ASC230�10�50�2 (formerly SFAS No. 95), total interest payments should not be reduced by capitalized intereston inventory because that interest would be included in operating cash flow.]

c. $75,000 should be disclosed as interest paid. [This answer is incorrect. SFAS No. 95 requires capitalizedinterest to be considered in the amount of the disclosure per FASB ASC 230�10�50�2 (formerly SFAS No.95).]

d. $45,000 should be disclosed as interest paid. [This answer is correct. FASB ASC 230�10�50�2(formerly SFAS No. 95) requires disclosure of interest paid net of amounts capitalized for plant orequipment. Interest capitalized for inventory does not need to be included. Therefore $75,000 less$30,000 = $45,000.]

8. Tuesday's Child Organization (TCO) must report the effect of its adoption of a new accounting principle as itrelates to unrealized gains. TCO uses the indirect method to prepare their statement of cash flows. What is theproper treatment of the cumulative accounting adjustment? (Page 222)

a. Because TCO uses the indirect method of reporting cash flows from operating activities, cumulativeaccounting adjustments would be excluded. [This answer is incorrect. According to FASB ASC


248

250�10�45�5 (formerly SFAS No. 154), if the direct method of reporting cash flows from operating activitieswas used, the cumulative accounting adjustment would be excluded because the direct method onlypresents cash receipts and payments.]

b. Due to the requirements of GAAP, TCO presents the cumulative accounting adjustment separately in thestatement of cash flows. [This answer is incorrect. GAAP does not require separate presentation of thecumulative accounting adjustment in the statement of cash flows per FASB ASC 250�10�45�5 (formerlySFAS No. 154).]

c. TCO should combine the total cumulative effect of adopting the new accounting principle with totalunrealized gains and report it as a single adjustment on the statement of cash flows. [This answeris correct. When using the indirect method, net income should be adjusted to arrive at cash flowsfrom operations by adding the noncash elements of expense amounts to net income and subtractingthe noncash elements of income amount from income. GAAP does not require cumulativeaccounting adjustments to be presented separately in the statement of cash flows.]

9. How should receipts from dividends and interest be classified in the cash flow statement? (Page 232)

a. As cash flows from operating activities. [This answer is correct. Receipts from interest anddividends should be classified as cash flows from operating activities rather than cash flows frominvesting activities. In many cases, interest and dividend income on investments held by outsidecustodians is automatically reinvested to principal per GASB ASC 230�10�20 (formerly SFAS No. 95).When that happens, the interest or dividend income should be reflected as a cash flow fromoperating activities, while the reinvestment should be reflected as an investing activity.]

b. As cash flows from investing activities. [This answer is incorrect. According to GASB ASC 230�10�20(formerly SFAS No. 95), receipts from interest and dividend should not be classified at cash flows frominvesting activities. The reinvestment of receipts from dividends and interest should be reflected as aninvesting activity.]

10. How should the interest collected on a loan be presented on the statement of cash flows? (Page 232)

a. As an operating activity. [This answer is correct. FASB ASC 230�10�20 (formerly SFAS No. 95,interest collected on the loans should be shown as an operating activity.]

b. As an investment activity. [This answer is incorrect. Making a loan is an investment activity. The principalamount of the loan should be shown as cash used for investing activities, and principal collected on theloans should be shown as cash provided by investing activities per FASB ASC 230�10�20 (formerly SFASNo. 95, but the interest should be separately stated.]

c. As a financing activity. [This answer is incorrect. According to FASB ASC 230�10�20 (formerly SFAS No.95, interest collected on a loan is not presented on the statement of cash flows as a financing activity.Financing activities include obtaining resources from owners and providing them with a return on, and areturn of, their investment; borrowing money and repaying amounts borrowed, or otherwise settling theobligation; and obtaining and paying for other resources from creditors on long�term creditnone ofwhich includes presenting interest collected on the statement of cash flows.]

d. As a noncash investing. [This answer is incorrect. According to FASB ASC 230�10�50�3 (formerly SFASNo.�95) requires investing and financing activities that do not involve cash receipts and payments duringthe period to be excluded from the cash flow statement and reported separately. The interest collected ona loan must be presented on the statement of cash flows.]

11. Which of the following is an example of a financing activity? (Page 235)

a. The Cut `N Dry purchased 10 barber chairs with dryer attachments for $2,500 for their newly renovatedbarber shop. [This answer is incorrect. This is an example of a cash outlay for acquiring long�lived assetsand should be reported as a cash outflow from investing activities per FASB ASC 230�10�20 (formerly SFASNo. 95).]


249

b. Sunshine Cleaners cleans homes in the Detroit metroplex. Sunshine has decided to sell its old vacuumcleaners for $25 each. [This answer is incorrect. The proceeds from sales of long�lived assets should beshown as cash inflows from investing activities on the statement of cash flows according to FASB ASC230�10�20 (formerly SFAS No. 95).]

c. Universal Bowling Lanes is purchasing 250 bowling shoes to replace the shoes that are worn out. The totalcost for the shoes is $7,500. [This answer is incorrect. As stated in FASB ASC 230�10�20 (formerly SFASNo. 95), operating activities include all transaction and events that are not investing or financing activities.Purchasing bowling shoes would be considered an operating activity because the shoes produce income.Operating activities meet the following criteria: the amounts are derived from activities that enter into thedetermination of net income; the amounts result from an organization's normal operations for deliveringor producing goods for sale and providing services; and the amounts represent the cash effects oftransactions or events.]

d. The owner of Heartland Inc. received a cash dividend from the company. [This answer is correct.

Financing activities include providing owners with a return on their investment, and, thus, cashdividends paid should be shown as cash outflow from financing activities. Dividends declared, but

not paid and stock options are noncash transactions.]


250


Lesson 1 (PFSTG103)


1. A statement of cash flows shows the change in cash and cash equivalents during a period. Which of thefollowing is not considered cash or cash equivalent?

a. Certificate of deposit.

b. Treasury bill.

c. Restricted cash.

d. Money market account.

2. Match the following classifications with the appropriate transaction.

Statement of Cash Flows

A. Operating i. Cash payments for inventory

B. Investing ii. Cash receipts from loan collections

C. Financing iii. Cash payments for dividends

iv. Cash payments for treasury stock

v. Cash receipts from sales of investment securities

vi. Cash payments for taxes

a. A, iii, iv; B, v, i; C, vi, ii.

b. A, i, vi; B, ii, v; C, iii, iv.

c. A, ii, v; B, i, vi; C, iii, iv.

d. A, ii, vi; B, i, iii; C, ii, iv.

3. Which of the following is not considered an operating activity?

a. Dividend income.

b. Administrative costs.

c. Landlord incentive allowances.

d. Depreciation allocations.

4. The direct method of presenting cash flows applies to all of the following except:

a. Starts with net income and adjusts for noncash items and changes in the period in operating current assetsand liabilities.

b. Lists the actual sources and uses of cash from operations. Therefore, it takes more time to prepare andis not widely used by many companies.

c. Requires a separate schedule showing the reconciliation of the change in net income to net cash flows fromoperating activities.

d. Begins with gross cash receipts and deducts gross cash payments for operating costs and expenses.


251

5. Willie is preparing financial statements for Wally's World. For which of the following would Willie only report thenet changes in assets and liabilities?

a. Discontinued operations.

b. Cumulative accounting adjustments.

c. Agency transactions.

d. Extraordinary items.

6. FASB ASC 230�10�45�7 through 45�9 (formerly SFAS No. 95), has a general rule that cash payments andreceipts should be reported on a gross basis rather than a net basis. Which of the following must be reportedunder a gross basis?

a. Customer deposits placed with other financial institutions.

b. The selling of investment securities by a company.

c. Investments that are short term with original maturities of three months or less.

d. Customer loans placed with other financial institutions.

7. How should sales of long�lived assets be presented in the cash flow statement?

a. Cash used by investing activities.

b. Cash outflow from financing activities.

c. Cash inflows from financing activities.

d. Cash inflows from investing activities.

8. Morning Sun, Inc. is selling stock to pay off debt from a previous renovation. This is an example of which of thefollowing activities?

a. Operating.

b. Investing.

c. Financing and investing.

d. Noncash investing and financing.

9. According to the guidance in FASB ASC 230�10�45�15 (formerly EITF Issue No. 95�13, �Classification of DebtIssue Costs in the Statement of Cash Flows"), debt issue costs are classified as which of the following activities?

a. Operating and financing.

b. Operating.

c. Financing.

d. Financing and investing.


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10. Battlefield Reproductions acquired treasury stock from their shareholders. This is an example of which of thefollowing activities?

a. Operating.

b. Investing.

c. Financing.

d. Noncash investing.

11. According to the guidance in FASB ASC 230�10�50�3, which of the following activities should be excluded fromthe cash flow statement and reported separately?

a. Noncash investing and financing.

b. Operating and financing.

c. Noncash investing and operating.

d. Investing.

12. ABC organization makes a down payment of $15,000 and finances the balance of a purchase with aninstallment loan in the amount of $90,000. The loan is to be paid in six annual installments of $15,000 plus a12% interest rate. This is an example of which of the following types of transactions?

a. Operating.

b. Noncash.

c. Agency.

d. Financing.


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Lesson 2:��Notes to Financial Statements

INTRODUCTION AND AUTHORITATIVE LITERATURE

Authoritative Basis for Notes

Authoritative pronouncements mandate many types of disclosures but do not mandate the manner of presentation.Some disclosures are best presented in separate notes rather than in the basic financial statements. Descriptionsof accounting policies and notes to financial statements are recognized in SAS No.�29 (AU 551A) as componentsof the �basic financial statements" necessary for a fair presentation in accordance with generally accepted account�ing principles. Thus, notes are an integral part of financial statements. They should be used to present materialdisclosures required by generally accepted accounting principles that are not otherwise presented in the state�ments, that is, on the face of the statements.

Organization of Lesson

Some disclosures may be efficiently provided on the face of the financial statements, for example, the allowance foruncollectible receivables. Other disclosures may be provided either on the face of the financial statements or innotes depending on considerations such as space limitations. This lesson explains disclosures for nonpubliccompanies commonly made in the notes. However, this lesson does not attempt to describe all possible disclo�sures. For those reasons, the lesson is not organized by financial statement caption, and there is not a discussionof disclosures related to every possible financial statement caption. The remaining sections of this lesson are:

Form and Style Considerations

Determining Necessary Disclosures

Summary of Significant Accounting Policies

Common Problems in Preparing Frequent Disclosures

Common Problems in Preparing General Disclosures

Common Problems in Preparing Other Disclosures

Disclosure of Information about Financial Instruments

Risks and Uncertainties

How to Use This Lesson

This Lesson should be consulted for practical guidance on drafting notes. The guidance given includes both formand style considerations as well as technical requirements for common problem areas. As noted previously, thislesson does not include examples of all disclosures required by GAAP.



notes to the financial statements and determine which significant accounting policies should be disclosed.� Recognize the common problems in preparing frequent disclosures, general disclosures, and other disclosures

related to inventory, debt, income taxes, related parties, going concerns, and lawsuits.� Describe how to disclose information about financial instruments in an organization's financial statement notes.� Summarize issues that organizations might encounter with disclosing information about risks and uncertainties

in the notes to their financial statements.


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FORM AND STYLE CONSIDERATIONS

Title and Format

Title. When the notes are presented on separate pages, the pages should be appropriately titled as follows:

ABC CORPORATIONNOTES TO FINANCIAL STATEMENTS

The format and capitalization policy of the note heading should be consistent with that used for heading thefinancial statements. Many accountants use the caption �Notes to Financial Statements" without a date becausenotes relate to the accompanying statements, each of which is dated. However, other preparers use the balancesheet date in the caption.

Arrangement. Generally, notes are presented on a separate page or pages after the basic financial statements.The notes should be arranged in the same order as the financial statement captions to which they relate, and eachnote should bear a descriptive caption corresponding to the related financial statement caption. In using thatapproach, best practices suggest using the following additional guidelines:

� If a note addresses items in more than one statement, its placement would be determined by the firststatement that would ordinarily be encountered. For example, a note providing disclosure of assets andliabilities under capital leases and rent expense under operating leases would be placed with asset notes.

� Commitments and contingent liabilities notes would be placed between liabilities and equity notes.

� A subsequent events note would be the last note.

Heading Individual Note Captions. This course recommends using the following style for heading of individualnotes within the �Notes to Financial Statements" section:

NOTE CPROPERTY AND EQUIPMENT

Using letters of the alphabet to identify notes rather than numbers is preferred because they seem to soften whatotherwise may appear to be an overwhelming sea of numbers. Also, the entire �NOTE" caption is capitalized, whichsets off the title from the text of the notes and facilitates location of specific notes.

Wording

The notes, as an integral part of the financial statements, are the responsibility of the client even though theaccountant may assist with, or totally prepare, the statements and notes. The wording of the notes should followthat principle, and words such as �we," �us," �client," and �our" should not be used to avoid any implication ofreference to the CPA. Use of �the Company," �the Corporation," or �Management," is a more appropriate way ofreferring to the client.

Comparative Financial Statements

When comparative financial statements are issued, FASB ASC 205�10�45�4 (formerly ARB No. 43) requires disclo�sures for prior periods to be repeated if they continue to be of significance. Many accountants believe thatdisclosures related to the income statement and the statement of cash flows generally should be presented for allperiods; however, disclosures related to the balance sheet should be evaluated to determine whether they are stillmeaningful. For example, information about commitments and contingent liabilities is disclosed primarily becauseit is helpful in assessing future cash flow. Accordingly, that information as of the preceding balance sheet dategenerally is not relevant. Best practices indicate that exceptions to that policy also are justified in the followingsituations:

� An authoritative pronouncement requires disclosures only for the current period or future periods incomparative presentations. For example, FASB ASC 470�10�50�1 (formerly SFAS No.�47) requiresdisclosure of maturities of long�term debt for the five years following the current balance sheet.


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� An authoritative pronouncement requires disclosures for all periods presented. For example, FASB ASC320�10�50�2 (formerly SFAS No. 115) requires disclosure of the following information about available�for�sale securities for each balance sheet presented: (a) amortized cost basis, (b) total other�than�temporaryimpairment recognized in accumulated other comprehensive income, (c) aggregate fair value, (d) totalgains for securities with net gains in accumulated other comprehensive income, and (e) total losses forsecurities with net losses in accumulated other comprehensive income. FASB ASC 320�10�50�5 (formerlySFAS No. 115) also requires disclosure of the following information about held�to�maturity securities foreach balance sheet presented: (a) amortized cost basis, (b) total other�than�temporary impairmentrecognized in accumulated other comprehensive income, (c)�aggregate fair value, (d) gross unrecognizedholding gains, (e) gross unrecognized holding losses, (f) the net carrying amount, and (g) gross gains andlosses in accumulated other comprehensive income for any derivatives that hedged the forecastedacquisition of held�to�maturity securities.

One Financial Statement Presented

Preparers are sometimes asked to present only one basic financial statement, for example, a balance sheet withoutstatements of income and retained earnings and cash flows. In those situations, the preparer should present onlythe disclosures that relate to the financial statement presented. For example, if only a balance sheet is presented,there would be no need to disclose depreciation expense. Also, preparers are sometimes requested to present afull set of basic financial statements for some users and a single financial statement, such as a balance sheet, forothers. In that situation, different sets of notes also should be prepared to provide a relevant presentation. Sincethat only involves eliminating some items from the notes of the full set, it should not be costly or time�consuming.When a single statement is presented and notes are presented on separate pages, the title should include thename of the statement rather than the general term �financial statement," such as:

ABC CORPORATIONNOTES TO BALANCE SHEETS

DETERMINING NECESSARY DISCLOSURES

Determining what is required for a fair presentation in conformity with GAAP involves consideration of both of thefollowing:

a. Specific disclosures required by authoritative pronouncements.

b. Disclosures not specifically required by authoritative pronouncements but that are necessary to keep thefinancial statements from being misleading.

Determining the disclosures that are necessary in specific circumstances may be complex and requires seasonedprofessional judgment. For determining disclosures that may be necessary in specific circumstances, this lessonoffers the following general advice:

� Assume that the reader is a business person who has a basic knowledge of accounting and is not a partof management.

� Read the statements from the viewpoint of that type of reader and evaluate whether the information wouldaffect the reader's conclusions about the statements.

A reader of the financial statements should not reach the wrong conclusion about financial position and operatingresults based on a reasonable reading of the statements including the notes.

Companies filing with the Securities and Exchange Commission (SEC) are required to provide certain disclosuresthat exceed GAAP requirements, for example, average rates of short�term borrowings. Nonpublic companies arenot required to provide those disclosures, and best practices indicate that they not be provided. Some preparersconsult Accounting Trends and Techniques for sample notes. Although that is a good source of information, all ofthe companies included in that survey are public companies. Preparers should be careful to distinguish GAAP andSEC disclosure requirements when using Accounting Trends and Techniques.


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SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

According to FASB ASC 235�10�50�1 (formerly APB Opinion No. 22), all significant accounting policies followed bya company should be disclosed in its financial statements. The format, including the location, of the disclosure isflexible. However, it is preferable to use a separate summary that presents the information or to include it in the firstnote. Best practices indicate that companies use it as the first note. In addition, FASB ASC 275�10�50�1 (formerlySOP 94�6, Disclosure of Certain Significant Risks and Uncertainties) requires a company to disclose the nature ofits operations. Many accountants already include it as the first item in the summary of significant accountingpolicies.

Caption and Format

Generally, the summary of significant accounting policies note is divided into subsections for each specific policyor financial statement caption discussed. The format used in this lesson includes first letter capitalization andunderlining of the subcaptions as follows:


Nature of Operations

Use of Estimates

Inventories

Depreciation

Income Taxes

Content

General Requirements. The accounting policies of a company are the specific accounting principles and methodsof applying those principles that have been adopted for preparing the financial statements. An accounting policy issignificant if it materially affects the determination of financial position, cash flows, or results of operations. Accord�ing to FASB ASC 235�10�50�3 (formerly APB Opinion No. 22), the disclosure of accounting policies should describeaccounting principles and methods that involve any of the following:

a. A selection from existing acceptable alternatives

b. Industry peculiarities

c. Unusual or innovative application of GAAP

Application. If there are existing acceptable alternatives, a specific authoritative pronouncement will normallyrequire disclosure. For example, FASB ASC 360�10�50�1 (formerly APB Opinion No. 12) requires a description ofdepreciation methods. Also, there generally are authoritative pronouncements that provide guidance on account�ing policies peculiar to specific industries. However, there is little guidance on disclosure of unusual or innovativeapplications of GAAP. In general, preparers of financial statements should assume that readers have a fundamentalknowledge of accounting principles, but not expert knowledge. That means, for example, that the accountingtreatment of changes in a company's tax status might be considered unusual and would be disclosed.

Practice Problems

Methods That Approximate GAAP. If an accounting method approximates a generally accepted principle ormethod, best practices indicate using the GAAP description. Describing both the GAAP method and the methodthat approximates it only serves to confuse the reader. If the difference between methods is not material, the factthat a method is used that only approximates GAAP is not really significant.


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There are many examples of methods that approximate GAAP. For example, parts inventories are often priced atcurrent replacement cost, which approximates the lower of FIFO cost or market. In all cases involving methods thatapproximate GAAP, best practices indicate describing only the GAAP method, and that recommendation is notrepeated in relation to each caption to which it might apply.

Numbers in Policy Notes. Normally the accounting policies note should only deal with policies, and numbersshould be excluded. However, best practices indicate that exceptions to that policy are justified when an additionalnote would have to be used only to disclose the number. For example, if the only inventory disclosures required fora company are the basis of valuation, method of determining cost, and inventory components, the policy notecould be expanded to disclose the inventory components.

More Than One Policy for a Caption. In some cases, primarily for inventory and depreciation, more than oneaccounting method may be used. Generally, the accounting policy note should describe only the primary ordominant method. The accounting policy disclosure is intended to identify the methods that have a significanteffect on the financial statements. If one method accounts for most of the effect on the financial statements, onlythat method need be identified. For example:

� Inventories are stated at the lower of cost or market value with cost determined using primarily the first�in,first�out method.

� Depreciation is computed using primarily the straight�line method.

If two methods have a significant effect, both should be described. For example:

� Inventories are stated at the lower of cost or market value. Cost is determined using the last�in, first�out(LIFO) method for groceries and primarily the first�in, first�out (FIFO) method for all other inventories.

� Depreciation is computed using accelerated methods for buildings and production equipment and thestraight�line method for all other depreciable assets.

Accounting Changes. In addition to the other disclosures required for a change in accounting principle, therelevant accounting policy note should be expanded to describe use of different methods during the periodscovered by the financial statements. For example:

Inventories are stated at the lower of cost or market. Prior to 20X2, cost was determined using primarilythe first�in, first�out (FIFO) method. However, as described in Note X, effective January 1, 20X2, theCompany adopted the last�in, first�out (LIFO) method to determine the cost of substantially all of itsinventories.

Specifically Required Accounting Policy Disclosures

Several authoritative pronouncements specifically require disclosure of an accounting policy. Some disclosuresthat are common for nonpublic companies are as follows:

� Inventoriesthe basis for stating inventories and the method of determining cost (FASB ASC 210�10�50�1)(formerly ARB No. 43, Ch.�3A).

� Depreciationa general description of the methods used in computing depreciation for major classes ofdepreciable assets (FASB ASC 360�10�50�1) (formerly APB Opinion No. 12).

� Cash Equivalentsthe policy used to determine which short�term investments are treated as cashequivalents in the statement of cash flows (FASB ASC 230�10�50�1) (formerly SFAS No. 95).

� Marketable Securitiesthe basis on which the cost of a security sold or the amount reclassified out ofaccumulated other comprehensive income into earnings was determined (FASB ASC 320�10�50�9)(formerly SFAS No. 115) and the policy for requiring collateral or other security for repurchase agreementsor securities lending transactions (FASB ASC 860�30�50�1A) (formerly SFAS No. 140).


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� Notes Receivable or Loansthe policy for recognizing interest income on impaired loans, including howcash receipts are recorded (FASB ASC 310�10�50�15) (formerly SFAS No. 114).

� Advertisingthe policy used for reporting advertising (i.e., whether costs are expensed as incurred or whenthe advertising first takes place (FASB ASC 340�20�50�1) (formerly SOP 93�7).

� Sales and Similar Taxesthe policy regarding the presentation of sales and similar taxes (for instance, use,value added and certain excise taxes), that is, whether such taxes are presented on a gross or net basis(FASB ASC 605�45�50�3) (formerly EITF Issue No. 06�3).

� Shipping and Handling Coststhe policy for classifying shipping and handling costs. For example,whether such costs are included in cost of sales (FASB ASC 605�45�50�2) (formerly EITF Issue No. 00�10).

In addition to the examples listed above, FASB ASC 235�10�50�4 (formerly APB Opinion No. 22) identifies thefollowing examples of required accounting policy disclosures:

� Recognition of profit on long�term, construction�type contracts

� Basis of consolidation

Recommended Accounting Policy Disclosures

GAAP requires disclosure of all significant accounting policies. In addition to disclosures required by specificpronouncements, best practices indicate that companies should disclose the accounting methods prescribed byauthoritative literature that are relatively complex such as the following:

� Investments in Debt and Equity Securitiesdescribe the accounting treatment of unrealized gains andlosses for investments classified as trading securities, held�to�maturity securities, and available�for�salesecurities.

� Deferred Income Taxesbriefly describe how current and deferred taxes are calculated.

� Investments at Equitydisclose the lag if the investee's year end differs from the investor's year end. FASBASC 323�10�35�6 (formerly APB Opinion No. 18) recognizes that investees may not have the same year endas the investor and states that �a lag in reporting shall be consistent from period to period." The authorsrecommend that the lag not exceed three months, which is consistent with GAAP for consolidations.

� Derivativesdescribe the accounting treatment of gains and losses related to fair value, cash flow, orforeign currency hedges.

Commonly Asked Questions about Specific Accounting Policy Disclosures

Methods of Applying LIFO. Two approaches (specific goods and dollar value) and various computational tech�niques, such as link chain and double extension, are used in practice. Do those need to be disclosed? Bestpractices indicate that the method of applying LIFO need not be disclosed. Most readers are only interested inwhether LIFO is used, and, unaccompanied by other information, disclosure of the LIFO approach used does notenable users to quantify the effects of using LIFO.

Some companies use an accelerated method until approximately the middle of the estimated useful life then switchto the straight�line method; do both methods need to be disclosed? This lesson suggests disclosing the methodthat is currently being used.

Comprehensive Income. If comprehensive income is not presented, should the notes disclose the reason why?Companies that do not have any items of other comprehensive income in any period presented do not have toreport comprehensive income. In such cases, best practices indicate that the notes need not disclose whycomprehensive income is not presented. However, the summary of significant accounting policies could (but is notrequired to) include a statement that the company has not reported comprehensive income since it has no items ofother comprehensive income.


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Required Disclosure Regarding Subsequent Events. FASB ASC 855�10�50�1 (formerly Paragraph 12 of SFASNo. 165, Subsequent Events) requires reporting entities that are not SEC filers to disclose the date through whichsubsequent events have been evaluated and whether that date is the date the financial statements were issued orwere available to be issued. That disclosure is required regardless of whether the reporting entity recognizes ordiscloses a subsequent event in its financial statements. Accordingly, it should be included in all financial state�ments prepared in accordance with GAAP. The authors believe many accountants will make this disclosure as partof the summary of significant accounting policies note. The following is an example of a note that meets thisdisclosure requirement:

Management has evaluated subsequent events through March 25, 20X4, the date the financial state�ments were available to be issued.


260


261

SELF�STUDY QUIZ


12. Which of the following statements is most accurate regarding the notes to the financial statements?

a. They are a supplemental part of the financial statements and not required.

b. They restate significant information from the face of the financial statements.

c. Authoritative pronouncements specifically mandate the manner of presentation.

d. They are included with the basic financial statements.

13. Should disclosure notes from prior�periods be repeated if they continue to be significant when comparativestatements are issued?

a. Yes.

b. No.

14. Zoe's Gently Used Clothes employs both the declining balance and the straight�line methods of depreciationfor different types of assets. The declining�balance method is the primary method used by Zoe's. How will thisaffect Zoe's accounting policy?

a. Both depreciation methods should be included.

b. Only the straight�line method should be included.

c. Only the declining�balance method should be mentioned in the accounting policy note.

15. Zoe's Gently Used Clothes, a nonpublic company, has certain disclosures that are required by authoritativepronouncements. Which of the following is not a required GAAP disclosure, but it recommended due to theircomplex nature?

a. The policy the company uses to classify costs related to inventories.

b. The policy the company uses to determine which short�term investments are treated as cash equivalentsin the statement of cash flows.

c. The policy that the company uses to explain the accounting treatment of unrealized gains and losses forinvestments classified as trading securities.

d. The policy the company uses to determine if certain excise taxes are presented on a net or gross basis.


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12. Which of the following statements is most accurate regarding the notes to the financial statements? (Page 253)

a. They are a supplemental part of the financial statements and not required. [This answer is incorrect.According to the authoritative literature, notes are considered an integral part of financial statements.]

b. They restate significant information from the face of the financial statements. [This answer is incorrect.Financial statement notes should be used to present material disclosures required by GAAP that are nototherwise presented in the statements, that is, on the face of the statements.]

c. Authoritative pronouncements specifically mandate the manner of presentation. [This answer is incorrect.Authoritative pronouncements mandate many types of disclosures, but generally do not mandate themanner of presentation.]

d. They are included with the basic financial statements. [This answer is correct. Descriptions ofaccounting policies and notes to financial statements are recognized in SAS No. 29 (AU 551A), ascomponents of the basic financial statements necessary for a fair presentation in accordance withgenerally accepted accounting principles (GAAP).]

13. Should disclosure notes from prior�periods be repeated if they continue to be significant when comparativestatements are issued? (Page 254)

a. Yes. [This answer is correct. When comparative financial statements are issued, FASB ASC205�10�45�4 (formerly ARB No. 43) requires disclosures for prior periods to be repeated if theycontinue to be of significance.]

b. No. [This answer is incorrect. Under FASB ASC 205�10�45�4 (formerly ARB No. 43), significant prior�perioddisclosures should be repeated. Best practices indicate that disclosures related to the statement ofactivities and the statement of cash flows generally should be presented for all periods; however,disclosures related to the statement of financial position should be evaluated to determine whether theyare still meaningful.]

14. Zoe's Gently Used Clothes employs both the declining balance and the straight�line methods of depreciationfor different types of assets. The declining�balance method is the primary method used by Zoe's. How will thisaffect Zoe's accounting policy? (Page 257)

a. Both depreciation methods should be included. [This answer is incorrect. According to authoritativeliterature, if both methods had a significant effect on the financial statements, it would be appropriate forthe company to include both methods in its summary of significant accounting policies. However, in thisscenario, one method accounts for most of the effect on the financial statements, so both depreciationmethods should not be included in the company's accounting policy note.]

b. Only the straight�line method should be included. [This answer is incorrect. According to this scenario, thestraight�line method does not have a significant effect on the company's financial statements; therefore,it would not be the sole depreciation method listed in the organization's accounting policy note per theauthoritative literature.]

c. Only the declining�balance method should be mentioned in the accounting policy note. [This answeris correct. In some cases, primarily for inventory and depreciation, more than one accountingmethod may be used. Generally, the accounting policy note should describe only the primary ordominant method. The accounting policy disclosure is intended to identify the methods that havea significant effect on the financial statements, and in the scenario above, that would be thedeclining balance method.]


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15. Zoe's Gently Used Clothes, a nonpublic company, has certain disclosures that are required by authoritativepronouncements. Which of the following is not a required GAAP disclosure, but it recommended due to theircomplex nature? (Page 258)

a. The policy the company uses to classify costs related to inventories. [This answer is incorrect. Thisdisclosure is required by (FASB ASC 210�10�50�1) (formerly ARB No. 43, Ch. 3A). The company is requiredto disclose the basis for stating inventories and the method of determining cost.]

b. The policy the company uses to determine which short�term investments are treated as cash equivalentsin the statement of cash flows. [This answer is incorrect. This disclosure is required by (FASB ASC230�10�50�1) (formerly SFAS No. 95). The company is required to determine which short�term investmentsare treated as cash equivalents in the statement of cash flows.]

c. The policy that the company uses to explain the accounting treatment of unrealized gains and lossesfor investments classified as trading securities. [This answer is correct. GAAP requires disclosuresof all significant accounting policies. However, there are accounting methods that are recom�mended, by not necessarily required, by authoritative literature such as describing the accountingtreatment of unrealized gains and losses for investments classified as trading securities,held�to�maturity securities, and available�for�sale securities due to their complexity.]

d. The policy the company uses to determine if certain excise taxes are presented on a net or gross basis.[This answer is incorrect. This disclosure is required by (FASB ASC 605�45�50�3) (formerly EITF Issue No.06�3). The company is required to present sales and similar taxes (for instance, use, value added andcertain excise taxes), that is, whether such taxes are presented on a gross or net basis.]


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COMMON PROBLEMS IN PREPARING FREQUENT DISCLOSURES

This section describes recommendations on common problems that arise in preparing note disclosures related tospecific financial statement captions.

LIFO Inventories

Readers of financial statements are often interested in determining the effect LIFO has on the financial results.Although the differences between FIFO, weighted average, and specific identification should not be material, thedifferences between LIFO and those methods are frequently material. One problem in preparing the disclosures isthat IRS regulations stipulate that the information may only be presented in the notes or supplementary schedulesand not on the face of the financial statements, and they place certain limitations on the disclosure. The challengeis to prepare an informative narrative that does not violate IRS restrictions.

An AICPA Issues Paper titled Identification and Discussion of Certain Financial Accounting and Reporting IssuesConcerning LIFO Inventories suggests that the financial statements disclose the following information when inven�tory costs are determined using the LIFO method:

� LIFO reserve, i.e., the difference between inventory priced at LIFO and inventory priced at replacement costor some other acceptable accounting method.

� The extent to which LIFO is used for companies that have not fully adopted LIFO, for example, the portionof ending inventory priced on LIFO, the portion of cost of sales resulting from the application of LIFOcompared to reported cost of sales, or the dollar amount of balance sheet inventories priced at LIFO andother methods.

� The effect of LIFO inventory liquidations on income.

The LIFO conformity regulations still prohibit the disclosure of annual income or loss on any basis other than LIFOin the main body of a company's financial statements; for example, such disclosures cannot be shown on the faceof the income statement or in the equity section of the balance sheet. However, the regulations do allow disclosureof a company's annual income on a FIFO basis in a supplementary schedule or in the notes to the financialstatements. The AICPA Issues Paper recommends that the effects of nondiscretionary variable expenses such asprofit sharing plans, profit�based bonuses, and income taxes be considered in determining income statement orbalance sheet amounts on a FIFO basis. (In practice, many companies using LIFO base bonuses and similar itemson FIFO earnings.)

Property and Equipment

FASB ASC 360�10�50�1 (formerly APB Opinion No. 12) requires disclosure of the balances of major classes ofdepreciable assets by nature or function at the balance sheet date and a general description of depreciationmethods by major class. (Accumulated depreciation generally is disclosed in total rather than by major classes.)Two common questions about preparing notes to meet those requirements are:

� How do you group major classes of depreciable assets by nature and function?

� Is it necessary or desirable to also disclose the bases, lives, and repairs and maintenance practices for themajor classes of assets?

Grouping Depreciable Assets by Major Class. The following steps are recommended for developing majorclasses of property and equipment:

� The accounts should be grouped by type (land, buildings, leasehold improvements, and equipment).

� If equipment consists of items with essentially the same characteristics, no further detail is needed.

� If equipment consists of material amounts of items with significantly different characteristics, such as heavymachinery, automobiles, and furniture and fixtures, it should be distinguished by those characteristics.


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� Immaterial amounts should be presented either in an �other" caption or combined with the materialcomponents.

Although sometimes disclosed on the face of the balance sheet, the information may be conveniently presented ina table in the notes to the financial statements. Trends includes numerous examples of property and equipmentnotes.

Limiting Policies Disclosures to Depreciation Methods. It is recommended that accounting policies disclosuresfor property and equipment be limited to depreciation methods. The note heading should normally be �depreci�ation." Using the balance sheet caption, for example, �equipment and leasehold improvements," is not as precise,since only depreciation policies are being discussed. Also, there is no need to use the term �amortization" forcapital leases and leasehold improvements. Instead, the simple term �depreciation" is appropriate for all itemsincluded in property and equipment. Since GAAP requires only a general description, best practices indicate that�accelerated" and �straight�line" are sufficient descriptions. Although more detailed descriptions, for example,�declining balance" or �150% declining balance," are also acceptable, they generally do not provide the readerwith additional useful information.

Some preparers also disclose the following policies in the accounting policies note or the note on major classes ofdepreciable assets:

� The basis of property and equipment

� Accounting policies for repairs and maintenance and betterments

� Estimated useful lives (typically ranges)

The preceding disclosures are acceptable, but they are not required and do not normally provide the reader withuseful information. Requiring disclosure of estimated useful lives also has the following disadvantages:

� Many companies set lives on a case�by�case basis rather than establish policies for classes of assets.

� It complicates disclosures because generally accepted accounting principles require some capital leasesand leasehold improvements to be depreciated over the lease term and others over their estimated usefullives.

Trends includes numerous examples of disclosure of depreciation methods.

Long�term Debt

In practice, the following terms of long�term debt are usually disclosed:

a. Timing of payments

b. Amount of scheduled payments and whether it includes interest

c. Interest rate

Common questions that arise in preparing note disclosure of the preceding information are as follows:

� Is all that detail really necessary?

� How do you disclose payment terms for combined categories of debt?

� Does the schedule of long�term debt need to be apportioned between current and noncurrent?

� Is it necessary to identify the creditor?


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Need for Detail on Rates, Dates, and Payments. Some preparers question whether all of the detail normallypresented is really necessary. They note that the reader can generally assess the effect of debt on cash flowsthrough the following:

� FASB ASC 470�10�50�1 (formerly SFAS No. 47, Disclosure of Long�Term Obligations) requires disclosureof principal reductions during each of the next five years.

� FASB ASC 835�20�50�1 (formerly SFAS No. 34, Capitalization of Interest Cost) requires disclosure of interestcosts.

The writer's of this course have found that information on payment terms and interest rates of long�term debt isoften useful to readers in more accurately assessing the effect of debt (including interest) on cash flows. Since theinformation must be gathered to compute the five years' maturities, disclosing it requires little additional time. SeeTrends for examples of long�term debt notes presenting five years' maturities.

Disclosing Payment Terms for Combined Debt. If notes have been combined because of immateriality, thepreparer has the following alternatives in disclosing payment terms:

a. Disclose only that the notes are payable in periodic installments, for example, �Notes payable in monthlyinstallments."

b. Disclose the current total of installments and a range of current interest rates, for example, �Notes payablein monthly installments currently totaling $1,000, including interest ranging from 8% to 12%."

Since the grouping relates to immaterial items, either alternative is acceptable. If the second alternative is chosen,the total of installments will normally be of greater interest to a reader than a range of installments because it helpsin the assessment of cash flows. Similarly, current amounts are of more use than comparative amounts.

Need to Apportion Debt Schedule between Current and Noncurrent. Using captions that indicate that thecurrent portion of long�term debt is included in current liabilities is recommended, for example �Current portion oflong�term debt" and �Long�term debt, less current portion." (See also Trends for an analysis of the captions usedfor the current portion of long�term debt in the statements of nonpublic companies.) Also, GAAP requires disclosureof maturities during each of the next five years. Accordingly, best practices indicate that the note need only showthe total of long�term debt and does not need to show how it is allocated between current and noncurrent.

Is It Necessary to Identify the Creditor? There is no requirement in authoritative literature to identify the lender byname, and this course suggests against providing such detail unless the additional information would be useful tothe reader, for example, when statements are prepared primarily for management use.

Income Taxes

Summary of Disclosure Requirements. The following paragraphs discuss the disclosure requirements that bestpractices indicate will most frequently affect small businesses: (a) disclosing common types of temporary differ�ences, (b) disclosing components of net deferred tax assets and liabilities, (c) disclosing available operating losscarryforwards, (d) disclosing the benefits of operating loss carryforwards, and (e)�disclosing the reasons forvariances between the tax provision allocated to continuing operations and the expected provision. FASB ASC740�10�50�15 [formerly FASB Interpretation No. (FIN) 48, �Accounting for Uncertainty in Income Taxes"] requiresadditional disclosures relating to unrecognized tax benefits.

Disclosing Significant Temporary Differences. FASB ASC 740�10�50�8 (formerly SFAS No. 109) requires thetypes of temporary differences that give rise to significant portions of a deferred tax asset or liability to be disclosed.It does not prescribe how the differences should be disclosed. This course, however, recommends disclosing themin the accounting policies note using a caption such as �Income Taxes." Since temporary differences are definedas differences between the financial and tax bases of assets and liabilities, describing them by referring to balancesheet, rather than income statement, accounts is recommended (for example, accounts receivable instead of baddebts).


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In drafting disclosures about temporary differences, questions may arise about which types of temporary differ�ences to disclose when there are several types of temporary differences or when the net deferred tax assets orliabilities for a particular tax jurisdiction are not significant. Since the deferred tax assets or liabilities presented in thebalance sheet are the net result of offsetting current deferred tax assets and liabilities and noncurrent deferred taxassets and liabilities. This course recommends disclosing significant temporary differences that give rise to thegross amounts of deferred tax assets and liabilities before (a) reduction of deferred tax assets for a valuationallowance and (b) offset for presentation in the financial statements. In other words, best practices indicate thattemporary differences should be disclosed if, when considered individually, the temporary difference causes amaterial difference between taxable income and GAAP pretax income.

Best practices also indicate that it often may be helpful to readers of the financial statements of small businesses todisclose a brief description of how the accounting for the transactions differs for financial and tax reporting even ifthe GAAP treatment is disclosed more fully in another policy note.

The following note illustrates how a company might disclose its accounting policies for income taxes and the typesof its temporary differences:

NOTE AACCOUNTING POLICIES

Income taxes

Income taxes are provided for the tax effects of transactions reported in the financial statements andconsist of taxes currently due plus deferred taxes. Deferred taxes are recognized for differences betweenthe basis of assets and liabilities for financial statement and income tax purposes. The differences relateprimarily to depreciable assets (use of different depreciation methods and lives for financial statementand income tax purposes), allowance for doubtful receivables (deductible for financial statement pur�poses but not for income tax purposes), and profit on installment sales (deferred for income taxpurposes but recognized for financial statement purposes). The deferred tax assets and liabilitiesrepresent the future tax return consequences of those differences, which will either be deductible ortaxable when the assets and liabilities are recovered or settled. Deferred taxes also are recognized foroperating losses and tax credits that are available to offset future taxable income.

Disclosing Components of Net Deferred Tax Assets and Liabilities. For each tax jurisdiction, all current deferredtax assets and liabilities should be offset and presented as a single amount and all noncurrent deferred tax assetsand liabilities should be offset and presented as a single amount. However, FASB ASC 740�10�50�2 (formerly SFASNo. 109) requires the gross amounts of deferred tax assets (before reduction for a valuation allowance) andliabilities and the total valuation allowance to be disclosed. The disclosure will generally be made in a note to thefinancial statements. For example, a company that is subject only to federal income taxes may include informationsuch as the following in the income tax note:

NOTE HINCOME TAXES

.�.�.�At the end of 20X1, deferred tax liabilities recognized for taxable temporary differences total$155,000. Deferred tax assets recognized for deductible temporary differences and operating losscarryforwards total $101,900, net of a valuation allowance of $5,000.

or

NOTE HINCOME TAXES

.�.�.�The Company's total deferred tax liabilities, deferred tax assets, and deferred tax asset valuationallowances at December 31 are as follows:


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20X2 20X1

Total deferred tax assets $ 28,000 $ 24,000Less valuation allowance 7,000 6,000

21,000 18,000Total deferred tax liabilities 20,000 20,000

Net deferred tax asset (liability) $ 1,000 $ (2,000 )

Those amounts have been presented in the company's financial statements as follows:

Noncurrent deferred tax asset $ 7,000 $ 5,000Current deferred tax liability 6,000 7,000

Net deferred tax asset (liability) $ 1,000 $ (2,000 )

Note that only the components of the total deferred tax asset or liability are required to be disclosed. It is notnecessary to disclose the components of current and noncurrent categories separately. Some companies maydecide to reconcile the amounts disclosed to amounts recorded in the financial statements, however.

In some cases, it may be practicable to disclose the required information on the face of the balance sheet asfollows:

A company's financial statements include deferred tax assets and liabilities, but a valuationallowance is not required:

20X2 20X1

Included in current liabilities

Deferred income taxes, net of deferred tax benefits of$4,000 in 20X2 and 20X1 5,000 6,000

Included in noncurrent assets

Deferred income tax benefits, net of deferred tax liabilities of$11,000 in 20X2 and $10,000 in 20X1 13,000 10,000

A company's financial statements include deferred tax assets, net of a valuation allowance, butno deferred tax liabilities:

Included in current assets

Deferred income tax benefits, net of a valuation allowanceof $6,000 in 20X2 (none in 20X1) 28,000 11,000

However, disclosure on the face of the balance sheet generally is not practicable if a company has both taxable anddeductible temporary differences and provides a valuation allowance for deferred tax assets. In those circum�stances, best practices indicate that the disclosure in the notes as illustrated above is the better alternative.

If none of the deferred tax balance sheet accounts reflect the net result of offsetting (for example, the company hasonly deductible temporary differences and a valuation allowance is not required or has deductible differences thatare classified as current and taxable differences that are classified as noncurrent), best practices indicate that noadditional disclosure is required. In that case, the deferred tax asset and liability accounts are presented in thefinancial statements at their gross amounts.

FASB ASC 740�10�50�2 (formerly SFAS No. 109) also requires companies to disclose the net change during theyear in the total valuation allowance. Best practices indicate that the disclosure generally will be made in the incometax note of the notes to the financial statements.

Available Operating Loss Carryforwards. FASB ASC 740�10�50�3 (formerly SFAS No. 109) requires the amountsand expiration dates of operating loss carryforwards for income tax reporting to be disclosed. The loss carryforward


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for tax purposes is the amount that is available to offset future taxable income (in other words, the carryforward thatwould be reported in the company's tax return). The disclosure will generally be included in an income tax notesuch as the following:

The company has a loss carryforward of $60,000 that may be offset against future taxable income.Substantially all of the carryforward expires in approximately equal amounts in 20X7 and 20X8.

GAAP does not require disclosure of operating loss carryforwards for financial statement purposes.

Disclosing the Benefits of Operating Loss Carryforwards. FASB ASC 740�10�50�9 (formerly SFAS�109) requiresthe components of the income tax provision that are attributable to continuing operations to be disclosed. One ofthe components required to be disclosed is the tax benefit of operating loss carryforwards. GAAP requires adeferred tax asset to be recognized for operating loss carryforwards. The benefit to be recognized in the financialstatements is calculated by (a) multiplying the amount of the carryforward for tax purposes by the applicable taxrate and (b) reducing the deferred tax asset for a valuation allowance if it is more likely than not that all or a portionof the asset will not be realized. Accordingly, deferred tax expense is reduced by the tax benefits attributable to thecarryforward (that is, the deferred tax asset related to the carryforward, net of any valuation allowance) in the year

that the net operating loss (NOL) arises, and realization of the carryforward in future years' tax returns generally hasno effect on income tax expense.

To illustrate how to determine the amount to be disclosed, assume the following facts:

a. A loss for financial reporting of $10,000 in 20X1 (the first year of the company's operations) and incomefor financial reporting of $50,000 in 20X2.

b. Taxable temporary differences of $5,000 at the end of 20X1 and $7,000 at the end of 20X2; there are nopermanent differences.

c. Average graduated tax rate of 15% applies both to the taxable temporary difference and the losscarryforward.

d. No valuation allowance was considered necessary at the end of 20X1 for the deferred tax asset related tothe NOL carryforward.

Income tax expense would be computed as follows for 20X1 and 20X2:

20X1 20X2

Current income taxes:

GAAP income (loss) $ (10,000 ) $ 50,000

Temporary difference (5,000 ) (2,000 )

Taxable income (loss) beforecarryforward (15,000 ) 48,000

NOL carryforward 15,000 (15,000 )

Taxable income $ � $ 33,000

Current tax at 15% $ � $ 4,950


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20X220X1

Deferred income taxes:

Deferred tax asset (liability)EOY:

Temporary Difference

(20X1$5,000 at 15%) $ (750 )

(20X2$7,000 at 15%) $ (1,050 )

NOL carryforward ($15,000 at 15%) 2,250 �

1,500 (1,050 )

Deferred tax asset (liability)BOY � 1,500

Deferred tax expense (benefit) (1,500 ) 2,550

Total income tax expense (benefit) $ (1,500 ) $ 7,500

FASB ASC 740�10�20 (formerly SFAS No. 109) defines income tax expense as the sum of current and deferred taxexpense. According to FASB ASC 740�10�55�80 (formerly question 18 of the FASB Special Report, A Guide toImplementation of Statement 109 on Accounting for Income Taxes), the amount to be disclosed as the tax benefit ofoperating loss carryforwards is only the amount by which total income tax expense from continuing operations hasbeen reduced by the NOL. In the preceding example, the NOL carryforward affects income tax expense (the sumof current and deferred tax expense) only in 20X1 when a deferred tax asset is recognized in the financialstatements. There is no effect on income tax expense in 20X2 because the separate effects on current and deferredtax expense offset each other. In other words, the current tax expense will be reduced for the $2,250 tax benefit ofthe NOL realized on the tax return (tax of $48,000 at 15% = $7,200 before the NOL carryforward less tax of $33,000at 15% = $4,950 after the NOL carryforward) and deferred tax expense will be larger by the same amount.Accordingly, the requirement for separate disclosure of the effects of the tax benefits of an NOL carryforward wouldnot apply for 20X2. However, the disclosure requirement applies to the financial statements for 20X1.

Generally, the tax benefits of the NOL carryforward would be disclosed in the income tax note. For example:

NOTE XINCOME TAXES

Income tax expense consists of the following components:

20X2 20X1

Current $ 4,950 $ �

Deferred 2,550 750

Tax benefit of net operating loss carryforward � (2,250 )

Total tax expense (benefit) $ 7,500 $ (1,500 )

Alternatively, in some cases, it may be practicable to disclose the components of income tax expense on the faceof the income statement as follows:

INCOME TAX EXPENSE (BENEFIT)

Current 4,950 �

Deferred, including tax benefit of net operating losscarryforward of $2,250 in 20X1 2,550 (1,500 )

Disclosing the Reasons for Variances between the Income Tax Provision Allocated to Continuing Operationsand the Expected Provision. GAAP requires the reasons for significant variations between the income taxprovision allocated to continuing operations and the expected provision to be disclosed. The expected provisionshould be calculated by applying domestic federal statutory rates (under the regular tax system) to pretax incomefrom continuing operations as reported in the income statement. (Best practices indicate that financial statementusers should be expected to understand the effect of the graduated rate structure, and, accordingly, the expected


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provision should be calculated by applying the graduated rates. As a result, the tax benefit of graduated rates willnot be a reconciling item.)

For most small businesses, the relationship between income taxes allocated to continuing operations andexpected income taxes will be affected principally by (a) permanent differences, (b) valuation allowances fordeferred tax assets and subsequent changes in the valuation allowance, (c) income taxes assessed by other taxjurisdictions, (d) tax credits, (e) enacted tax rate changes, and (f) reversals of temporary differences at rates thatdiffer from those used to calculate deferred income taxes at the beginning of the year. (For example, a companymay calculate deferred taxes using an average graduated tax rate of 34%. The effect of the difference between 34%and the company's actual tax rate in the period that the temporary differences reverse will be reflected as anadjustment to income tax expense.)

FASB ASC 740�10�50�13 (formerly SFAS No. 109) does not require nonpublic companies to disclose a numericalreconciliation, and best practices indicate that disclosing the nature of reconciling differences in narrative formgenerally will be sufficient. Illustrative disclosures are as follows:

a. Variances Caused by Permanent Differences. The income tax provision differs from the expense that wouldresult from applying federal statutory tax rates to income before income taxes because certain investmentincome is not taxable.

b. Variances Caused by Valuation Allowance for Deferred Tax Assets. The income tax provision differs fromthe expense that would result from applying federal statutory rates to income before income taxes becausea valuation allowance has been provided to reduce deferred tax assets to the amount that is more likelythan not to be realized.

c. Variations Caused by Calculating Deferred Income Taxes Using an Average Tax Rate or a Flat Rate. Theincome tax provision differs from the expense that would result from applying federal statutory rates toincome before income taxes because deferred income taxes are based on average tax rates.

d. Variances Caused by Enacted Rate Changes. The income tax provision differs from the expense that wouldresult from applying federal statutory rates to income before income taxes to reflect the benefit of anenacted tax rate reduction.

Disclosing Investment Tax Credits. GAAP requires investment tax credits (ITC) and the amounts and expirationdates of ITC carryforwards to be disclosed. In addition, the method of accounting for investment tax credits is alsorequired to be disclosed. That disclosure requirement arose because there are two methods of accounting for ITC.Under the deferral method, ITC is recognized in earnings over the depreciable life of the asset, and under theflow�through method, all of the credit generally is recognized in earnings when used. Disclosure of the method ofaccounting for ITC was considered necessary because earnings reported in the financial statements could varysignificantly depending on the method used.

Since ITC has been repealed, accountants have questioned whether the method of accounting for ITC shouldcontinue to be disclosed. Best practices indicate that disclosure would be necessary only if the financial statementsinclude a tax provision that is significantly affected by the credits. Accordingly, indications show that the method ofaccounting for ITC generally need not be disclosed if the company used the flow through method. In that situation,earnings would only be affected in comparative presentations that include years prior to 1986. Similarly, futureearnings would not be affected by unused ITC carryforwards because GAAP requires a deferred tax asset to berecognized for tax credit carryforwards. Thus, best practices indicate that disclosure of the method used to accountfor ITC is required only so long as ITC benefits are being amortized under the deferral method.

Although the Tax Reform Act of 1986 (TRA) did not affect the ability to carry forward ITC, it requires the availablecredit to be reduced by 35%. While the requirements to disclose the amount of carryforward available and theprimary expiration dates still apply, the authors believe that the amount disclosed should reflect reductionsexpected to be realized under TRA. It is not necessary to disclose original credits since the objective of thedisclosure is to provide readers with information about the future effect of the credits on earnings. The followingnote illustrates an ITC disclosure:


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NOTE XINCOME TAXES

The Company has investment tax credits totaling approximately $6,500 that are available for offsetagainst future federal income taxes through 2010.

Common Problems Noted in Trends Financial Statements

The Trends volume included with this course is prepared from the financial statements of actual companiesprovided by accounting firms across the country. In selecting and reviewing the statements and notes to include inthis edition, the writers noted some common problems that were evident in some of the financial statements. Thefollowing discussion is based on those problems noted.

Accounts Receivable Accounting Policy Note. GAAP includes numerous requirements for the disclosure ofaccounting policies related to trade accounts receivable and the related allowance for doubtful accounts. However,several financial statements did not include all of the required information in the accounts receivable policy note.

Date of Management's Review. A new disclosure required in financial statements for years ending after June 15,2009 is to disclose the date through which subsequent events were evaluated. That disclosure should also includea statement that such date is the date the financial statements were available to be issued.

Advertising Costs. GAAP requires entities to disclose their policy for accounting for advertising expenses. Adver�tising expense for each income statement period presented should also be disclosed. These amounts may bedisclosed on the face of the income statement or in the notes to the financial statements. Some of the financialstatements included a policy note related to advertising costs but failed to disclose the advertising expense foreach period, while others failed to disclose either of the two.

Imputing Interest. In the long�term debt note of some financial statements, some note descriptions included anominal interest rate, such as .9%, or even no interest, and no mention was made on imputing a reasonable interestrate. When a note is exchanged for property, goods, or services, GAAP requires consideration of whether theinterest rate stated in the agreement is reasonable in comparison with prevailing market conditions.

Variances Between the Income Tax Provision and the Expected Provision. Nonpublic entities are required todisclose the reasons for significant variations between the income tax provision and the expected provision basedon the domestic federal statutory rates in effect. Some of the financial statements failed to include this discussionin the income tax note.

Cash Flow Statement Presentations. Three common problems were noted in the cash flow statements. GAAPrequires that the total amounts of cash and cash equivalents at the beginning and end of the period agree withsimilarly titled line items or subtotals shown in the balance sheets. Several statements used inconsistent captionsfor cash between the balance sheet and cash flow statement; for example, �cash" on the balance sheet but �cashand cash equivalents" on the cash flow statement. Another problem was failing to properly exclude investing andfinancing activities that did not involve cash receipts and payments from the cash flow statement and report themseparately. A common example of a noncash transaction is acquiring assets by assuming a new bank loan. Finally,when using the indirect method, several statements failed to include bad debt expense and deferred tax expenseas adjustments to reconcile net income to net cash provided by operating activities.

Shipping and Handling Costs Policy. Entities are required to disclose their policy for classifying shipping andhandling costs in the income statement. Some of the financial statements failed to disclose this information in theirpolicy note.

Policy for Presenting Taxes Assessed by Governmental Authorities. Some entities collect various taxes, suchas sales and use taxes, on behalf of one or more governmental authorities and remit those amounts to theappropriate authority. Entities that collect these taxes may elect whether they are presented on a gross or net basisin the income statement, but must disclose their policy for presenting those amounts; that is, whether they includethe gross amounts in revenue and cost of sales, or net the amounts and only report the net amount, if any. Someof the financial statements failed to disclose this accounting policy.


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Fair Value Measurement Disclosures. FASB ASC 820 (formerly SFAS No. 157, Fair Value Measurements)requires several disclosures about assets and liabilities measured at fair value, and for private companies, thesedisclosures were new for the 2008 calendar year�end financial statements. Some companies failed to include thesenew disclosures in their notes to financial statements.

COMMON PROBLEMS IN PREPARING GENERAL DISCLOSURES

General disclosures in financial statements are frequent disclosures concerning matters that do not relate to afinancial statement caption, such as contingencies, or that relate to several captions, such as related parties.

Related Party Transactions

General. FASB ASC 850�10�50�1 (formerly SFAS No. 57, Related Party Disclosures) requires the following disclo�sures for material related party transactions:

a. The nature of the relationship involved.

b. A description of the transactions, including those to which no amounts or nominal amounts were ascribed,for each of the income statement periods presented, and such other information deemed necessary tounderstand the effects of the transactions on the financial statements.

c. The dollar amounts of transactions for each of the periods for which income statements are presented andthe effects of any change in the method of establishing the terms from that used in the preceding period.

d. Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwiseapparent, the terms and manner of settlement.

In addition, disclosures may also be affected by the requirement to recognize the economic substance of leasingarrangements with related parties rather than the legal form.

Typical Related Party Transactions. The most common related party disclosures for nonpublic companiesinclude the following:

a. Officer or stockholder loans to or from the company.

b. Purchases, sales, and related payables or receivables between affiliated companies.

c. Leases between stockholders and the company.

d. Guarantees or pledged personal assets of a stockholder.

The salary paid to an owner/manager (that is, compensation arrangements, expense allowances, and other similaritems in the ordinary course of business) is explicitly excluded from related party disclosure requirements by FASBASC 850�10�50�1 (formerly SFAS No. 57, Paragraph 2).

Common questions that arise in preparing related party disclosures are:

� What is meant by the nature of the relationship?

� How much detail is necessary about settlement arrangements?

� How do you account for the substance of a lease arrangement?

Nature of Relationship. Disclosure of the relationship and amounts often may be conveniently provided throughbalance sheet captions. The �nature of the relationship" is generally interpreted to mean position rather than anindividual's name. Accordingly, captions usually simply refer to �stockholders," �officers," or �affiliates." However,


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FASB ASC 850�10�50�3 (formerly SFAS No. 57) requires related parties to be identified by name if that is necessaryto an understanding of the effects of the transactions on the financial statements.

Settlement Arrangements. Using separate balance sheet captions for related party open accounts and informalloans is normally sufficient to meet the requirement to disclose settlement arrangements. As a practical matter,loans usually fluctuate to avoid IRS problems with declaration of dividends. However, best practices indicate thatthe settlement terms of notes should be disclosed to conform with GAAP and that the disclosure normally may beprovided most efficiently in a note.

Leasing Arrangements with Related Parties. Many nonpublic companies have lease arrangements with relatedparties. Although some of the leases may be under written agreements, others are verbal. In addition, some of thewritten agreements are cancelable. FASB ASC 840�10�25�26 (formerly SFAS No. 13) notes that in some leasingarrangements it is clear that the terms of the transactions have been significantly affected by the fact that the partiesare related. In those cases, GAAP requires accounting for the substance rather than the form of the transaction. Inpractice, it is extremely difficult to account for the substance of such related party arrangements. As an example, ifa company leases its operating facilities from its stockholders under a cancelable arrangement, it is difficult todefine a capitalization period even if the company will probably not move from the location. A similar problem existswith a written noncancelable lease that does not provide for renewals. Accordingly, best practices indicate thatdisclosure of the nature of the arrangement usually is sufficient.

Income Tax Disclosures. When the company is part of a group that files a consolidated tax return, FASB ASC740�10�50�17 (formerly SFAS No. 109) requires the following disclosures in its separately issued financial state�ments:

a. The aggregate amount of current and deferred tax expense for each income statement presented

b. The amount of any tax�related balances due to or from affiliates as of the date of each balance sheetpresented

c. The principal provisions of the method by which the consolidated amount of current and deferred taxexpense is allocated to members of the group

d. The nature and effect of any changes in the method of allocating current and deferred tax expense tomembers of the group and in determining the related balances due to or from affiliates during each yearfor which the disclosures in a. and b. above are presented

Pension Plans

Definition of Pension Plan. One of the most common practice problems regarding pension plans is determiningwhat compensation arrangements meet the definition of pension benefits. FASB ASC 715�30�20 (formerly Appen�dix D of SFAS No.�87, Employers' Accounting for Pensions) defines pension benefits as �periodic (usually monthly)payments made pursuant to the terms of the pension plan to a person who has retired from employment or to thatperson's beneficiary." Pension plans include the following:

a. Written plans as well as plans whose existence may be implied from a well�defined, although unwritten,company policy

b. Unfunded plans as well as insured plans and trust fund plans

c. Defined benefit and defined contribution plans

d. Deferred compensation contracts with individual employees if the contracts taken together are equivalentto a pension plan

e. Deferred profit�sharing plans that are, or are part of, an arrangement that is, in substance, a pension plan

Pension plans exclude the following:

a. Death and disability payments under a separate arrangement


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b. Paying retirement benefits to selected employees in amounts determined on a case�by�case basis or afterretirement

c. Deferred profit�sharing plans that are not, in substance, pension plans

Accounting for the two basic types of pension plansdefined contribution plans and defined benefit plans.

Required Disclosures for Defined Benefit Plans. FASB ASC 715�20 [formerly SFAS No. 132 (revised 2003),Employers' Disclosures about Pensions and Other Postretirement Benefits] includes disclosure requirements foremployers that sponsor one or more defined benefit pension plans or other defined benefit postretirement plans.FASB ASC 715�20�50�5 [formerly SFAS No. 132(R)] provides reduced disclosure requirements for nonpublicentities; however, entities controlled by a public entity must make the disclosures required of public entities.Disclosures about defined benefit pension plans cannot be combined with disclosures about defined benefitpostretirement plans, except for certain multiemployer plans. However, an employer with two or more definedbenefit plans may combine the disclosures for all of the employer's defined benefit pension plans and separatelycombine the disclosures for all of the employer's defined benefit postretirement plans.

Required Disclosures for Defined Contribution Plans. FASB ASC 715�70�50�1 [formerly SFAS No. 132(R)]requires employers to disclose the amount of cost recognized for all periods presented for defined contributionpension or other postretirement benefit plans separately from the cost recognized for defined benefit plans. Thedisclosures must describe the nature and effect of any significant changes during the period affecting comparability(such as a change in the rate of employer contributions, a business combination, or a divestiture). GAAP does notrequire employers to provide a general description of their defined contribution plans. However, best practicesindicate that such information often is useful and recommend that employers provide general plan descriptions.

Restrictive Debt Covenants

General. A debtor loan agreement may contain several complicated restrictive covenants. If the borrower does notcomply with the requirements, he will be in default and the debt will come due immediately. Thus, violations of debtcovenants affect the classification of debt as current or noncurrent and also may have a significant effect on cashflows. The requirements of debt agreements (restrictive covenants) may be grouped in the following broadcategories:

a. TransactionsFor example, a borrower may be required to obtain lender approval before acquiringequipment above a certain dollar amount or increasing the salaries of the primary stockholders.

b. ConditionsFor example, the borrower may be required to increase profits at a prescribed rate or to reducethe debt�equity relationship to a prescribed level.

If a violation of a restrictive covenant occurs, a waiver should be obtained. Violations of restrictions related totransactions are normally waived unconditionally, but for violations of restrictions related to conditions, the lenderoften will only waive his right to accelerate the due date subject to some caveat, such as no significant adversechanges in operations.

Common questions that arise about preparing note disclosures about restrictive covenants relate to the followingcircumstances at the balance sheet date:

� If there are no violations of covenants, does the note describing the covenants need to disclosecompliance?

� If there are violations of covenants, how does the existence and type of waiver affect disclosure?

No Violations of Covenants. The notes do not have to disclose compliance. However, if the preparer wishes toaddress compliance, positive assurance should normally be avoided. Instead, wording such as �management isnot aware of any violations of the covenants" would be appropriate.


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Violation of Covenants. Best practices indicate that the existence of a waiver and the type of waiver obtained affectdisclosure as follows:

a. If an unconditional waiver has been obtained, neither classification as a current liability nor disclosure isrequired.

b. If a waiver has not been obtained, disclosure of the condition is recommended and classification as acurrent liability is required. However, normally the financial statements are not issued before the waiver isobtained.

The nonauthoritative Technical Practice Aid at TIS 3200.17 addresses disclosure of debt covenant violationsexisting at the balance sheet date that have been waived by the creditor for a stated time period. The TPA states thatdisclosure of the existing violation and the waiver period should be considered (even if the debt is not callable) if theviolation resulted from nonpayment of principal or interest on the debt, inability to maintain required financial ratios,or other financial covenants. If the lender waived the right to demand repayment for more than one year after thebalance sheet date but retained the future covenant requirements (e.g.,�at�interim dates during the next year), theaccounting and disclosure requirements of FASB ASC 470�10�45 and 10�55 (formerly EITF Issue No.�86�30,�Classification of Obligations When a Violation Is Waived by the Creditor") apply.

ContingenciesPledging Assets and Other Collateral Arrangements

General. Authoritative pronouncements require disclosure of the following collateral arrangements:

� FASB ASC 860�30�50�1A (formerly SFAS No. 140, Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities) requires disclosure of company assets that are pledged ascollateral for loans.

� FASB ASC 850�10�05�4 (formerly SFAS No. 57, Related Party Disclosures) includes guarantees in itsexamples of related party transactions requiring disclosure.

Some nonpublic companies have debt that is affected by both of the pronouncements because it is secured by allof the following:

a. Company assets

b. The company's voting stock

c. Personal assets of the major stockholders

d. The personal guarantees of the major stockholders and their spouses

The following paragraphs provide recommendations on common questions that arise in preparing note disclo�sures on pledged assets and other collateral arrangements. Trends includes numerous note examples disclosingcollateral arrangements.

How Much Detail Should Be Provided? Collateral arrangements are specified in legal documents that are oftendetailed. Accordingly, problems arise in determining how much information about the arrangements should bedisclosed in the notes to the financial statements. In developing the necessary disclosure, best practices indicatethat the following limitations of financial statements should be considered:

� The statement disclosures are not intended to be a substitute for legal agreements. At best they can notifyreaders of the key provisions that may affect their evaluation of the financial statements. Readers interestedin further details, for example, prospective lenders assessing collateral, should look to the agreements.

� The statements are not intended to provide an evaluation of whether the lender's investment is protected.

� The statements are not intended to disclose assets available for pledging.


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However, GAAP does require disclosing the carrying amount and classification of any assets pledged as collateralthat are not reported separately in the balance sheet. For many small and midsize private companies, all of theassets in specific balance sheet categories, such as equipment, land, inventory, and accounts receivable, may bepledged as collateral on debt. In those cases, the description of the category should enable the reader to relate theasset to a balance sheet caption. Some agreements are secured by assets �now owned and hereafter acquired."In practice, if a company wants to finance the future acquisition of an asset, it usually can obtain a waiver of sucha provision. Accordingly, best practices indicate it is unnecessary to disclose the commitment related to futureacquisitions.

Does Pledging of Daily Cash Receipts Have to Be Disclosed? Some collateral arrangements are secured bydaily receipts and require the borrower to establish an account with the lender. Customers are directed to sendremittances to that account, which is monitored by the lender. The substance of such an arrangement is that cashis pledged, thus meeting the requirements for disclosure. Normally, wording such as �secured by daily receipts" issufficient.

Does the Absence of Pledging Have to Be Disclosed? GAAP only deals with assets that are pledged and doesnot require disclosure of the fact that some debt is unsecured. Some preparers believe that disclosure is unneces�sary because the absence of security disclosures should be sufficient notification that the debt is unsecured. Othersbelieve the disclosure may be readily provided, e.g., using a caption such as �unsecured debt," and that it mayavoid some confusion. Best practices indicate either approach is acceptable. However, the second alternative hasan additional practical advantage in that it forces the preparer to reconsider whether there are collateral arrange�ments.

What Terminology and Format Should Be Used? To describe collateral arrangements, best practices indicatethat the terms �secured" and �unsecured" should be used. Since �secured" may imply that the value of thecollateral is sufficient to permit full recovery of the asset, �collateralized" is sometimes used. However, bestpractices indicate that �collateralized" is not a word with which most readers are familiar and, therefore, discourageits use. If collateral arrangements are simple, for example, secured only by assets, they usually may be disclosedin the table describing long�term debt. However, more complex arrangements usually are best disclosed inseparate paragraphs of the debt note.

ContingenciesObligations under Guarantees

FASB ASC 460 (formerly FASB Interpretation No. 45, �Guarantor's Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others") clarifies the accounting requirements forguarantors and specifies the disclosures guarantors must make about their guarantee obligations. Guarantorsmust disclose the following information in their financial statements:

a. The nature of the guarantee, including the guarantee's approximate term, how it arose, the events orcircumstances that would require the guarantor to perform under the guarantee, and the current status,as of the balance sheet date, of the payment/performance risk of the guarantee. (For an entity that usesinternal groupings to manage risk, the disclosure should indicate how those groupings are determined andused for managing risk.)

b. The maximum potential amount of future payments the guarantor could be require to make (undiscountedand not reduced by possible recoveries under recourse or collateralization provisions) or the reasons whyan estimate of that amount cannot be made. (The disclosure is not applicable to product warranties or otherguarantees related to the functionality of nonfinancial assets owned by the guaranteed party.)

c. The carrying amount of the liability, if any, for the guarantor's obligations under the guarantee, includingamounts recognized under FASB ASC 450�20�30 (formerly SFAS No. 5, Accounting for Contingencies).

d. The recourse provisions that would enable the guarantor to recover amounts paid under the guarantee orcollateral that could be sold. (If estimable, the extent to which proceeds from the sale of collateral wouldbe expected to cover the maximum potential amount of future payments under the guarantee should bedisclosed.)


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The following illustrates how a company might disclose a guarantee of a related party's or other entity's debt:

The Company has guaranteed $200,000 of Midtown Supply Company's debt, which is due in annualinstallments with final payment due during the Company's fiscal year ended June 30, 20X5. TheCompany would be obligated to perform under the guarantee if Midtown Supply Company failed to payprincipal and interest payments to the lender when due. Including accrued interest, the maximumpotential amount of future (undiscounted) payments under the guarantee would be $225,000. However,if the Company were required to honor the guarantee, it would be entitled to property and equipmentowned by Midtown Supply Company that collateralizes the loans. In accordance with generallyaccepted accounting principles, the Company has recognized a guarantee liability of $25,000, whichrepresents the fair value of its obligation to perform under the guarantee. As of June 30, 20X2, MidtownSupply Company is current with its debt payments. Based on information gathered as part of itsmonitoring of risks, the Company believes there is only a remote possibility Midtown Supply Companywill not remain current with its debt payments and the Company will be required to perform under theguarantee.

The following illustrates how a company might disclose its product warranty obligations:

The Company accrues an estimate of its exposure to warranty claims based on both current andhistorical product sales data and warranty costs incurred. The majority of the Company's products carrya five�year warranty. The Company assesses the adequacy of its recorded warranty liability annually andadjusts the amount as necessary. The warranty liability is included in accrued liabilities in the accompa�nying balance sheet. Changes in the Company's warranty liability were as follows:

20X3 20X2

Warranty accrual, beginning of year $ 225,000 $ 150,000

Warranties issued during the period 350,000 287,000

Adjustments to preexisting accruals 61,000 42,000

Actual warranty expenditures (395,000 ) (254,000 )

Warranty accrual, end of year $ 241,000 $ 225,000

ContingenciesGoing Concern

If a company's ability to continue as a going concern is in doubt, SAS No. 59 (AU 341) specifies that it may benecessary to disclose the principal conditions that raise a question about continued existence and related matters.Common questions in disclosing such information concern when it is really necessary and how to word theinformation.

SAS No. 59 notes that uncertainty about a company's ability to continue as a going concern relates to its inabilityto continue to meet its obligations as they become due without substantial disposition of assets outside theordinary course of business, restructuring of debt, externally forced revisions of its operations, or similar actions.The auditors' evaluation of a company's ability to continue as a going concern is not merely a matter of evaluatingthe recoverability, classifications, and amounts of recorded assets and liabilities. SAS�No. 59 requires auditors tomodify their report if they have a substantial doubt about an entity's ability to continue as a going concern, even ifrecoverability of assets or classification of liabilities is not in question. Some readers interpret the going concerndisclosures as predicting doom. In fact, many view them as causing a business to fail. Accordingly, the decision todisclose such information should not be taken lightly. Normally the disclosure is not provided unless there areserious concerns about the viability of the business. If disclosure is necessary, the following is recommended:

a. The disclosure should include all relevant factors, such as:

(1) Pertinent conditions and events giving rise to the assessment of the entity's ability to continue as agoing concern, even if the information is apparent from the financial statements

(2) The possible effects of such conditions and events


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(3) Management's evaluation of the significance of the conditions and events and any mitigating factors

(4) Management's plans, including disclosure of possible discontinuance of operations

(5) Information about the recoverability or classification of recorded assets or the amounts orclassifications of liabilities

b. The wording should be neutral and should not be unduly pessimistic or optimistic.

c. If there are no mitigating factors or management has no specific plans to overcome the conditions, the noteshould be silent about their absence.

Proposed New Guidance related to Going Concern. The FASB currently has a going concern project on itsagenda. The objective of the project is to include in the FASB authoritative literature guidance related to (a)preparing financial statements as a going concern and the responsibility of an entity to evaluate its ability tocontinue as a going concern, (b) required disclosures when financial statements are not prepared on a goingconcern basis and when there is substantial doubt about the entity's ability to continue as a going concern, and (c)the adoption and application of the liquidation basis of accounting. The FASB has decided to not provide abright�line horizon for the assessments under the proposed guidance. However, the FASB has also decided thatany assessment of the period beyond a year is not intended to be open�ended or an indefinite period of time. TheFASB plans to issue an exposure draft of a proposed ASU in the fourth quarter of 2010 followed by a final ASU inthe first quarter of 2011.

ContingenciesLawsuits

If there are material lawsuits against the company, FASB ASC 450�20�50�4 (formerly SFAS No. 5) requires disclo�sure of the following information unless the possibility of the loss is remote: (A liability should be accrued wheneverit is probable that an asset has been impaired or a liability incurred as of the balance sheet date and the amount canbe reasonably estimated.)

a. Nature of the contingency

b. Estimate of the possible loss or range of loss or a statement that such an estimate cannot be made

A statement asserting that the contingency is not expected to be material does not satisfy the disclosure require�ments if there is at least a reasonable possibility that a loss exceeding amounts already recognized may have beenincurred. In that case, the financial statements must either disclose the estimated additional loss or range of lossthat is reasonably possible, or state that such an estimate cannot be made.

Often an accountant will request that the client send a letter of inquiry to its attorneys to obtain the precedinginformation. (Such a letter is required to be obtained in audit engagements.) Although the lawyers' description ofthe litigation and the progress of the case to date may be used as a basis for the note to the financial statements,lawyers' evaluations may be unclear about the likelihood of an unfavorable outcome. In such cases, the accountantshould request clarification either in a follow�up letter or in a conference with the lawyer and the client. Bestpractices indicate that lawyers' responses to inquiry letters not be quoted or referred to in the financial statementswithout first consulting with the lawyers.

A practice problem that sometimes occurs is whether to disclose a nuisance suit. Nuisance suits generally arisewhen anyone remotely connected with an event is sued in an attempt to collect as much money as possible.Generally, the damages claimed are clearly out of proportion with the damages suffered, and ultimately a settle�ment will be reached for a much smaller amount. The following are examples of nuisance suits:

� In traffic accidents involving a chain collision, a driver may sue everyone involved instead of the person thatinitiated the collision.

� In malpractice suits, a patient may sue the hospital as well as the doctors and nurses actually involved withthe case.


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In nuisance suits, lawyers are often willing to state that the chance of an adverse outcome is remote, and thusdisclosure would not be required under GAAP.

Subsequent Events

FASB ASC 855�10 (formerly SFAS No. 165, Subsequent Events) includes accounting and disclosure standards onsubsequent events does not apply to subsequent events specifically addressed in other applicable GAAP, includ�ing FASB ASC 740�10�25�15 (formerly FIN 48, �Accounting for Uncertainty in Income Taxes") and FASB ASC450�30�25�1 (formerly SFAS No. 5, Accounting for Contingencies).

GAAP identifies two types of subsequent events. The first type is recognized subsequent events (called type I inprior standards) and the second type is nonrecognized subsequent events (called type II in prior standards). Thekey to proper treatment of subsequent events is identifying the event or condition and determining when the eventor condition arose.

Recognized (Type I). Recognized (type I) subsequent events are those that provide additional evidence aboutconditions that existed at the balance sheet date, including the estimates inherent in preparing the financialstatements. The proper accounting treatment for those events is to recognize the effects of the events in thefinancial statements. For example, a litigation accrual would be recognized at the settlement amount if the eventthat gave rise to the litigation took place before the balance sheet date and the litigation was settled after thebalance sheet date but before the financial statements are available to be issued.

Most subsequent events that affect the realization of recorded assets, for example, receivables and inventories, orthe settlement of estimated liabilities, for example, product warranty reserves, fall into this category that requiresrecognition in the financial statements. That is often true because the subsequent events represent the culminationof conditions that existed over a relatively long period, and the recorded amounts are simply adjusted as newinformation provides a better basis for the estimates that were used. Assets and liabilities recorded at the balancesheet date should not be adjusted, however, if the event or changed condition clearly did not exist at the balancesheet date. For example, the financial statements should not be adjusted for an event arising after the balancesheet date but before the financial statements are available for issuance that results in litigation or for a receivablesloss resulting from a customer's major casualty (e.g., fire or flood) that occurred after the balance sheet date butbefore the financial statements are available for issuance. Instead, those examples are nonrecognized subsequentevents, whose treatment is discussed in the next paragraph.

Nonrecognized (Type II). Nonrecognized (type II) subsequent events are events that provide evidence aboutconditions that did not exist at the balance sheet date but arose after that date but before the financial statementsare available to be issued. Such events should not be recognized in the financial statements but, nevertheless,should be disclosed if disclosure is considered necessary to keep the financial statements from being misleading.If required, disclosures should include the nature of the event and an estimate of its financial effect, or disclosurethat such an estimate cannot be made. For some events, disclosure may best be made by presenting pro formafinancial data. Examples of the events include:

a. Sale of a bond or capital stock issue

b. Purchase of a business

c. Loss of plant or inventories caused by fire or flood

GAAP requires nonpublic entities to evaluate subsequent events through the date that the financial statements areavailable to be issued. In contrast, SEC filers and certain conduit bond obligors are required to evaluate subse�quent events through the date the financial statements are issued. Nonpublic entities are also required to disclosethe date through which events were evaluated and whether that date is the date the financial statements wereissued or were available to be issued.

When Financial Statements are Issued and Available to be Issued. According to FASB ASC 855�10�20 (formerlySFAS No. 165, Paragraphs 5 and 6), financial statements are issued �when they are widely distributed to sharehold�ers and other financial statement users for general use and reliance in a form and format that complies with GAAP."


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Financial statements are available to be issued �when they are complete in a form and format that complies withGAAP and all approvals necessary for issuance have been obtained, for example from management, the board ofdirectors, and/or significant shareholders." Best practices indicate that the date disclosed by small to midsizednonpublic entities will be the date the financial statements are available to be issued because those entities are notSEC filers or conduit bond obligors and that is the date through which they are required to evaluate subsequentevents. Accordingly, throughout this course, only to the date that the financial statements are available to be issuedwhen discussing the evaluation of subsequent events are referred to.

Nonmarketable Equity SecuritiesThe Equity Method

The significance of an investment accounted for by the equity method to the investor's financial position and resultsof operations should be considered in deciding the nature of disclosures, such as whether information about morethan one investment should be combined, and their extent. However, according to FASB ASC 323�10�50�3 (for�merly APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock) the followingdisclosures generally apply:

a. Parenthetically on the financial statements, in a note, or a separate schedule, the following informationshould be disclosed:

(1) Investee's name and percentage of ownership

(2) Investor's accounting policies for the investments including the names of investee corporations inwhich the investor holds 20% or more of the voting stock but that are not accounted for on the equitymethod and the reasons why the equity method is not considered appropriate and the names ofinvestee corporations in which the investor holds less than 20% of the voting stock that are accountedfor on the equity method and the reasons why the equity method is considered appropriate

(3) Any difference at the balance sheet date between the carrying amount of the investment and theamount of underlying equity in net assets and the manner of accounting for the difference

b. In a note or in a separate schedule, summarized information about assets, liabilities, and results ofoperations for investments in common stock of corporate joint ventures or other investments accountedfor under the equity method that are, in the aggregate, material in relation to the investor's financial positionor results of operations

c. Material effects of potential conversion of securities or exercise of outstanding stock options and warrants

d. Market value of investment if a quoted market price is available (not required for investments insubsidiaries)

Share�based Payment or Compensation Arrangements

FASB ASC 718�10�50�1 [formerly SFAS No. 123 (revised 2004), Share�Based Payment] requires entities with one ormore share�based payment or compensation arrangements to disclose information that enables financial state�ment users to understand (a) the nature and terms of arrangements that existed during the period and the potentialeffects of the arrangements on shareholders, (b) the income statement effect of compensation cost arising from thearrangements, (c) the method of estimating the fair value of goods and services received or the fair value of theequity instruments granted or offered during the period, and (d) the cash flow effects of the arrangements. Thefollowing are minimum disclosure requirements necessary to meet those objectives, but the entity may need todisclose additional information to meet the disclosure objectives.

The following items should be disclosed about the entity's share�based payment or compensation arrangements(separately for each type of award to the extent separate disclosure would be useful):

a. A description of the arrangement, including the general terms of the awards, such as the required serviceperiod and other substantive conditions (including those related to vesting), the maximum contractual termof share options, and the number of shares authorized for awards


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b. The method used to measure compensation cost from share�based payment arrangements withemployees

c. For the most recent year for which an income statement is presented:

(1) The number and weighted�average exercise prices for share options (or share units) outstanding atthe beginning of the year, outstanding at the end of the year, exercisable or convertible at the end ofthe year, and granted, exercised or converted, forfeited, or expired during the year

(2) The number and weighted�average grant�date fair value (or calculated or intrinsic value for awardsmeasured under those methods) of equity instruments nonvested at the beginning of the year,nonvested at the end of the year, and granted, vested, or forfeited during the year

d. For each year for which an income statement is presented:

(1) The weighted�average grant�date fair value (or calculated or intrinsic value for awards measuredunder those methods) of equity options or other equity instruments granted during the year

(2) The total intrinsic value of options exercised or converted, share�based liabilities paid, and the totalfair value of shares vested during the year

e. For fully vested share options and share options expected to vest at the date of the latest balance sheet:

(1) The number, weighted�average exercise price, and weighted�average remaining contractual term ofoptions outstanding

(2) The number, weighted�average exercise price, and weighted�average remaining contractual term ofoptions currently exercisable

f. If the intrinsic value method is not used, for each year for which an income statement is presented:

(1) A description of the method used during the year to estimate fair value (or calculated value)

(2) A description of the significant assumptions used during the year to estimate fair value (or calculatedvalue), including (a) the expected term of share options, including the method used to incorporate thecontractual term and employees' expected exercise and post�vesting employment terminationbehavior into the fair value; (b) expected volatility of the entity's shares and the method used toestimate it (if the calculated value method is used, disclose the reasons why it is not practicable toestimate expected volatility, the appropriate industry sector index and reasons for selecting it, and howhistorical volatility was calculated using the index); (c) expected dividends; (d) risk�free rates; and (e)discount for post�vesting restrictions and the method for estimating it

The following items should be disclosed about the entity's total share�based payment or compensation arrange�ments:

a. For each year for which an income statement is presented:

(1) The total compensation cost for share�based payment arrangements (a) recognized in income as wellas the total recognized related tax benefit and (b) capitalized as part of the cost of an asset

(2) A description of significant modifications, including the terms of the modifications, number ofemployees affected, and total incremental compensation cost resulting from the modifications

b. As of the latest balance sheet date presented, the total compensation cost related to nonvested awardsnot yet recognized and the weighted�average period over which it is expected to be recognized

c. The amount of cash received from exercise of share options and similar instruments granted undershare�based payment arrangements and the tax benefit realized from stock options exercised during theperiod


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d. The amount of cash used to settle equity instruments granted under share�based payment arrangements

e. A description of the entity's policy for issuing shares upon exercise or conversion of options, including thesource of the shares and, if the entity expects to repurchase shares in the following annual period, anestimate of the amount of shares to be repurchased during that period

COMMON PROBLEMS IN PREPARING OTHER DISCLOSURES

Other disclosures concern matters that do not necessarily occur every year, such as accounting changes ordiscontinued operations.

Accounting Changes

Accounting changes include (a) changes in accounting estimates, (b) changes in the reporting entity, and (c)changes in accounting principles. The following is a summary of disclosure requirements for accounting changesbased on FASB ASC 250�10�50 (formerly SFAS No. 154):

a. Changes in Accounting Estimates. The effect of the change on income from continuing operations and netincome should be disclosed if the change affects future years such as the estimated useful lives of propertyand equipment. Disclosure generally is not required for routine changes such as uncollectible accountsunless they are material. If the change in estimate has no material effect in the period of change but isreasonably certain to have a material effect in later periods, a description of the change should be disclosedwhenever the financial statements of the period of change are presented. Also, if a change in accountingestimate has been affected by changing an accounting principle, the disclosures in item c. should also bemade.

b. Changes in Reporting Entity. Disclosure of the nature of the change and the reason for it should be madein the period of change. The effect on net income, income before extraordinary items, and othercomprehensive income also should be disclosed for all periods presented. If the change has no materialeffect in the period of change but is reasonably certain to have a material effect in later periods, the natureof the change and the reason for it should be disclosed whenever the financial statements of the periodof change are presented.

c. Changes in Accounting Principles. Disclosure should include the following in the fiscal period in which thechange is made:

(1) The nature of the change, the reason for it, and why the new principle is preferable. If the change hasno material effect in the period of change but is reasonably certain to have a material effect in laterperiods, this disclosure is required whenever the financial statements of the period of change arepresented.

(2) The method of applying the change, including (a) a description of any prior�period information thathas been retrospectively adjusted, (b) the effect of the change on income from continuing operations,net income, and any other affected financial statement line item for the current and prior periodsretrospectively adjusted, (c) the cumulative effect of the change on retained earnings (or othercomponents of equity) as of the beginning of the earliest period presented, and (d) the reasons forand a description of the alternative method used to report the change when retrospective applicationto all prior periods is impracticable.

(3) If the indirect effects of a change in accounting principle are recognized, a description of the indirecteffects of the change, including amounts that have been recognized in the current period, and theamount of the total recognized indirect effects of the accounting change that are attributable to eachprior period presented, unless impracticable.

(4) For interim periods subsequent to the date of adoption of the change in accounting principle, the effectof the change on income from continuing operations and net income for the post�change interimperiods.


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Discontinued Operations

According to FASB ASC 205�20�50 (formerly SFAS No. 144), certain amounts relating to the disposal should bedisclosed in the financial statements, such as income or loss from operations of the discontinued component andgain or loss on disposal. The following required disclosures are typically made in the notes to the financialstatements:

a. The facts and circumstances resulting in the expected disposal

b. The segment in which the assets to be disposed of are included under FASB ASC 280 (formerly SFASNo.�131)

c. The expected manner and timing of disposal

d. The carrying amount of the major classes of assets and liabilities of the disposal group if not separatelydisclosed on the face of the balance sheet

e. The amount of any gain or loss recognized and where that amount is included in the income statement,if not disclosed on the face of the income statement

f. Revenues and pretax profit or loss of the discontinued operation

g. Description of any changes to the plan of disposal and the effects of the changes on the results ofoperations for all periods presented

Additional disclosures are required in situations where the discontinued operation generates continuing cash flowsand in situations where the reporting entity has continued involvement with the component after disposal.

Prior�period Adjustments

GAAP permits only corrections of errors in previously issued financial statements to be accounted for as prior�period adjustments. Disclosure of prior�period adjustments as required by FASB ASC 250�10�50�8 and 50�9(formerly APB Opinion No. 9, Paragraph 26, Reporting the Results of Operations) consist of the effects of theadjustment, both gross and net of tax, on net income for all periods presented. For single period financialstatements, disclosure should include the effects of the adjustment, both gross and net of tax, on beginningretained earnings and net income of the preceding period. The amount of income tax applicable to the adjustmentshould also be disclosed. The disclosures should be made in the year in which the adjustment is made and neednot be repeated in subsequent years.

In addition, FASB ASC 250�10�50�7 (formerly SFAS No. 154, Accounting Changes and Error Corrections) requiresthe following disclosures when financial statements are restated to correct an error:

a. A statement indicating that the previously issued financial statements have been restated.

b. A description of the nature of the error.

c. For each prior period presented, the effect of the error correction on each affected financial statement lineitem.

d. The cumulative effect of the change on retained earnings (or other components of equity) as of thebeginning of the earliest period presented.

Environmental Remediation Costs

FASB ASC 410�30�50 (formerly SOP 96�1, Environmental Remediation Liabilities) provides guidance for disclosingenvironmental remediation liabilities and contingencies. The following paragraphs explain the disclosure require�ments for accounting policies, accrued liabilities, unaccrued contingencies, and unasserted claims, as well as


285

optional disclosures. The disclosure requirements of FASB ASC 275�10 (formerly SOP 94�6, Disclosure of Certain

Significant Risks and Uncertainties) also apply to environmental remediation liabilities. In addition, FASB ASC450�20 (formerly SFAS No. 5, Accounting for Contingencies) provides the primary guidance relevant to disclosuresof environmental remediation loss contingencies.

Disclosure of Accounting Policies. FASB ASC 410�30�50�4 (formerly SOP 96�1) requires financial statements todisclose whether environmental remediation liabilities are measured on a discounted basis. In addition, FASB ASC410�30�50�8 indicates that companies are encouraged, but not required, to disclose (a) the circumstances thatgenerally trigger accrual of environmental remediation liabilities (such as completion of the feasibility study) and (b)the company's policy for recognizing recoveries.

Accrued Liabilities. The following disclosures should be made for accrued environmental remediation liabilities:

a. The nature and amount of the accrual (if necessary for the financial statements not to be misleading)

b. If any part of the accrued obligation is discounted, the discount rate used and the undiscounted amountof the obligation

c. An indication that it is at least reasonably possible that the estimate of the accrued obligation (or any relatedthird�party receivables) will change in the near term, if the criteria of FASB ASC 275�10�50�8 (formerly SOP94�6) for certain significant estimates are met.

Unaccrued Contingencies. For reasonably possible loss contingencies (including reasonably possible losses inexcess of accrued amounts), the following disclosures should be made:

a. A description of the contingency and an estimate of the possible loss (or the fact that such an estimatecannot be made)

b. An indication that it is at least reasonably possible that the estimate will change in the near term, if the criteriaof FASB ASC 275�10�50�8 (formerly SOP 94�6) for certain significant estimates are met.

For probable but not reasonably estimable loss contingencies that may be material, the following disclosuresshould be made:

a. A description of the remediation obligation

b. The fact that a reasonable estimate cannot be currently made

Unasserted Claims. Under FASB ASC 410�30�50�13 (formerly SOP 96�1), if assertion of a claim is probable or ifexisting laws require the company to report the release of hazardous substances and begin a remediation study, aloss contingency should be disclosed subject to the FASB ASC 450�20�50�3 and 50�4 (formerly SFAS No. 5)disclosure provisions.

Optional Disclosures. Companies are encouraged, but not required, to disclose the following:

a. The estimated time frame for making environmental remediation disbursements (if expenditures areexpected to occur over a long period)

b. The estimated time frame for realizing recognized recoveries (if realization is not expected in the near term)

c. The factors that cause the estimate of accrued environmental remediation liabilities, unaccruedcontingencies, or third�party receivables to be sensitive to change if the criteria for significant estimates aremet

d. The reasons why an estimate of the loss (or range of the loss) cannot be made for probable or reasonablypossible losses


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e. The estimated time frame for resolving the uncertainty as to the amount of a probable but not reasonablyestimable loss

f. The following information related to an individual site, if relevant to an understanding of the company'sfinancial position, cash flows, or results of operations:

� Total environmental remediation liability accrued for the site

� Nature and estimated amount of any reasonably possible loss contingency

� Involvement of other potentially responsible parties

� Status of regulatory proceedings

� Estimated time frame for resolving the contingency

g. The amount recognized in the income statement for environmental remediation loss contingencies in eachperiod

h. The amount of any third�party recovery credited against environmental remediation costs in the incomestatement in each period

i. The income statement caption that includes environmental remediation costs and related recoveries

Companies may make the following additional note disclosures:

� A conclusion about whether the total unrecorded exposure to environmental remediation obligations ismaterial to the financial statements. Such conclusion is not a substitute for the disclosures required byGAAP. If management asserts that the unrecorded exposure is not material, that assertion must besupportable.

� A description of the general applicability and impact of environmental laws and regulations on theirbusiness and how those laws and regulations may result in loss contingencies for future remediation.Those disclosures often acknowledge the uncertainty of the effect of possible future changes inenvironmental laws and their application. Those disclosures normally are made on a company�wide basis,considering exposures from all the company's sites.


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SELF�STUDY QUIZ


16. Which of the statements most accurately describes how policies to depreciation methods should be limited?

a. When disclosing property and equipment for accounting policies, the note heading should generally read�Other."

b. Preparers are required to disclose repair and maintenance accounting policies in the note on majordepreciation classes.

c. Preparers should limit the disclosure to the depreciation method.

d. Disclosures of estimated useful lives must be presented on the note on major classes of depreciableassets.

17. Which of the following statements regarding the disclosure of long�term debt in the notes to financial statementsis most accurate?

a. GAAP requires that the lender's name be disclosed in the notes.

b. GAAP requires maturities to be disclosed every year for the next five years.

18. Which of the following statements regarding the disclosure of significant temporary differences is false?

a. GAAP details how temporary differences that give rise to significant parts of a deferred tax asset bedisclosed.

b. Authoritative literature does not recommend detailing temporary differences by referring to the incomestatement.

c. According to best practices, if GAAP treatment is included in another policy note, a brief description of thedifference between accounting for the transactions and financial and tax reporting should be disclosed.

d. When a temporary individual difference creates a material difference between GAAP pretax income andtaxable income, the differences should be disclosed.

19. Heartland Feed Store, Inc., must decide if they have any related parties and disclose those transactions in thefinancial statements. Which of the following disclosures would be required if they do discover they have relatedparty transactions?

a. Amounts due to or from related parties as of the date of the statement of financial position.

b. Only the related party transactions that have a material effect on the financial statements of the company.

c. Expense allowances and other compensation arrangements in conjunction with the related partytransactions.

20. Looking Glass Antiques (LGA) has a debtor loan agreement that includes a restrictive covenant. LGA violatesthe covenant; however, it acquires an unconditional waiver from its lender in which the lender waives the rightto demand payment for two years. Is this a required disclosure?

a. Yes.

b. No.


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21. Dina's Dolls (DD) has a collateral arrangement with its bank secured by daily receipts. DD maintains an accountat the bank and the clients in the program send their payments directly to the account at the bank. Does thisarrangement need to be disclosed in the financial statements?

a. No.

b. Yes.

22. Which of the following statements regarding uncertainties about an entity's ability to continue as a goingconcern is most accurate?

a. SFAS No. 59 states that uncertainty regarding an organization's ability to continue as a going concernrelates to changes in economic or concentrations of credit risk.

b. Auditors should base their evaluation of an organization's ability to continue as a going concern solely onhis or her evaluation of recoverability.

c. Auditors should carefully consider disclosing such information and the wording should not be undulyoptimistic.

d. Auditors should disclose any information regarding management's absence of specific plans to overcomethe condition.

23. ACNE Brick has a pending lawsuit with one of their customers that is material in nature. Which of the followingis not required to be disclosed?

a. A statement regarding the nature of contingency.

b. A statement estimating the possible loss.

c. A statement detailing the lawyer's evaluation of the case without having consultation with the lawyer.

d. A statement estimating a range of loss or statement that the estimate cannot be made.

24. Which of the following statements regarding accounting changes is most accurate?

a. Generally, routine accounting changes do not require disclosure.

b. Changes in the reporting entity should be disclosed prior to the change.

c. The nature of the change in accounting principles should be disclosed during the reporting period.

d. It is not necessary to disclose an accounting principle if it creates cash flow for the company.

25. In which of the following scenarios, has a disclosure issue related to the organization been handledappropriately?

a. Seamus Builders has an unaccrued contingent liability for a residential house that was completed last year.It is probable that the homeowners will sue the company, but Seamus has not had the funds to accrue inthe down economy. They have decided to disclose it when the economy turns around.

b. Freemont Botanical Gardens has a pond that needs to be dredged due to a chemical spill in the property.They have accrued for the clean�up and have plans for it to be completed before the end of the year, sothey see no reason to disclose the situation in their financial statements.

c. Norwood Construction is facing environmental remediation costs. It discloses whether the liabilities forthese costs were measured on a discounted basis. It also discloses the circumstances that would triggerthe liability and the organization's policy for recognizing recoveries.


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16. Which of the statements most accurately describes how policies to depreciation methods should be limited?(Page 265)

a. When disclosing property and equipment for accounting policies, the note heading should generally read�Other."[This answer is incorrect. Recommendations state that accounting policies disclosures forproperty and equipment heading that would normally be �depreciation."]

b. Preparers are required to disclose repair and maintenance accounting policies in the note on majordepreciation classes. [This answer is incorrect. Although this information is acceptable, it is not requiredbecause this type of information does not provide the reader with helpful information.]

c. Preparers should limit the disclosure to the depreciation method. [This answer is correct. It isrecommended that accounting policy disclosures for property and equipment be limited todepreciation methods since GAAP only requires a general description and detailed descriptions donot provide the reader with additional useful information.]

d. Disclosures of estimated useful lives must be presented on the note on major classes of depreciableassets. [This answer is incorrect. Not only is the disclosure of estimated useful lives not require, but manycompanies set lives on a case�by�case basis rather than establish policies for classes of assets. Anotherdisadvantage to disclosing estimated useful lives is that it complicates disclosures because generallyaccepted accounting principles require some capital leases and leasehold improvements to bedepreciated over the lease term and others over their estimated useful lives.]

17. Which of the following statements regarding the disclosure of long�term debt in the notes to financial statementsis most accurate? (Page 266)

a. GAAP requires that the lender's name be disclosed in the notes. [This answer is incorrect. There is norequirement in authoritative literature to identify the lender by name, and this course suggests notproviding such detail unless the additional information would be useful to the reader, for example, whenstatements are prepared primarily for management use.]

b. GAAP requires maturities to be disclosed every year for the next five years. [This answer is correct.GAAP requires disclosure of maturities during each of the next five years. Accordingly, bestpractices indicate that the note need only show the total of long�term debt and does not need to showhow it is allocated between current and noncurrent.]

18. Which of the following statements regarding the disclosure of significant temporary differences is false?(Page 266)

a. GAAP details how temporary differences that give rise to significant parts of a deferred tax assetbe disclosed. [This answer is correct. FASB ASC 740�10�50�8 (formerly SFAS No. 109) requires thetypes of temporary differences that give rise to significant portions of a deferred tax asset or liabilityto be disclosed. It does not prescribe how the differences should be disclosed in the notes to thefinancial statements.]

b. Authoritative literature does not recommend detailing temporary differences by referring to the incomestatement. [This answer is incorrect. Because temporary differences are defined as differences betweenthe financial and tax bases of assets and liabilities, describing them by referring to balance sheet, ratherthan income statement, accounts is recommended (for example, accounts receivable instead of baddebts).]

c. According to best practices, if GAAP treatment is included in another policy note, a brief description of thedifference between accounting for the transactions and financial and tax reporting should be disclosed.


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[This answer is incorrect. It may be helpful to readers of the financial statements of small businesses todisclose a brief description of how the accounting for the transactions differs for financial and tax reportingeven if the GAAP treatment is disclosed more fully in another policy note.]

d. When a temporary individual difference creates a material difference between GAAP pretax income andtaxable income, the differences should be disclosed. [This answer is incorrect. Since the deferred taxassets or liabilities presented in the balance sheet are the net result of offsetting current deferred tax assetsand liabilities and noncurrent deferred tax assets and liabilities, this course recommends disclosingsignificant temporary differences that give rise to the gross amounts of deferred tax assets and liabilitiesbefore (a) reduction of deferred tax assets for a valuation allowance and (b) offset for presentation in thefinancial statements. Best practices indicate that temporary differences should be disclosed if, whenconsidered individually, the temporary difference causes a material difference between taxable incomeand GAAP pretax income.]

19. Heartland Feed Store, Inc. must decide if they have any related parties and disclose those transactions in thefinancial statements. Which of the following disclosures would be required if they do discover they have relatedparty transactions? (Page 273)

a. Amounts due to or from related parties as of the date of the statement of financial position. [Thisanswer is correct. Under FASB ASC 850�10�50�1, Heartland Feed Store, Inc. should discloseamounts due from or to related parties as of the date of each statement of financial positionpresented and, if not otherwise apparent, the terms and manner of settlement.]

b. Only the related party transactions that have a material effect on the financial statements of the company.[This answer is incorrect. According to FASB ASC850�10�50�1, if Heartland Feed Store, Inc. has relatedparty transactions, it is required to disclose a description of all the transactions, including those to whichno amounts or nominal amounts were ascribed, for each of the periods for which statements of activitiesare presented, and such other information deemed necessary to an understanding of the effects of thetransactions on the financial statements. Only disclosing descriptions of material related party transactionswould not put Heartland Ministries in compliance with the authoritative pronouncement.]

c. Expense allowances and other compensation arrangements in conjunction with the related partytransactions. [This answer is incorrect. Salaries, expense allowances, and other compensation are clearlyexcluded from related party disclosure requirements; therefore, Heartland Feed Store, Inc. would not haveto make this disclosure.]

20. Looking Glass Antiques (LGA) has a debtor loan agreement that includes a restrictive covenant. LGA violatesthe covenant; however, it acquires an unconditional waiver from its lender in which the lender waives the rightto demand payment for two years. Is this a required disclosure? (Page 276)

a. Yes. [This answer is incorrect. If LGA had not acquired the unconditional waiver, disclosure of the conditionand classification as a current liability would be required. However, that is not the case in this scenario sincethey did acquire the unconditional waiver.]

b. No. [This answer is correct. Due to obtaining the unconditional waiver, the company does not havea contingent liability and is not required to make a disclosure. However, in a Technical Practice Aid(TIS 3200.17), the AICPA states that disclosure of the existing violation and the waiver period shouldbe considered (even if the debt is not callable) if the violation from nonpayment of principal orinterest on the debt, inability to maintain required financial ratios, or other financial covenants.]

21. Dina's Dolls (DD) has a collateral arrangement with its bank secured by daily receipts. DD maintains an accountat the bank and the clients in the program send their payments directly to the account at the bank. Does thisarrangement need to be disclosed in the financial statements? (Page 277)

a. No. [This answer is incorrect. According to GAAP, the substance of such an arrangement is that cash ispledged and meets the requirement for disclosure in the nonprofit organization's financial statements.]


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b. Yes. [This answer is correct. Some collateral arrangements are secured by daily receipts and requirethe borrower to establish an account with the lender. Clients are directed to send remittances to thataccount, which is monitored by the lender. The substance of such an arrangement is that cash ispledged, thus meeting the requirements for disclosure. Normally, wording such as �secured by dailyreceipts" is a sufficient disclosure in the financial statements.]

22. Which of the following statements regarding uncertainties about an entity's ability to continue as a goingconcern is most accurate? (Page 279)

a. SFAS No. 59 states that uncertainty regarding an organization's ability to continue as a going concernrelates to changes in economic or concentrations of credit risk. [This answer is incorrect. SAS No. 59 notesthat uncertainty about an organization's ability to continue as a going concern is its inability to continueto meet its obligations as they become due without substantial disposition of assets outside the ordinarycourse of business, restructuring of debt, externally forced revisions of its operations, or similar actions.It does not relate to the current economic conditions of the market or the credit risk of the company.]

b. Auditors should base their evaluation of an organization's ability to continue as a going concern solely onhis or her evaluation of recoverability. [This answer is incorrect. The auditors' evaluation of anorganization's ability to continue as a going concern is not merely a matter of evaluating the recoverability,classifications, and amounts of recorded assets and liabilities per SAS No. 59. SAS No. 59 requiresauditors to modify their report if they have a substantial doubt about an entity's ability to continue as a goingconcern, even if recoverability of assets or classification of liabilities is not in question.]

c. Auditors should carefully consider disclosing such information and the wording should not beunduly optimistic. [This answer is correct. SAS No. 59 requires auditors to modify their report if theyhave a substantial doubt about an entity's ability to continue as a going concern, even ifrecoverability of assets or classification of liabilities is not in question. Some readers interpret thegoing concern disclosures as predicting doom. In fact, many view them as causing a business tofail. Accordingly, the decision to disclose such information should not be taken lightly. Normally thedisclosure is not provided unless there are serious concerns about the viability of the business.Thus, the wording should be neutral and should not be unduly pessimistic or optimistic.]

d. Auditors should disclose any information regarding management's absence of specific plans to overcomethe condition. [This answer is incorrect. According to SAS No. 59, if there are no mitigating factors ormanagement has no specific plans to overcome the conditions, the note should be silent about theirabsence.]

23. ACNE Brick has a pending lawsuit with one of their customers that are material in nature. Which of the followingis not required to be disclosed? (Page 279)

a. A statement regarding the nature of contingency. [This answer is incorrect. If there are material lawsuitsagainst the organization, FASB ASC 450�20�50�4 (formerly SFAS No. 5) requires the nature of contingencyto be disclosed.]

b. A statement estimating the possible loss. [This answer is incorrect. If there are material lawsuits againstthe organization, FASB ASC 450�20�50�4 (formerly SFAS No. 5) requires the estimate of the possible lossto be disclosed.]

c. A statement detailing the lawyer's evaluation of the case without having consultation with the lawyer.[This answer is correct. Although the lawyer's description of the litigation and the progress of thecase to date may be used as a basis for the note to the financial statements, lawyer evaluation maybe unclear about the likelihood of an unfavorable outcome. Best practices indicate that lawyer'sresponses to inquiry letters not be quoted or referred to in the financial statements without firstconsulting the lawyers.]

d. A statement estimating a range of loss or statement that the estimate cannot be made. [This answer isincorrect. A range of loss or statement that the estimate cannot be made is required to be disclosed asstated in FASB ASC 450�20�50�4 (formerly SFAS No. 5).]


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24. Which of the following statements regarding accounting changes is most accurate? (Page 283)

a. Generally, routine accounting changes do not require disclosure. [This answer is correct.Disclosure generally is not required for routine changes, such as the method for dealing withuncollectible accounts, unless they are material. If the change in estimate has no material effect inthe period of change, but is reasonably certain to have a material effect in later periods, a descriptionof the change should be disclosed whenever the financial statements of the period of change arepresented.]

b. Changes in the reporting entity should be disclosed prior to the change. [This answer is incorrect.Disclosure of the nature of the change and the reason for it should be made in the period of change. Theeffect on net income, income before extraordinary items, and other comprehensive income also shouldbe disclosed for all periods presented.]

c. The nature of the change in accounting principles should be disclosed during the reporting period. [Thisanswer is incorrect. Disclosures should include the nature of the change, the reason for it, and why the newprinciple is preferable during the fiscal period.]

d. It is not necessary to disclose an accounting principle if it creates cash flow for the company. [This answeris incorrect. The nature of the change, the reason for it, and why the new principle is preferable should bedisclosed. If the change has no material effect in later periods, this disclosure is required whenever thefinancial statements of the period of change are presented.]

25. In which of the following scenarios, has a disclosure issue related to the organization been handledappropriately? (Page 285)

a. Seamus Builders has an unaccrued contingent liability for a residential house that was completed last year.It is probable that the homeowners will sue the company, but Seamus has not had the funds to accrue inthe down economy. They have decided to disclose it when the economy turns around. [This answer isincorrect. For reasonably possible loss contingencies on unaccrued amounts, the company should makea disclosure in the financial statements that describes the contingency and estimates the possible loss orthe fact that such an estimate cannot be made. Ignoring the contingency until the economy is better is notan appropriate way to handle the situation.]

b. Freemont Botanical Gardens has a pond that needs to be dredged due to a chemical spill in the property.They have accrued for the clean�up and have plans for it to be completed before the end of the year, sothey see no reason to disclose the situation in their financial statements. [This answer is incorrect.According to FASB ASC 410�30�50�4, the following disclosures should be made when environmentalremediation liabilities are accrued: (1) the nature and amount of the accrual, (2) the discount rate used andundiscounted amount of the obligation, if the accrued liability is discounted, and (3) an indication that itis at least reasonably possible that the estimate of the accrued obligation will change in the near term, ifrequired by FASB ASC 275�10�50�8.]

c. Norwood Construction is facing environmental remediation costs. It discloses whether the liabilitiesfor these costs were measured on a discounted basis. It also discloses the circumstances thatwould trigger the liability and the organization's policy for recognizing recoveries. [This answer iscorrect. Under FASB ASC 410�30�50�4, the organization is required to make the first disclosure listedin this scenario and encouraged, but not required, to make the other disclosures. NorwoodConstruction has handled its environmental remediation liabilities correctly.]


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DISCLOSURE OF INFORMATION ABOUT FINANCIAL INSTRUMENTS

FASB ASC 825�10�50�10 (formerly SFAS No. 107, Disclosures about Fair Value of Financial Instrument) primarilyrequires certain entities to disclose the fair values of financial instruments for which it is practicable to estimate fairvalues.

Identifying financial instruments that are subject to these disclosure requirements often is difficult. The followingparagraphs define financial instruments and provide detailed guidance on identifying those financial instrumentsfor which specific disclosures are required; discuss credit and market risk disclosures, and discuss fair valuedisclosures.

Identifying Financial Instruments

There are three major categories of financial instruments: cash, evidence of an ownership interest in an entity, anda contract that requires the exchange of cash or other financial instruments. Identifying cash and ownershipinterests is straightforward.

a. Cash. Best practices indicate that cash for this purpose is the same as discussed in the previous lessonin connection with the statement of cash flows. Therefore, it includes currency on hand, demand deposits,and other kinds of accounts that have the general characteristics of demand deposits in that the customermay deposit or withdraw additional funds at any time.

b. Evidence of an Ownership Interest in an Entity. Evidence of an ownership interest in an entity includescommon stock, preferred stock, certificates of interest or participation, and warrants and options tosubscribe to or purchase stock from the issuing entity.

c. Contracts That Require the Exchange of Cash or Other Financial Instruments. Under FASB ASC 825�10�20(formerly Paragraph 3 of SFAS No. 107), a contract is a financial instrument if it both:

(1) Imposes on one entity a contractual obligation to (a) deliver cash or another financial instrument toa second entity or (b) exchange other financial instruments on potentially unfavorable terms with thesecond entity, and

(2) Conveys to that second entity a contractual right to (a) receive cash or another financial instrumentfrom the first entity or (b) exchange other financial instruments on potentially favorable terms with thefirst entity.

Generally, if the conditions for a financial instrument are met for the issuer, they will also be met for the holder.Likewise, if they are met for the holder, they will also be met for the issuer.

Considering the Definition of an Asset or a Liability. The definition of a financial instrument in the aboveparagraph, item c. requires a contractual right and a contractual obligation. Since contractual rights and obligationsmeet the definitions of assets and liabilities provided in FASB Concepts Statement No. 6, Elements of FinancialStatements, an agreement that does not meet the definition of an asset and a liability is not a financial instrument.

The definition of assets and liabilities contained in FASB Concepts Statement No. 6 requires the occurrence of atransaction or event. It further notes that when the transaction occurs depends on the agreement. Therefore, if thetransfer is based on future performance, there is no obligation prior to that performance. Accordingly, that agree�ment is not a financial instrument. The unexpired or future portions of the following common agreements are notfinancial instruments because they do not meet the definition of an asset or a liability:

� Deferred Compensation and Pension Plan Agreements. Deferred compensation and pension planagreements often provide benefits based on past and future service. There is no contractual right orobligation related to payments for future service until that service is provided, and the agreement for thatservice is not a financial instrument.


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� Covenants Not to Compete That Have Economic Substance. These covenants provide for payments basedon the passage of time. However, there is no contractual right or obligation related to payments for theunexpired term of the agreement; thus, the agreement for the unexpired term is not a financial instrument.

� Operating Lease. A noncancelable operating lease requires payments based on the passage of time. Sincethere is no contractual right or obligation related to payments for the unexpired term of the lease, theagreement for those periods is not a financial instrument.

� Royalty Agreement. A royalty agreement requires payments based on some factor such as sales orproduction. There is no contractual right or obligation for royalty payments related to future sales orproduction. Therefore, the agreement for those future transactions is not a financial instrument.

For each of those agreements, however, a contractual right or obligation exists for the expired portion. Therefore,that portion is a financial instrument with the characteristics discussed below.

Using the Fundamental Financial Instrument Approach to Identify Financial Instruments. In August 1990, theFASB issued a discussion memorandum, Distinguishing between Liability and Equity Instruments and Accountingfor Instruments with Characteristics of Both. The discussion memorandum uses the fundamental financial instru�ment approach to identify financial instruments. Although not authoritative, best practices indicate that approach isuseful in determining whether an agreement that meets the definition of an asset or a liability is a financialinstrument.

The approach defines six basic categories of financial instruments. Five of the categories deal with contracts andthe sixth deals with equity instruments. (Cash is excluded because the discussion memorandum focuses onfinancial instruments with liability and equity characteristics.) The five contract categories are distinguished primar�ily by whether they involve a one�way transfer of financial instruments or an exchange of financial instruments andwhether future performance is contingent or fixed. The following paragraphs illustrate how the approach may beused to identify common agreements that are financial instruments.

Unconditional Receivable�payable Contract. An unconditional receivable�payable contract both:

a. Imposes on one entity an unqualified contractual obligation to deliver a specified amount of cash or otherfinancial instrument to a second entity on demand or on or before a specified date, and

b. Conveys to that second entity an unqualified contractual right to receive a specified amount of cash or otherfinancial instrument from the first entity on demand or on or before a specified date.

This category includes the items considered to be cash equivalents discussed in the previous lesson, someshort�term investments, loans receivable and payable, and the contractual rights and obligations under expiredportions of the contracts discussed earlier in this lesson. The following are common examples:

� Cash equivalents such as U.S. Treasury bills, commercial paper, and money market accounts that are notclassified as cash

� Short�term investments with original maturities of three months or less

� Trade accounts receivable, notes receivable, and receivables from stockholders that will be settled in cash

� Short�term and long�term notes payable

� Accrued receivables and payables for operating items such as vacation pay, bonuses, interest, andwarranty claims and returns that will be settled in cash

� Receivables and payables related to the expired portion of a deferred compensation agreement, acovenant not to compete, an operating lease, a retirement plan, or a royalty agreement [However, adeferred compensation agreement and a retirement plan are excluded from the fair value disclosurerequirements of FASB ASC 825�10�50 (formerly SFAS No.�107).]


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� Leases that effectively transfer the benefits and risks of ownership of an asset from the lessor to the lesseeat the inception of the lease such as a capital lease or a direct financing lease (That type of lease is excludedfrom the fair value disclosure requirements, but is not excluded from the requirement to discloseconcentrations of credit risk.)

Each of the preceding examples involves a one�way transfer of a financial instrument, usually cash, either ondemand or at specified dates.

If the transfer is other than through a financial instrument, the requirements for a financial instrument are not met.The following are common examples:

� A payment as a loan to a stockholder is a contractual right and obligation. But, if it will be settled througha charge to compensation or a dividend, it is not a financial instrument because the charge is not a transferof a financial instrument.

� A prepayment under a liability insurance contract or under a membership agreement is a contractual rightand obligation to provide services. It is not a financial instrument, however, because it will be settled byproviding services rather than transferring a financial instrument.

� A prepayment to a supplier is a contractual right and obligation to provide merchandise. It is not a financialinstrument, however, since it will be settled through the shipment of merchandise rather than the transferof a financial instrument.

Conditional Receivable�payable Contract. A conditional receivable�payable contract both:

a. Imposes on one entity a contractual obligation to deliver a specified amount of cash or other financialinstrument to a second entity if a specified event beyond the control of either entity occurs, and

b. Conveys to that second entity a contractual right to receive a specified amount of cash or other financialinstrument from the first entity if a specified event beyond the control of either entity occurs.

Future performance under the contract is contingent, but the event is outside the control of both the holder and theissuer. All insurance policies are financial instruments under this category. As an example, under a life insurancepolicy, the holder receives cash and the issuer pays cash if the insured dies during the term of the policy; otherwise,no cash is transferred. However, certain insurance contracts are excluded from the fair value disclosure require�ments.

Financial Option Contract. A financial option contract both:

a. Imposes on an entity (the option writer) a contractual obligation to exchange other financial instrumentswith a second entity (the option holder) on potentially unfavorable terms if an event within the control of theholder occurs, and

b. Conveys to the option holder a contractual right to exchange other financial instruments with the optionwriter on potentially favorable terms if an event within the control of the holder occurs.

The holder will typically only exercise the option if it is favorable, and that situation is typically unfavorable to theoption writer. Common examples are a fixed�rate loan commitment, a mortgage loan with a prepayment right, andconvertible debt. Each of those involves an exchange of financial instruments.

A financial option contract is a financial instrument only if the option is potentially unfavorable to the option writer.To illustrate, a fixed�rate loan commitment gives the holder the right to demand that the option writer provide a loanat a specified rate. Typically, the holder pays a fee for the commitment. If market interest rates decline, the holderhas the option of exercising the commitment or finding a loan at current rates. However, if market rates increase, theholder has the option of exercising the commitment at the lower fixed rate. Although the option could be favorableto the option writer (for example, if rates decline but the holder exercises the option because other sources offinancing cannot be located), the option is potentially unfavorable and is therefore a financial instrument. However,


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if the loan commitment is for a market rate, it is not a financial instrument because the option is not potentiallyunfavorable to the option writer.

If the option involves an exchange of assets other than financial instruments, it is not a financial instrument. Acommon example is an option sold by a real estate developer to a homebuilder that permits the homebuilder to buya prescribed number of developed lots at a fixed price. That option is not a financial instrument because exercisingthe option causes an exchange of cash for real estate, and real estate is not a financial instrument.

Financial Guarantee or Other Conditional Exchange. A financial guarantee or other conditional exchangecontract both:

a. Imposes on one entity a contractual obligation to exchange other financial instruments with a second entityon potentially unfavorable terms if an event outside the control of either party to the contract occurs, and

b. Conveys to that second entity a contractual right to exchange other financial instruments with the first entityon potentially favorable terms if an event outside the control of either party to the contract occurs.

A common example is a guarantee of third�party indebtedness. In some situations a fee is charged for theguarantee. The guarantee is considered to be an exchange because exercise of the guarantee requires anexchange of cash for subrogating rights that place the guarantor in the same role as the lender had been.

The definition in the above paragraph requires that the event causing the transfer be outside of the control of eitherthe holder or the guarantor. The following illustrate that point:

� Assume that a wholesaler finances construction of its operating facilities through an industrial developmentbond and acquires a letter of credit equal to the principal outstanding from a bank. The letter of credit isa financial instrument of the bank (the guarantor) and of the industrial development authority (the holder).The default that triggers the payment is within the control of the wholesaler, and therefore the letter of creditis not a financial instrument of the wholesaler.

� Assume that a developer acquires a performance bond covering its responsibility to build roads in aresidential development. If the developer does not perform within a certain time, the municipality willcomplete the roads, and the bonding company will pay the municipality for the costs it incurs. The bondis a financial instrument of the municipality (the holder) and the bonding company (the guarantor). Thebond is not a financial instrument of the developer since performance is within its control.

� Assume that an individual owns all of the stock of two companies, one of which has guaranteed the bankdebt of the other. Since the same individual controls both companies, the guarantor controls theperformance of the debtor. Therefore, the guarantee is not a financial instrument. While the�holder of theguarantee (the bank) has the contractual right in the event the debtor defaults, the event that causes theguarantor (the company) to exchange cash for subrogation rights is effectively within its control. (However,even though the guarantee is not a financial instrument, its disclosure is still required as a related partytransaction.)

Financial Forward Contract. A financial forward contract both:

a. Imposes on each of two entities an unconditional obligation to exchange other financial instruments withthe other entity on potentially unfavorable terms, and

b. Conveys to each of those entities an unconditional right to exchange other financial instruments with theother entity on potentially favorable terms.

An example is a contract under which a corporation agrees to buy back a prescribed number of its shares at a pricethat will be determined based on the value of the company at the purchase date. The agreement involves anexchange of financial instruments (that is, cash in exchange for an equity interest).

If the forward contract is not limited to the exchange of financial instruments, it is not a financial instrument. As anexample, a commitment to acquire inventory at a fixed price is not a financial instrument because it requires anexchange of cash for inventory instead of for a financial instrument.


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Credit and Market Risk Disclosures

The following summarizes this lesson's general approach to determining the credit and market risk disclosuresrequired by FASB ASC 825�10�50 (formerly SFAS No. 107):

a. Identify the financial instruments of the entity. Financial instruments consist of cash, an ownership interestin another entity, and certain contracts. All entities have financial instruments. Some financial instrumentsare recorded as assets or liabilities, but others are not.

b. Determine whether the financial instruments are specifically excluded from the credit risk disclosurerequirements.

c. Identify whether the remaining financial instruments are subject to credit or market risk of loss.

d. If the credit risk for those instruments relates to the actions of parties that are similarly affected by changesin economic or other conditions (referred to as concentrations of credit risk), describe the sharedconditions, disclose the maximum loss that could result, describe the entity's policy of requiring collateralto minimize the risk, describe the collateral, and discuss the entity's access to the collateral.

Financial Instruments Excluded from the Requirements of SFAS No. 107. FASB ASC 825�10�50�8 and 50�22(formerly SFAS No. 107) specifically exclude the following financial instruments from its disclosure requirements forconcentrations of credit risk:

� Certain insurance contracts.

� Unconditional purchase obligations subject to the disclosure requirements of FASB ASC 440�10�50�2(formerly SFAS No. 47, Disclosure of Long�Term Obligations). (Those requirements generally only applyto noncancelable agreements negotiated in connection with arranging financing for the facilities that willprovide the contracted goods or services.)

� Employers' and plans' obligations for pension benefits, postretirement health care and life insurancebenefits, postemployment benefits, employee stock option and stock purchase plans, and other forms ofdeferred compensation arrangements.

� Financial instruments of a pension plan, including plan assets, when subject to the accounting andreporting requirements of FASB ASC 715 (formerly SFAS No. 87, Employers' Accounting for Pensions).

� Warranty obligations and rights.

Determining Whether a Financial Instrument Is Subject to Credit or Market Risk. Credit and market riskdisclosures relate to the risk of an accounting loss. Accounting loss is essentially a charge to earnings that wouldresult from losing the contractual right or settling the contractual obligation of a financial instrument. Three types ofrisk could cause an accounting loss: credit risk, market risk, and the risk of theft or physical loss. These disclosuresonly deal with credit and market risk.

a. Credit risk is the possibility that a loss may occur from the failure of another party to perform according tothe terms of a contract.

b. Market risk is the possibility that future changes in market prices may make a financial instrument lessvaluable or more onerous.

In general, best practices do not indicate that credit risk affects an evidence of ownership interest or a contractualobligation other than under a financial guarantee. Ownership interests are generally affected by market risk, and,since there are only two parties to a contractual obligation, a loss cannot result from the failure of another party toperform. The following illustrate why credit risk does not apply to contractual obligations:

� Assume that a wholesaler has a note payable to a bank (an unconditional payable contract). The note isa contractual right of the bank and a contractual obligation of the wholesaler. The bank has no performanceresponsibilities. Thus, there is no credit risk to the wholesaler.


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� Assume that the founder of a company agrees that the company will buy the stock of venture capitalistsat the end of five years (a financial forward contract). The agreement is a contractual right of the venturecapitalists and a contractual obligation of the company. The venture capitalists have no performanceresponsibilities. The same conclusion would apply if the company provided the venture capitalists with anoption (a financial option contract) instead of a commitment.

However, credit risk would affect cash, contractual rights, and contractual obligations under financial guarantees asillustrated by the following:

� The contractual right to cash deposits is subject to the risk that the financial institution will not pay whenthe cash is requested.

� A contractual right under an unconditional receivable contract such as a cash equivalent, trade accountsreceivable, or note receivable is subject to the risk that the other party will not pay the balance due.

� A contractual right under a financial guarantee is subject to the risk that the issuer of the financial guaranteewill not pay in the event of a default.

� A contractual obligation under a financial guarantee is subject to the risk that the party whose debt isguaranteed will default.

The following illustrate consideration of market risk:

� The holder of an ownership interest is subject to the risk of a loss from a decrease in value, for example,because of a decline that is other than temporary or from a sale. However, the issuer of the interest doesnot recognize a loss from a decrease in value and, therefore, is not subject to market risk.

� The holder of a contractual right under a fixed rate loan commitment is unaffected by changes in marketrates of interest and thus has no market risk. However, the issuer of the commitment has market risk sinceit is subject to the risk of a loss that results from issuing a loan at a lower rate than market and then sellingit.

� The holder of a contractual right under an option to convert a note into common stock at fair market valueis unaffected by a decrease in value because the option would not be exercised. Under FASB ASC470�20�40�4 (formerly AICPA Interpretation No. 1 of APB Opinion No. 26, Early Extinguishment of Debt), theissuer would recognize no gain or loss on conversion and accordingly has no market risk.

Disclosures Required for Market Risk. FASB ASC 825�10�50�23 (formerly SFAS No. 107) encourages but doesnot require disclosure of quantitative information about the market risks of financial instruments. Such disclosureshould be consistent with the way the company manages or adjusts market risks. For example, market riskdisclosures could include (a) more details about current positions and activity during the period, (b) hypotheticaleffects on comprehensive income of possible changes in market prices, (c) the duration of the financial instru�ments, (d) an analysis of interest rate repricing or maturity dates, or (e) the company's value at risk from derivativesat the balance sheet date and the average value at risk during the�year.

Disclosures Required for Concentrations of Credit Risk. Concentrations of credit risk of financial instrumentsare considered to occur if their holders would be similarly affected by changes in economic or other conditions inmeeting their contractual obligations. FASB ASC 825�10�50�21 (formerly SFAS No. 107, as amended) requires thefollowing to be disclosed about each significant concentration of credit risk:

a. Information about the activity, region, or economic characteristic that identifies the concentration.

b. The maximum amount of the accounting loss due to credit risk the entity would incur if parties to thefinancial instruments that make up the concentration failed completely to perform according to the termsof the contracts and the collateral or other security, if any, for the amount due proved to be of no value.

c. The entity's policy of requiring collateral or other security to support financial instruments subject to creditrisk, information about the entity's access to that collateral or other security, and the nature and a briefdescription of the collateral or other security supporting those financial instruments.


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d. The entity's policy of entering into master netting arrangements to mitigate the credit risk of financialinstruments. That disclosure should include information about the master netting arrangements for whichthe entity is a party and a brief description of their terms, including the extent to which they would reducethe entity's maximum amount of loss due to credit risk.

These disclosure requirements about concentrations of credit risk apply to derivative instruments accounted forunder FASB ASC 815 (formerly SFAS No. 133).

Best practices indicate that for most small to medium�sized businesses, significant concentrations of financialinstruments with credit risk will arise whenever customer financing is significant. For example, the credit riskassociated with recourse provisions would be significant for a dealership that provides financing for a significantamount of its sales and sells the contracts to financial institutions in the same geographical region with recourse.(However, the disclosure of the concentration can be combined with the optional disclosure of the off�balance�sheet risk.)

Disclosing Concentrations of Credit Risk for Cash Deposits

Cash deposits with banks, broker�dealers, and other financial entities are financial instruments with credit risk.Significant concentrations of credit risk can result when cash is deposited in a single financial entity or in two ormore financial entities that are based in the same geographic region. (Maintaining deposits in two or more financialentities based in the same geographic region concentrates credit risk because the financial entities are similarlyaffected by changes in economic conditions.)

To increase the yield on deposits, many banks offer accounts with some investment characteristics. To enabledepositors to use these as interest�bearing checking accounts, the funds typically are invested in repurchaseagreements, commercial paper, and similar financial instruments that mature quickly, usually overnight. Somebank statements for such accounts indicate that they are not deposits or other obligations of the bank. Because ofsuch descriptions and the nature of the investment vehicles themselves, some accountants question whether suchaccounts should be viewed as cash. Using the definition of cash discussed earlier in this lesson, best practicesindicate that such accounts should be viewed as cash, and therefore are subject to credit risk.

GAAP requires companies to disclose information about significant concentrations of credit risk. In practice,however, accountants disagree as to whether the amount of credit risk disclosed should be based on financialstatement or bank statement balances and whether credit risk can be reduced by deposit insurance.

Should Disclosures Be Based on Financial Statement or Bank Statement Balances? Best practices indicatethat the amount of credit risk that should be disclosed is the cash balance reported by the financial entity (i.e., thebank statement balance). The objective of the disclosure requirement is to disclose concentrations of credit riskthat result from maintaining cash deposits in financial entities. Therefore, the amount of that risk is the amount forwhich the financial entity is responsible. Generally, the financial entity is not responsible for:

� Deposits in Transit. Undeposited receipts are a reconciling item between financial statement and bankstatement balances. Although undeposited receipts can be misplaced, destroyed, or stolen, normally thepayors are required to replace them because the payor's responsibility for a check is not eliminated untilthe bank on which the check was drawn has reduced its deposit obligation. The credit risk that exists relatedto undeposited receipts is the possibility that the debtor will not replace the receipt, not the risk that thefinancial entity will fail to perform.

Deposits made, including wire transfers, also will be a reconciling item between financial statement andbank statement balances if they are received by the bank after its daily cut�off. Generally, the bank has noperformance responsibility until it recognizes a deposit obligation. If the bank were to close, it probablywould deny any responsibility for deposits made after its closing time for the day. The credit risk for thosedeposits is the same as for undeposited receipts.

� Outstanding Checks. Checks that have been released but have not cleared the bank will be a reconcilingitem between financial statement and bank statement balances because the bank does not reduce itsdeposit liability until the checks clear. In the event of a bank failure, the bank would be responsible for its


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deposit liability, not its deposit liability reduced by outstanding checks. The company would be requiredto satisfy outstanding checks with other funds.

Should Deposit Insurance Be Considered? Some, but not all, bank deposits are insured against bank failure. Forexample:

� The Federal Deposit Insurance Corporation (FDIC) is a federal agency that insures the deposits of manybanks. It covers up to $250,000 of a depositor's regular checking accounts, interest�bearing checkingaccounts, money market accounts, and certificates of deposits in a bank. More information related to thedeposit insurance coverage can be found on the FDIC's website at www.fdic.gov. This limit generallyapplies to the depositor's combined deposits in the bank.

� Repurchase agreements are uninsured, but they are secured by pools of marketable securities of federalagencies.

� Master notes are uninsured, but some are secured by assets of the bank.

� Commercial paper is uninsured and normally is unsecured.

The Securities Investor Protection Corporation (SIPC) provides insurance for deposits with broker�dealers that issimilar to that provided by the FDIC.

GAAP does not address whether the credit risk for cash deposits can be reduced by insurance. Some accountantsargue that it should not. They believe that insurance merely decreases the likelihood of loss, but has no effect onthe overall amount of credit risk (i.e., there is still a risk that the insurance may not be collected). While that may beconceptually correct, best practices indicate that credit risk for cash deposits should be reduced by amounts thatare federally insured. Federal insurance will fail only in the event of a national financial catastrophe, and such anegligible risk should be ignored for purposes of disclosing concentrations of credit risk. Furthermore, in anonauthoritative Technical Practice Aid at TIS 2110.06, the AICPA stated that bank statement balances in excess ofFDIC�insured amounts represent a credit risk, and the uninsured cash balances should be disclosed if theyrepresent a significant concentration of credit risk. The TPA further states that while a material uninsured cashbalance with a single bank should generally be disclosed, numerous immaterial uninsured cash balances ondeposit with several banks may not require disclosure. Judgment must be used in determining the threshold forsignificance, which will vary with individual circumstances. For example, the financial statement preparer shoulduse judgment to determine the aggregate materiality of numerous immaterial uninsured cash balances on depositwith several banks.

Disclosure Considerations. Financial statements should disclose the information discussed earlier in this lessonabout each significant concentration of credit risk for cash deposits at each date for which a balance sheet ispresented. The disclosures may be made in a manner that is most effective and efficient for the reporting entity.Therefore, many entities will disclose all concentrations of credit risk (e.g., for cash deposits, trade accountsreceivable, notes receivable, etc.) in a single note such as �Significant Concentrations of Credit Risk." For example,assume that a company's cash balance at the end of 20X1 consists of the following:

BankStatementBalance

FinancialStatementBalance

Allen Fidelity Bank money market account $ 43,500 $ 43,500Bailey Bank interest�bearing checking

account 310,300 310,300Commonwealth Bank

Regular checking account 31,500 (340,600)Escrow accounts 456,000 426,800Unsecured master note 332,600 332,600


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FinancialStatementBalance

BankStatementBalance

Regal BankRegular checking account 10,600 20,500Repurchase agreement collateralized by a

GNMA pool 244,600 244,600

$ 1,429,100 1,037,700

Petty Cash 900

$ 1,038,600

Assume further that all of the banks are local, and, with the exception of the Commonwealth Bank master note andthe Regal Bank repurchase agreement, all of the deposits are federally insured. The concentration of credit risk iscalculated as follows:

Allen Fidelity Bank (None since all of the balance is federallyinsured) $ �

Bailey Bank ($310,300 bank statement balance less $250,000maximum federal insurance) 60,300

Commonwealth BankChecking account (None since all of the balance is federally

insured) �Escrow accounts (None since all of the balances are feder�

ally insured) �Master note (All of the balance is subject to credit risk since

none of it is federally insured.) 332,600Regal Bank

Checking account (None since all of the balance is federallyinsured) �

Repurchase agreement (All of the balance is subject tocredit risk since none of it is federally insured.) 244,600

$ 637,500

The company's 20X1 balance sheet reports cash of $611,800 ($1,038,600 cash less the escrow obligation of$426,800). The disclosure of concentrations of credit risk for cash deposits may be disclosed as follows (20X0amounts are assumed):

NOTE XSIGNIFICANT CONCENTRATIONS OF CREDIT RISK

Cash includes escrow accounts maintained for deposits by buyers under sales contracts and accord�ingly has been reduced by the Company's obligation under those arrangements of $426,800 at the endof 20X1 and $384,600 at the end of 20X0. The Company has concentrated its credit risk for cash bymaintaining deposits in banks located within the same geographic region. The maximum loss thatwould have resulted from that risk totalled $637,500 at the end of 20X1 and $428,200 at the end of 20X0for the excess of the deposit liabilities reported by the banks over the amounts that would have beencovered by federal insurance. Shares of a pool of mortgage�backed securities are pledged as collateralfor $244,600 of that excess in 20X1 and $195,000 in 20X0.

Credit risk for trade accounts and notes is concentrated as well because substantially all of the balancesare receivable from individuals located within the same geographic region.

Disclosures about the Fair Value of Financial Instruments

FASB ASC 825�10�50�10 (formerly SFAS No. 107) requires disclosure of the fair value of all financial instruments forwhich it is practicable to estimate that value. The disclosures about the fair value of financial instruments do not


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apply to all entities, however. For annual reporting periods, the disclosures are optional for a nonpublic entity that(a) has less than $100 million in total assets on the balance sheet date and (b) has no instrument that, in whole orin part, is accounted for as a derivative instrument, except for commitments related to the origination of mortgageloans to be held for sale during the reporting period. Publicly traded entities are also required to make thedisclosures in interim reporting periods. However, interim disclosure is optional for nonpublic entities.

For companies not exempt from the fair value disclosure requirements, this lesson's general approach to determin�ing the required disclosures, is as follows:

a. Determine whether the financial instruments identified when identifying the entity's financial instrumentsare specifically excluded from the disclosure requirements.

b. For each category of financial instruments (such as notes payable) subject to the disclosure requirements,determine if a quoted market price is available.

c. If a quoted market price is available, use it to estimate the fair value of the instrument.

d. If a quoted market price is not available, determine if it is cost effective to estimate fair value.

e. For instruments for which fair value has been determined, disclose the fair value and the methods andsignificant assumptions used to estimate fair value.

f. For instruments for which it is not cost effective to estimate fair value, disclose the pertinent informationabout the financial instrument and the reasons why estimating fair value is not cost effective.

The preceding steps can be reduced to a few simple decisions as outlined in Exhibit 2�1. Once certain questionsare answered, specific actions regarding fair value disclosures can be taken to comply with GAAP.

Financial Instruments Excluded from the Disclosure Requirements. FASB ASC 825�10�50�8 (formerly SFASNo. 107) specifically excludes the following financial instruments from the fair value disclosure requirements:

� Employers' and plans' obligations for pension benefits, other postretirement benefits including health careand life insurance benefits, postemployment benefits, employee stock option and stock purchase plans,and other forms of deferred compensation arrangements

� Substantively extinguished debt subject to the disclosure requirements of FASB ASC 405�20 (formerlySFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities)

� Certain insurance contracts

� Lease contracts

� Warranty obligations and rights

� Unconditional purchase obligations as defined in FASB ASC 440�10�50�2 (formerly Paragraph 6 of SFASNo.�47, Disclosure of Long�Term Obligations)

� Investments accounted for under the equity method in accordance with the requirements of FASB ASC 323(formerly APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock)

� Noncontrolling interests in consolidated subsidiaries

� Equity investments in consolidated subsidiaries

� Equity instruments issued by the entity and classified in stockholders' equity in the balance sheet

In addition, the requirements presume that the carrying value of trade receivables and payables approximates fairvalue. Therefore, fair value disclosures are required only when that is not the case.


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Exhibit 2�1

Applying the FASB ASC 825�10�50 (formerly SFAS No. 107) Fair Value ofFinancial Instruments Disclosure Requirementsa

FINANCIALINSTRUMENT?

SPECIFICALLYEXCLUDED FROM

FAIR VALUE DISCLOSUREREQUIREMENTS?

DOES CARRYINGVALUE ALREADY

APPROXIMATE FAIRVALUE (for trade receiv�

ables or payables)?

DOES OTHER GAAPALREADY REQUIRE

DISCLOSURE OFFAIR VALUE?

IS FAIR VALUEPRACTICABLE TO

DETERMINE?

DISCLOSUREREQUIREMENTSDO NOT APPLY

NO ADDITIONAL FAIRVALUE DISCLOSURE

IS REQUIRED

DISCLOSE WHY FAIR VALUEIS NOT PRACTICABLE TO

DETERMINE AND PERTINENTINFORMATION ABOUT THE FINANCIAL INSTRUMENT

DISCLOSE FAIR VALUE,METHOD OF

DETERMINING FAIRVALUE, AND SIGNIFICANT

ASSUMPTIONS

NO

NO

YES

YES

YES

YES

YES

NO

NO

NO

Note:

a For annual reporting periods nonpublic entities with less than $100 million in total assets on the balance sheetdate are exempt from the fair value disclosure requirements if the entities have not issued or held certainderivatives during the reporting period.

* * *

Determining the Fair Value of Financial Instruments. FASB ASC 820 (formerly SFAS No. 157, Fair ValueMeasurements) provides a common definition of fair value, establishes a framework to measure fair value withinGAAP, and requires disclosures about fair value measurements. It generally applies under other accounting


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pronouncements that require or permit fair value measurements, including the disclosure of fair value informationfor financial instruments.

Disclosure Requirements. Entities subject to the requirement to disclose information regarding the fair value offinancial instruments in accordance with FASB ASC 825�10�50 (formerly SFAS No. 107) must disclose the follow�ing. The disclosure requirements of FASB ASC 820 (formerly SFAS No. 157) also apply to financial instrumentsrecognized at fair value in the balance sheet.

a. For each financial instrument (or category of financial instruments) for which fair value has beendetermined, disclose the following either in the body of the financial statements or in the notes:

(1) The fair value of the financial instrument (or category)

(2) The methods and significant assumptions used to estimate fair value

(3) A description of any changes in methods and significant assumptions used to estimate fair valueduring the period

b. For each financial instrument (or category of financial instruments) for which it is not cost�effective toestimate fair value, disclose the following:

(1) Relevant information about the financial instrument (or category), such as the book value, effectiveinterest rate, and maturity

(2) The reasons why it is not practical to estimate fair value

In some cases, it may be cost�effective to disclose the fair value of a class or portfolio of financial instruments whenit is not cost�effective to disclose the fair value of an individual instrument.

GAAP also requires the following related to these disclosures:

� Fair value disclosures should be made in such a way that it is clear whether the reported amounts representassets or liabilities and how the carrying amounts relate to those reported in the balance sheet.

� The fair value of a financial instrument should not be combined, aggregated, or netted with the fair valueof other financial instruments, except where netting is allowed under FASB ASC 210�20�45�1 and815�10�45�5 (formerly FASB Interpretation No. 39) or FASB ASC 210�20�45�11 through 45�17 (formerlyFASB Interpretation No. 41).

� A summary table must be provided that includes fair value and related carrying amounts of all financialinstruments, with each cross�referenced to the note that provides the other fair value disclosures, if the fairvalue of financial instruments disclosures are made in more than one note.

As a practical matter, small and mid�sized entities normally do not have enough financial instruments to prohibitfinancial statement readers from readily assessing the effect of fluctuations in financial instrument values without atable. Accordingly, in those situations, best practices indicate that a separate table is unnecessary. Deciding whena table is necessary depends on the facts and circumstances. To illustrate, if an entity discloses the fair value ofnotes receivable and notes payable in the separate financial statement notes addressing them, and in a separatenote for an investment in a limited partnership discloses that determining its fair value is impractical, the reader caneasily assess the impact of fluctuations in financial instrument values without a summary table.

Derivative Financial Instruments and Hedging Activities

FASB ASC 815 (formerly SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities) requiresnumerous disclosures if an entity has derivative instruments or hedging activities.

Presentation and Disclosure Considerations for Receivables

Small and midsize nonpublic entities typically have a variety of receivables. Groups of homogeneous receivablesare referred to as portfolios of receivables. Generally accepted accounting principles for receivables generally


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focus on their realizability. The possibility that some or all of a receivable will not be realized is a contingency andaccordingly:

a. Provision should be made for realization losses that are probable and can be reasonably estimated. If asingle point estimate cannot be made, then consideration should be given to whether there is a range ofpossible losses. If there is a range and one amount in the range is better than any other amount, that amountshould be used for the estimate. Otherwise, the lowest amount in the range should be used.

b. Losses that are probable but cannot be reasonably estimated and losses that are reasonably possibleshould be disclosed.

Applying those principles to portfolios of receivables typically involves breaking the portfolio into two strataindi�vidual receivables with special characteristics, which are evaluated separately, and all other receivables, which areevaluated together as a group.

A summary of the presentation and disclosure considerations for receivables follows.

a. If the entity provides short�term or long�term financing to customers for sales of goods and services:

(1) The major categories of balances due under the financing arrangements should be presentedseparately in the balance sheet or should be disclosed in the notes to the financial statements.

(2) The method used to evaluate the need for a valuation allowance for losses on realization should bedisclosed.

(3) If the arrangements are interest�bearing, the following items should be disclosed:

(a) The method used for recognizing interest income.

(b) The policies for when to recognize interest on delinquent balances.

(c) The carrying amount of balances for which interest is not being recognized.

(d) The carrying amount of balances that are past due 90 days or more and still accruing interest.

(4) If balances have been factored and the conditions for sale accounting have been met, the aggregateamount of gains or losses should be presented separately in the financial statements or disclosed inthe notes to the financial statements.

b. The following amounts should be included in determining the carrying amount of the related receivables:

(1) Deferred fees or costs.

(2) Discount from imputing interest.

(3) Unearned interest included in the face of recorded receivables.

c. Gross profit deferred under the installment method should be offset in determining the carrying amountof the related receivables.

d. The following amounts included in determining the carrying amount of receivables should be disclosed:

(1) Deferred fees and costs.

(2) Deferred gross profit.

(3) Discount from imputing interest.


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e. Losses that are probable but cannot be reasonably estimated and losses that are reasonably possibleshould be disclosed.

f. Amounts due from officers, employees, or affiliates should be presented separately in the balance sheetor disclosed in the notes to the financial statements.

g. If the balance sheet is presented in a classified format, amounts due from officers, employees, affiliates,and others should be included in current assets only if they are collectible in the ordinary course of businesswithin a year.

h. Significant concentrations of credit risk arising from receivables should be disclosed.

ASU No. 2010�20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the

Allowance for Credit Losses, was issued in July 2010 and expands the disclosure requirements for certain portfo�lios of receivables. For nonpublic entities, ASU No. 2010�20 is effective for years ending on or after December 15,2011. The only portfolio of receivables small and midsize nonpublic entities typically have is from short�termfinancing provided to customers for the sale of goods and services. However, some small and midsize nonpublicentities have a portfolio of receivables from providing long�term financing to customers for the sale of goods andservices, such as:

a. A dealership that offers long�term financing to customers with higher�than�normal credit risk.

b. An insurance broker that offers long�term premium financing to high�risk customers.

The expanded disclosure requirements of ASU No. 2010�20 do not apply to short�term financing provided tocustomers for the sale of goods and services. For other receivables portfolios, ASU No. 2010�20 generally:

a. Expands some of the current disclosure requirements so that the information will now need to bedisaggregated by class of receivable, including:

(1) accounting policies for past due or delinquent balances,

(2) the carrying amount of receivables for which interest is no longer being accrued, and

(3) the carrying amount of receivables that are past due 90 days or more and still accruing interest.

b. Adds a requirement to disclose by class of receivable an analysis of the age of the carrying amount ofreceivables that are past due.

c. Expands the current requirements to disclose information about the factors the entity considers in providingan allowance for credit losses and to disclose changes in the allowance for credit losses during the periodcovered by the financial statements, so that the information will now need to be disaggregated by portfoliosegment.

d. Adds requirements to disclose the credit quality indicator used by the entity, the carrying amount of thereceivables by credit quality indicator, and when the information for each credit quality indicator wasupdated.

As a practical matter, small and midsize nonpublic entities affected by the expanded disclosure requirements ofASU No. 2010�20 may have only one class of financing receivable and one portfolio segment. For example, amidsize nonpublic dealership that offers long�term financing to customers with higher�than�normal credit risk mayonly offer the financing to customers within a relatively narrow range of risk characteristics. The portfolio of thelong�term receivables would therefore have a single class. Similarly, it would likely provide a single allowance forcredit losses for the receivables so there would be a single portfolio segment.

Small and midsize nonpublic entities typically pledge assets as security for obligations. The security interest maybe in specific assets, such as lending arrangements based on levels of portfolios of receivables and inventories, or


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in all assets. These arrangements give the creditor the right to foreclose on these assets if the entity defaults on theloan. FASB ASC 440�10�50�1(c) (formerly SFAS No. 5, paragraph 18) requires disclosure of these arrangements.Since the requirement is only to disclose �assets pledged as security for loans," quantitative information is notrequired. For example, a note describing borrowing arrangements might say �the note is secured by accountsreceivable" or �all the entity's assets are pledged as security for the loan."

Best practices indicate that these arrangements for pledging entire portfolios of receivables as security for obliga�tions are different than the arrangement to which FASB ASC 310�10�50�5 (formerly SOP 01�6, paragraph 13) isreferring when it says, �For required disclosures [by nonpublic entities] of the carrying amount of loans, tradereceivables, securities and financial instruments that serve as collateral for borrowings." FASB ASC Topic 860,Transfers and Servicing, relates to transfers of financial assets, and is therefore broader than just transfers ofreceivables. FASB ASC 860�30�50�1A(b) (formerly SFAS No. 140, paragraph 17) states:

If the entity has pledged any of its assets as collateral that are not reclassified and separately reportedin the statement of financial position pursuant to paragraph 860�30�25�5(a), it shall disclose thecarrying amount and classification of those assets as of the date of the latest statement of financialposition presented.

FASB ASC 860�30�25�5a (formerly SFAS No. 140, paragraph 15), referred to in the previous quotation says:

If the secured party (transferee) has the right by contract or custom to sell or repledge the collateral,then paragraph 860�30�45�1 requires that the obligor (transferor) reclassify that asset and report thatasset in its statement of financial position separately (for example, as security pledged to creditors)from other assets not so encumbered.

Paragraph 257 of the Basis for Conclusions in SFAS No. 140, which is not included in the Codification, describesthe type of collateral arrangement envisioned by that requirement:

The Board adopted an alternative approach that requires the debtor to reclassify, in its statement offinancial position, financial assets pledged that the secured party has the right to sell or repledge. Thatalternative carries over, and extends, a requirement in Statement 125 that applied only to collateral thatthe debtor did not have the right to redeem on short notice. The Board considers separateclassification of pledged receivables in the statement of financial position to be necessary once thoseassets are pledged to a party who has the right to, and commonly does, sell or repledge them,because those financial assets pledged are effectively only receivables from the secured party andshould not be reported in a way that suggests that the debtor still holds them. The Board consideredrequiring that the secured party recognize all such collateral as its assets but concluded that wasinappropriate for the reasons cited in developing the value�of�the�rights approach. The Board carriedover the requirement in Statement 125 that the secured party recognize its obligation to returncollateral that it has sold to other parties, which had not been questioned by commentators. The Boardalso carried over, in paragraphs 92�94 of this Statement, the requirement to recognize cash �collateral"or securities received as �collateral" that a securities lender is permitted to sell or repledge, becausethe Board considers them to be, not collateral, but the proceeds of either a sale of the �loaned"securities or a borrowing secured by them.

Therefore, best practices do not indicate that the carrying amount of receivables and other financial instrumentspledged as collateral is required to be disclosed for most small and midsize nonpublic entities.

Accounting Policies for Trade Receivables and Credit Losses and Doubtful Accounts. Best practices indicatethat the policies ordinarily can be disclosed through a relatively standard note in the summary of significantaccounting policies, such as

Trade Accounts Receivable

Trade accounts receivable are stated at the amount management expects to collect from outstandingbalances. Management provides for probable uncollectible amounts through a charge to earnings anda credit to a valuation allowance based on its assessment of the current status of individual accounts.


308

Balances that are still outstanding after management has used reasonable collection efforts are writtenoff through a charge to the valuation allowance and a credit to trade accounts receivable. Changes in thevaluation allowance have not been material to the financial statements.

Depending on the facts and circumstances, management may conclude that a valuation allowance is unnecessary,for example, because

� Substantially all of the entity's credit sales are to a small number of customers who have a history of payingpromptly.

� Management considered subsequent collection results and wrote off all year�end balances that were notcollected by the time the financial statements were issued or available to be issued.

� The entity's customer base is relatively stable, management closely monitors outstanding customerbalances, collection losses have historically been immaterial, and management is not aware of customerdisputes or financial difficulties.

The following is an example of the accounting policy disclosure when management has concluded that a valuationallowance is unnecessary.

Customer Accounts Receivable

Customer accounts receivable are reported at the amount management expects to collect on balancesoutstanding at year�end. Management closely monitors outstanding balances and writes off, as ofyear�end, all balances that have not been collected by the time the financial statements are available tobe issued.

As another example

Trade Accounts Receivable

Trade accounts receivable are stated at the amount management expects to collect from balancesoutstanding at year�end. Based on management's assessment of the credit history with customershaving outstanding balances and current relationships with them, it has concluded that realizationlosses on balances outstanding at year�end will be immaterial.

Depending on the facts and circumstances, appropriate disclosure may also be provided in connection with otherdisclosures, such as disclosure of the nature of business. For example

NOTE BNATURE OF BUSINESS AND CONCENTRATION OF CREDIT RISK

ABC Company primarily provides advertising services for three entities located in Norton, Wyoming.While its credit risk for trade receivables is therefore concentrated, those receivables typically arecollected within 60 days, and based on its assessment of current conditions management believesrealization losses on amounts outstanding at year�end will be immaterial. Accordingly, trade receivablesare reported at the amount of principal outstanding.

Amount of the Valuation Allowance and Material Changes in the Allowance. The amount of the valuationallowance can be disclosed through expansion of the trade receivables caption in the statement of financialposition. However, if there are material changes in the valuation allowance, a table can be included in the notes tothe financial statements that will disclose both the amount of the allowance and the changes in it. To illustrate


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NOTE XCHANGES IN THE VALUATION ALLOWANCE FOR TRADE ACCOUNTSRECEIVABLE

Changes in the valuation allowance for trade accounts receivable are

20X1 20X0

Beginning balance $ 80,000 $ 75,000

Provision for realization losses 95,000 80,000

Write�offs (65,000 ) (75,000 )

Ending balance $ 110,000 $ 80,000

Depending on the facts and circumstances, a change in the valuation allowance may be material in one year butnot the other in comparative financial statements. An illustration of appropriate disclosure in that situation follows.

NOTE XPROVISION FOR COLLECTION LOSS

Trade receivables are reported at their estimated net realizable value. Collection losses have historicallybeen immaterial, and management concluded that, based on its review of material balances outstand�ing, a valuation allowance was needed only for the balance due from an entity that is experiencingfinancial difficulties. The $75,000 allowance is equal to one�half of the balance outstanding to provide forcosts and concessions management believes are probable in negotiating settlement of the balance.Management will write off any balance that remains after it has exhausted all reasonable collectionefforts and concludes that additional collection efforts are not cost�justified.


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SELF�STUDY QUIZ


26. Which of the following would be categorized as cash?

a. Options to purchase stock.

b. Common stock.

c. Demand deposits.

d. A U.S. Treasury bill.

27. CWS Industries has an obligation to pay $25,000 to Primrose Manufacturing on demand or before the end ofthe year in relation to a short�term note payable. Primrose Manufacturing understands that they may demandpayment before the end of the year. What type of contract does CWS Industries currently have with PrimroseManufacturing?

a. Financial forward contract.

b. Financial option contract.

c. Conditional receivable�payable contract.

d. Unconditional receivable�payable contract.

28. Which of the following statements regarding unconditional receivable�payable contracts is most accurate?

a. If a stockholder receives a payment as a loan, it is considered a financial instrument.

b. If a supplier receives a prepayment, it is considered a contractual obligation to provide products.

c. If a supplier receives a prepayment under a membership agreement, it is considered a financial instrument.

29. Boy's Gym has a contract with Basketball City (BC). However, if BC does not deliver the promised goods bythe date specified in the contract, it will cost Boy's Gym a significant amount gross profit by not being able tosupply the goods to prepaid customers. This is an example of what type of risk?

a. The risk of theft or physical loss.

b. Market risk.

c. Credit risk.

30. A contractual obligation under a financial guarantee is affected by credit risk. Which of the following indicatesa credit risk threat associated with an obligation?

a. The threat that the party will default the debt guarantee.

b. The threat that the financial issuer's guarantee will default.

c. The threat that the balance due will not be paid by the other party.

d. The threat that the financial institution will default when cash is requested.


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31. Comfort House has a concentration of credit risk, due to a significant portion of its assets are deposited in onefinancial institution. When disclosing this credit risk associated with the financial institution, which amountshould Comfort House use?

a. The amount of outstanding checks.

b. The bank statement balance.

c. The amount of deposits in transit.

32. Which of the following is correct regarding insured amounts with financial institutions?

a. The FDIC provides insurance for deposits with broker�dealers.

b. Any repurchase agreements held are insured by the FDIC.

c. The FDIC insures the deposits of many banks, up to a certain limit.

d. A company cannot consider their credit risk for cash deposits reduced by the amount of the insuranceprovided by the FDIC.

33. Which of the following statements is most accurate regarding applying fair value of financial instrumentsdisclosure requirements?

a. Disclosure requirements apply to the fair value of all financial instruments.

b. If a financial instrument is excluded from fair value disclosure requirements, other disclosure requirementswill apply.

c. If a financial instrument is not excluded from fair value disclosure requirements but the instrument doesalready carry an approximate fair value, additional fair value disclosure will be required.

d. If other GAAP conditions already require fair value disclosure, then additional fair value disclosures will berequired for the financial instrument.

34. Comfort House makes fair value disclosures about its financial instruments in its financial statements. Whichof the following statements best describes an aspect of that process?

a. Financial instruments should be summarized in a table with the fair value and the related carrying amountsand cross�referenced to the note disclosures.

b. The organization should aggregate the fair values of all financial instruments included in the financialstatements.

c. The organization should not mention financial instruments for which it is not cost effective to disclose thefair value.

d. For each financial instrument, the organization must disclose fair value in the notes to the financialstatements.


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26. Which of the following would be categorized as cash? (Page 293)

a. Options to purchase stock. [This answer is incorrect. Warrants and options to subscribe to or purchasestock from an issuing entity are categorized as evidence of an ownership interest in an entity. This is aseparate category of financial instruments.]

b. Common stock. [This answer is incorrect. Common stock is categorized as evidence of an ownershipinterest in an entity, which is a separate category of financial instruments. Preferred stock is anotherexample of this category of financial instrument.]

c. Demand deposits. [This answer is correct. It is relatively straightforward to identify financialinstruments that fall into the cash category. Cash for this purpose is the same as the items that arereflected on an organization's statement of cash flows, and it includes, among other things, demanddeposits and other kinds of accounts that have the general characteristics of demand deposits inthat the customer may deposit or withdraw additional funds at any time.]

d. A U.S. Treasury bill. [This answer is incorrect. This is considered a cash equivalent, which is different fromcash. Although cash equivalents are not cash, they are normally financial instruments. Treasury bills wouldalso be considered an unconditional receivable�payable contract.]

27. CWS Industries has an obligation to pay $25,000 to Primrose Manufacturing on demand or before the end ofthe year in relation to a short�term note payable. Primrose Manufacturing understands that they may demandpayment before the end of the year. What type of contract does CWS Industries currently have with PrimroseManufacturing? (Page 294)

a. Financial forward contract. [This answer is incorrect. A financial forward contract involves an exchange offinancial instruments that could have potentially unfavorable terms for one of the parties. An example isa contract under which a corporation agrees to buy back a prescribed number of its shares at a price thatwill be determined based on the value of the company at the purchase date.]

b. Financial option contract. [This answer is incorrect. A financial option contract allows the option holder toexercise an option if it is favorable to the holder, and that situation is typically unfavorable to the optionwriter. A common example of this type of contract is affixed�rate loan commitment and a mortgage loanwith a prepayment right.]

c. Conditional receivable�payable contract. [This answer is incorrect. According to the FASB memorandum,the condition in this type of contract must be a specified event beyond the control of the holder and theissuer. That is not the case since Primrose Manufacturing can demand payment at any time before the endof the year.]

d. Unconditional receivable�payable contract. [This answer is correct. An unconditional receivable�payable contract both: (a) imposes one entity an unqualified contractual obligation to deliver aspecified amount of cash or other financial instrument to a second entity on demand or on or beforea specified date, and (b) conveys to that second entity an unqualified contractual rights to receivea specified amount of cash or other financial instrument from the first entity on demand or on orbefore a specified date. Unconditional receivable�payable contract include items considered to becash equivalents such as short�term or long�term note payables.]


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28. Which of the following statements regarding unconditional receivable�payable contracts is most accurate?(Page 295)

a. If a stockholder receives a payment as a loan, it is considered a financial instrument. [This answer isincorrect. A payment as a loan to a stockholder is a contractual right and obligation. But, if it will be settledthrough a charge to compensation or a dividend, it is not a financial instrument because the charge is nota transfer of a financial instrument.]

b. If a supplier receives a prepayment, it is considered a contractual obligation to provide products.[This answer is correct. A prepayment to a supplier is a contractual right and obligation to providemerchandise. It is not a financial instrument, however, since it will be settled through the shipmentof merchandise rather than the transfer of a financial instrument.]

c. If a supplier receives a prepayment under a membership agreement, it is considered a financial instrument.[This answer is incorrect. A prepayment under a liability insurance contract or under a membershipagreement is a contractual right and obligation to provide services. It is not a financial instrument, however,because it will be settled by providing services rather than transferring a financial instrument.]

29. Boy's Gym has a contract with Basketball City (BC). However, if BC does not deliver the promised goods bythe date specified in the contract, it will cost Boy's Gym a significant amount gross profit by not being able tosupply the goods to prepaid customers. This is an example of what type of risk? (Page 297)

a. The risk of theft or physical loss. [This answer is incorrect. No theft or physical loss took place in thescenario above; therefore, this scenario is an example of one of the other two types of risk that can resultin accounting loss.]

b. Market risk. [This answer is incorrect. Market risk is defined as the possibility that future changes in marketprices may make a financial instrument less valuable or more onerous. Because the risk in the scenarioabove has to do with the parties in the contract and not the market for the goods that will be delivered, itwould not be an example of market risk.]

c. Credit risk. [This answer is correct. Credit risk is defined as the possibility that a loss may occur fromthe failure of another party to perform according to the terms of a contract. Credit and marketdisclosures relate to the risk of an accounting loss. Accounting loss is essentially a charge to netassets that would result from losing the contractual right or settling the contractual obligation of afinancial instrument.]

30. A contractual obligation under a financial guarantee is affected by credit risk. Which of the following indicatesa credit risk threat associated with an obligation? (Page 298)

a. The threat that the party will default the debt guarantee. [This answer is correct. A contractualobligation under a financial guarantee is subject to the risk that the party whose debt is guaranteedwill default on the guarantee and the obligation will not be satisfied. This indicates a credit risk sinceit is the possibility that a loss may occur from the failure of another party to perform according tothe terms of a contract.]

b. The threat that the financial issuer's guarantee will default. [This answer is incorrect. A contractual right,not a contractual obligation, under a financial guarantee is subject to the risk that the issuer of the financialguarantee will not pay in the event of a default.]

c. The threat that the balance due will not be paid by the other party. [This answer is incorrect. A contractualright, not a contractual obligation, under an unconditional receivable contract such as a cash equivalent,trade accounts receivable, or note receivable is subject to the risk that the other party will not pay thebalance due.]

d. The threat that the financial institution will default when cash is requested. [This answer is incorrect. Thecontractual right, not a contractual obligation, to cash deposits is subject to the risk that the financialinstitution will not pay when the cash is requested.]


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31. Comfort House has a concentration of credit risk, due to a significant portion of its assets are deposited in onefinancial institution. When disclosing this credit risk associated with the financial institution, which amountshould Comfort House use? (Page 299)

a. The amount of outstanding checks. [This answer is incorrect. The bank will not reduce its deposit liabilityuntil checks clear. In the event of a bank failure, the bank would be responsible for its deposit liability, notthe deposit liability reduced by outstanding checks. Comfort House would be required to satisfyoutstanding checks with other funds. Therefore, this type of deposit should not be disclosed in the abovescenario.]

b. The bank statement balance. [This answer is correct. Best practices indicate that the amount ofcredit risk that should be disclosed is the cash balance reported by the financial entity (i.e., the bankstatement balance). The objective of this disclosure requirement is to disclose concentrations ofcredit risk that result from maintaining cash deposits in financial entities.]

c. The amount of deposits in transit. [This answer is incorrect. The financial institution generally is notresponsible for deposits in transit. The credit risk that exists related to undeposited receipts is the possibilitythat the debtor will not replace the receipt, not the risk that the financial entity will fail to perform. Depositsreceived by the bank after its daily cutoff would have the same credit risk as those for undeposited receipts.Therefore, these types of deposits should not be disclosed in the above scenario.]

32. Which of the following is correct regarding insured amounts with financial institutions? (Page 300)

a. The FDIC provides insurance for deposits with broker�dealers. [This answer is incorrect. The SecuritiesInvestor Protection Corporation (SIPC) provides insurance for deposits with broker�dealers that is similarto that provided by the FDIC.]

b. Any repurchase agreements held are insured by the FDIC. [This answer is incorrect. Repurchaseagreements are uninsured, but they are secured by pools of marketable securities of federal agencies.]

c. The FDIC insures the deposits of many banks, up to a certain limit. [This answer is correct. TheFederal Deposit Insurance Corporation (FDIC) is a federal agency that insures the deposits of manybanks. It covers up to $250,000 of a depositor's regular checking accounts, interest�bearingchecking accounts, money market accounts, and certificates of deposit in a bank.]

d. A company cannot consider their credit risk for cash deposits reduced by the amount of the insuranceprovided by the FDIC. [This answer is incorrect. GAAP does not address this issue; therefore, it is a matterof professional judgment. Some accountants argue that it should not. They believe that insurance merelydecreases the likelihood of loss but does not affect the overall amount of credit risk. Another view is thatcredit risk for cash deposits should be reduced by amounts that are federally insured. Federal insurancewill fail only in the event of a national financial catastrophe, and such a negligible risk should be ignoredfor purposes of disclosing concentrations of credit risk.]

33. Which of the following statements is most accurate regarding applying fair value of financial instrumentsdisclosure requirements? (Exhibit 2�1)

a. Disclosure requirements apply to the fair value of all financial instruments. [This answer is correct.FASB ASC 825�10�50�10 requires disclosure of the fair value of all financial instruments for whichit is practicable to estimate the value.]

b. If a financial instrument is excluded from fair value disclosure requirements, other disclosure requirementswill apply. [This answer is incorrect. According to FASB ASC 825�10�50 (formerly SFAS No. 107),disclosure requirement will not apply if a financial instrument if specifically excluded from fair valuedisclosure requirements.]


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c. If a financial instrument is not excluded from fair value disclosure requirements but the instrument doesalready carry an approximate fair value, additional fair value disclosure will be required. [This answer isincorrect. If a financial instrument is not excluded from fair value disclosure requirements and does carryvalue already approximate fair value, no additional fair value is required per FASB ASC 825�10�50 (formerlySFAS No. 107).]

d. If other GAAP conditions already require fair value disclosure, then additional fair value disclosures will berequired for the financial instrument. [This answer is incorrect. If other GAAP prerequisites already requirefair value disclosure, then no additional fair value disclosure is required by FASB ASC 825�10�50.]

34. Comfort House makes fair value disclosures about its financial instruments in its financial statements. Whichof the following statements best describes an aspect of that process? (Page 304)

a. Financial instruments should be summarized in a table with the fair value and the related carryingamounts and cross�referenced to the note disclosures. [This answer is correct. A summary tablemust be provided that includes fair value and related carrying amounts of all financial instruments,with each cross�referenced to the note that provides the other fair value disclosures, if the fair valueof financial instruments disclosures are made in more than one note.]

b. The organization should aggregate the fair values of all financial instruments included in the financialstatements. [This answer is incorrect. Fair values of financial instruments should not be combined,aggregated, or netted with fair values of other financial instruments except where netting is allowed underFASB ASC 210�20�45�1 and 815�10�45�5 (formerly FASB Interpretation No. 39) or FASB ASC 210�20�45�11through 45�17 (formerly FASB Interpretation No. 41).]

c. The organization should not mention financial instruments for which it is not cost effective to disclose thefair value. [This answer is incorrect. When it is not cost effective to disclose the fair value of a financialinstrument, the pertinent information about the financial instrument (such as the carrying amount, effectiveinterest rate, and maturity) and the reasons why estimating fair value is not cost effective should bedisclosed in accordance with FASB 825�10�50.]

d. For each financial instrument, the organization must disclose fair value in the notes to the financialstatements. [This answer is incorrect. According to FASB ASC 825�10�50, the fair value of a financialinstrument should be disclosed either in the body of the financial statements or in the notes.]


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RISKS AND UNCERTAINTIES

In general terms, uncertainty stems from the inability to predict the future, and risks exist because uncertaintyexists. FASB ASC 275 (formerly SOP 94�6, Disclosure of Certain Significant Risks and Uncertainties) requiresfinancial statements to

� Disclose risks and uncertainties that could significantly affect the amounts reported in the financialstatements in the near term or the near�term functioning of the company.

� Communicate to financial statements users the inherent limitations in financial statements.

GAAP does not require disclosure of all risks and uncertainties, which would be an impossible task, but requiresdisclosure of certain risks and uncertainties that meet specified criteria. FASB ASC 275�10�50�1 (formerly SOP 94�6)requires disclosure in the following four areas:

� Nature of operations

� Use of estimates in the preparation of financial statements

� Certain significant estimates

� Current vulnerability due to certain concentrations

The first two disclosures, nature of operations and use of estimates, are required for all financial statements. Thesecond two are required only for estimates and concentrations that meet specified criteria. The following para�graphs discuss these disclosure requirements in detail and provides practical guidance for applying the disclosurerequirements.

Scope and Applicability

The disclosure requirements apply regardless of an entity's size and also apply to interim financial statements.They are not required in condensed or summarized interim financial statements. Certain risks and uncertainties areexplicitly excluded from the disclosure requirements, including those that might be associated with the following:

� Management or key personnel (for example, loss of the owner/manager of a small business)

� Proposed changes in government regulations

� Proposed changes in accounting principles

� Deficiencies in a company's internal control structure

� Acts of God

� War

� Sudden catastrophes

Nature of Operations

All financial statements should include a description of the major products or services the reporting entity sells orprovides and the entity's principal markets, including the locations of those markets. If the entity operates in morethan one business, disclosures must indicate the relative importance of each business and the basis for determin�ing relative importance. Relative importance can be based on such things as assets, revenues, or net income, anddoes not have to be quantified. It can be communicated by using terms such as �predominantly," �about equally,"or �major."


318

Many financial statements already disclose the nature of the company's operations, including its major products orservices, and concentrations of credit risk. If all or most of a company's sales are credit sales, the disclosure forconcentrations of credit risk may accomplish the disclosure of the company's principal markets. Consequently, thedisclosure requirements will often require only minor modification of existing disclosures. Additional modificationmight be necessary if, for example, the company operates in more than one business. The following are examplesof disclosures of an entity's nature of operations:

Friendly Car Dealership (the Company), is principally engaged in the sale and service of new and usedvehicles in Seattle, Washington. The Company operates as a franchised dealer for Domestic Manufac�turer, Inc. and Foreign Manufacturer, Inc. The Company also leases vehicles under long�term leases tobusinesses and individuals primarily in the Seattle area.

* * * * *

Do�It�Right Contractors, Inc. acts as the general contractor in constructing multi�family residential build�ings in the Greater Chicago area. In addition, it provides property management services throughout theMidwest United States. The two business units are about equal in size based on gross profit contribu�tions to the Company.

* * * * *

Southwest Sporting Goods, Inc. is engaged in retail sales of sporting goods with 17 stores located inTexas, Arkansas, Louisiana, Oklahoma, and New Mexico.

Use of Estimates

GAAP requires financial statement disclosures to include an explanation that preparation of financial statementsrequires the use of management's estimates. The disclosure will usually be standardized (that is, boilerplate). Thefollowing are examples of disclosures regarding the use of estimates:

The preparation of financial statements in conformity with generally accepted accounting principlesrequires management to make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reporting period. Actual results coulddiffer from those estimates.

* * * * *

Management uses estimates and assumptions in preparing financial statements. Those estimates andassumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assetsand liabilities, and the reported revenues and expenses. Actual results could differ from those estimates.

While best practices indicate that most financial statements will use the preceding standardized language todisclose the use of estimates, that may not be appropriate in all cases. For example, estimates may not bepervasive in the financial statements of some small companies with simple operations, or some financial state�ments may not include any estimates.

Certain Significant Estimates

GAAP requires additional disclosures for certain significant estimates. According to FASB ASC 275�10�50�8 (for�merly SOP 94�6), disclosure regarding an estimate is required when known information available before thefinancial statements are available to be issued indicates that both of the following criteria are met:

� It is at least reasonably possible that the estimate of the effect on the financial statements of a condition,

situation, or set of circumstances that existed at the date of the financial statements will change in the nearterm due to one or more future confirming events. [Emphasis added.]

� The effect of the change would be material to the financial statements."


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Existing Condition. The italicized wording in the first criterion along with the requirement that disclosure beevaluated based on known information available before the financial statements are available to be issued, isintended to clarify that accountants are not expected to predict future events. Essentially, the italicized wordingmeans that (a) the estimate is based on conditions that existed at the date of the financial statements and (b) thedisclosure criterion is met when it is known to be at least reasonably possible that the estimate will change due tofuture events. Some believe that the italicized wording has no real effect, and the first criterion is more easilyunderstood if read without it.

Reasonably Possible. While the �existing condition" requirement helps to narrow the range of estimates that meetthe criterion, the range is still very broad. That is primarily because of the use of the term reasonably possible, whichhas the same meaning in FASB ASC 275 (formerly SOP�94�6) as it does in FASB ASC 450 (formerly SFAS No. 5,Accounting for Contingencies). FASB ASC 450�20�20 (formerly SFAS No. 5) provides the following definitions:

� 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 thanlikely.

� Remote. The chance of the future event or events occurring is slight.

Consequently, �reasonably possible" means anything more than remote but less than probable. FASB ASC275�10�50�8 (formerly SOP 94�6) uses the phrase at least reasonably possible, which means anything more thanremote, or slight. The ranges of probabilities can be depicted as follows:

0% 100%

Remote(or slight)

Reasonably possible Probable(or likely)

0% 100%

Remote(or slight)

At least reasonably possible

There is no requirement to assign quantitative amounts to the range of probabilities. In fact, strict use of quantitativeguidelines is discouraged because it might restrict the accountant's and auditor's ability to apply judgment basedon the individual circumstances of each situation. However, quantitative guidelines can be helpful as a rule ofthumb. Best practices indicate that the interpretation of reasonably possible has varied in practice. Some interpretit to mean a likelihood of 15�20% or more, whereas others use 20�30% or more. In some cases, even a higherthreshold (such as 40% or more) or a lower threshold may be appropriate. Accountants must apply judgmentbased on the individual circumstances of each situation. Disclosure should generally be considered more closelywhen a condition, situation, or set of circumstances makes an estimate more susceptible to change than itordinarily would be. In addition, the more critical an estimate is to the financial statements, the more likely it is thatdisclosure is needed. As a practical matter, the disclosure can be used to provide an early warning to financialstatement users that certain estimates, based on the best information available, are still somewhat soft.

Near Term. This term is defined in FASB ASC 275�10�20 (formerly SOP 94�6) as �a period of time not to exceed oneyear from the date of the financial statements."

Material. The second criterion in the earlier paragraph �Certain Significant Estimates," is that the effect of thechange would be material to the financial statements. FASB ASC 275�10�50�14 (formerly SOP 94�6) goes on tostate:

Whether an estimate meets the criteria for disclosure .�.�. does not depend on the amount that hasbeen reported in the financial statements, but rather on the materiality of the effect that using a


320

different estimate would have had on the financial statements. Simply because an estimateresulted in the recognition of a small financial statement amount, or no amount, does not meanthat disclosure is not required�.�.�. [Emphasis added.]

Consequently, disclosure might be required even if no estimate is recognized in the financial statements (that is, theestimate is zero).

Estimates to Which this Disclosure Applies. The types of estimates that should be considered for disclosure arethose used in the determination of the carrying amounts of assets or liabilities or in the disclosure of gain or losscontingencies. In other words, the disclosure requirements relate to estimates used to determine (a) recordedamounts and (b) disclosures of gain or loss contingencies. The disclosure requirements do not apply to estimatessuch as those used when disclosing the fair value of financial instruments in accordance with FASB ASC 825�10�50(formerly SFAS No. 107). Also, disclosure should be considered for every estimate in the financial statements, butdisclosure is not necessarily required for every estimate in the financial statements. As noted previously, disclosureshould generally be considered more closely when a condition, situation, or set of circumstances makes anestimate more susceptible to change than it ordinarily would be. In addition, the more critical an estimate is to thefinancial statements, the more likely it is that disclosure is needed. As a practical matter, the disclosure can be usedto provide an early warning to financial statement users that certain estimates, based on the best informationavailable, are still somewhat �soft," and changes in them may affect future financial statements.

Known Information. The criteria in the paragraph above are to be considered using �known information availablebefore the financial statements . . . are available to be issued." Therefore, if management is unaware of informationthat would cause a significant estimate to change, disclosure is not required. However, that does not mean thatdisclosure can be avoided by the failure of management to exercise due care to be informed about relevant trends,events, and uncertainties that would be expected to affect significant estimates. This requirement is essentially thesame as that of FASB ASC 450�20�25�2 (formerly SFAS No. 5) which refers to �information available before thefinancial statements . . . are available to be issued."

Illustrative Disclosures. If an estimate meets the criteria for disclosure, the disclosure must:

� Describe the nature of the uncertainty, and

� Indicate that it is at least reasonably possible that a change in the estimate will occur in the near term(although use of the words reasonably possible is not required).

In addition, if the estimate involves a loss contingency subject to FASB ASC 450 (formerly SFAS No. 5), the losscontingency disclosure requirements must also be considered. As a result, the disclosure must include an estimateof the possible loss or range of loss, or state that such an estimate cannot be made. Disclosure of the factors thatcause the estimate to be subject to change is encouraged but not required.

The following are examples of disclosures that meet these requirements:

Specialized drilling equipment is depreciated over its remaining useful life using the units�of�productionmethod. Due to current industry conditions, it is at least reasonably possible that the estimated remain�ing life of the equipment will change in the near term.

* * * * *

Recently, a large public construction company entered Hometown's primary market of Amarillo, Texas.Due to potential market loss, it is reasonably possible that the amount of the Company's deferred taxasset that it expects to be realized might change in the near future.

* * * * *

As a result of recent changes in the Company's market for certain products, carrying amounts for thoseinventories have been reduced by approximately $60,000 due to quantities in excess of current require�ments. Management believes that this reduces inventory to the lower of cost or market, and no addi�


321

tional loss will be incurred upon disposition of the excess quantities. While it is at least reasonablypossible that the estimate will change materially in the near term, no estimate can be made of the rangeof additional loss that is at least reasonably possible.

Including a disclosure about an inventory valuation allowance (or about any estimate) should not be considered anindication that the estimate is materially misstated. It is merely an indication that the chances of the estimatechanging by a material amount in the near term is more than remote.

If a company has a number of estimates that have a reasonable possibility of changing within the next year by amaterial amount, it is possible to combine the disclosures about significant estimates into one financial statementnote. That approach is illustrated for a construction contractor as follows:

Significant estimates used in preparing these financial statements include those assumed in computingprofit percentages under the percentage�of�completion revenue recognition method, those used indepreciating the Company's equipment, and those used in recording a liability for outstanding claims.It is at least reasonably possible that the estimates used will change within the next year.

To take the approach one step further, it is possible to combine the significant estimates disclosure with thedisclosure about the general use of estimates, as follows:

Management uses estimates and assumptions in preparing financial statements. Those estimates andassumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assetsand liabilities, and reported revenues and expenses. Significant estimates used in preparing thesefinancial statements include those assumed in computing profit percentages under the percentage�of�completion revenue recognition method, and those used in recording a liability for outstanding claims.It is at least reasonably possible that the significant estimates used will change within the next year.

How Do Disclosures of Risks and Uncertainties Relate to Disclosures of Loss Contingencies?

Throughout the preceding discussion of certain significant estimates, numerous references are made to FASB ASC450 (formerly SFAS No. 5). A point of confusion for many practitioners is how the requirements for disclosingcertain significant estimates according to FASB ASC 275 (formerly SOP 94�6) relate to the requirements fordisclosing loss contingencies under FASB ASC 450 (formerly SFAS No. 5). The following paragraphs compare andcontrast the requirements.

Requirements for Loss Contingencies. FASB ASC 450�20�25�2 (formerly SFAS No. 5) requires accrual of losscontingencies if they are probable and can be reasonably estimated. In addition, FASB ASC 450�20�50�3 (formerlyParagraph 10 of SFAS No. 5) requires disclosure of loss contingencies if:

� A loss contingency is probable, but it is not accrued because it cannot be reasonably estimated.

� A loss contingency is reasonably possible, in which case it would not be accrued because it is not probable.

� A loss contingency is probable and is accrued, but an exposure to loss exists in excess of the amountaccrued.

In those situations, the disclosure must indicate the nature of the contingency and must include:

� An estimate of the possible loss or range of loss, or

� A statement that such an estimate cannot be made.

Differences in FASB ASC 275 (formerly SOP 94�6) and FASB ASC 450 (formerly SFAS No. 5). The followingsummarizes the differences in these requirements:

� FASB ASC 275 applies to estimates. FASB ASC 450 does not specifically apply to estimates; it applies tocontingencies. So, for example, FASB ASC 450 would not apply to a profitable long�term contract because


322

no loss contingency is involved. FASB ASC 450 also does not apply to depreciation or amortizationbecause �the eventual expiration of the utility of the asset is not uncertain." Additionally, FASB ASC 450(does not apply to accrued amounts owed for services received, such as advertising and utilities. They arenot contingencies even though the accrued amounts may have been estimated. There is nothing uncertainabout the fact that those obligations have been incurred.

� FASB ASC 450 does not apply to the write�down of long�lived operating assets (such as property, plant,equipment, or intangible assets). FASB ASC 275 does.

� FASB ASC 450 does not confine consideration to the near term, whereas FASB ASC 275 does.

� FASB ASC 450 disclosures are based on �information available before the financial statements are . . .available to be issued," whereas disclosures under FASB ASC 275 are based on �known informationavailable before the financial statements . . . are available to be issued." Best practices indicate, however,that this difference does not affect the application of the documents because the difference is moresemantic than substantive. The FASB ASC 450 guideline seems broader, but has generally been appliedin practice similar to the guideline in FASB ASC 275.

Consequences of Those Differences. Based on the above differences, the disclosure requirements can besummarized as follows:

a. When FASB ASC 450 (formerly SFAS No. 5) and FASB ASC 275 (formerly SOP 94�6) both apply, disclosethe following:

(1) Nature of the uncertainty.

(2) Estimate of possible loss or range of loss, or a statement that such estimate cannot be made.

(3) An indication that it is at least reasonably possible that a change in the estimate will occur in the nearterm.

b. When FASB ASC 450 (formerly SFAS No. 5) applies, but not FASB ASC 275 (formerly SOP 94�6) (forexample, because the change in estimate is not expected to occur in the near term), disclose the following:


(2) Estimate of possible loss or range of loss, or a statement that such estimate cannot be made.

c. When FASB ASC 275 (formerly SOP 94�6) applies, but not FASB ASC 450 (formerly SFAS No. 5) (forexample, because the estimate relates to property and equipment, an intangible asset, or a profitablelong�term contract) disclose the following:


(2) An indication that it is at least reasonably possible that a change in the estimate will occur in the nearterm.

Current Vulnerability Due to Concentrations

FASB ASC 275�10�50 (formerly SOP 94�6) also requires disclosure of concentrations that meet certain criteria. Thetypes of concentrations that must be considered for disclosure are as follows:

� Concentrations in the volume of business transacted with a particular customer, supplier, lender, grantor,or contributor.

� Concentrations in revenue from particular products, services, or fund�raising events.


323

� Concentrations in the available sources of supply of materials, labor, or services, or of licenses or otherrights used in the entity's operations.

� Concentrations in the market or geographic area in which an entity conducts its operations.

Certain of the concentrations are already disclosed in some financial statements. One example is economicdependence on major customers or suppliers. Another example is disclosure of concentrations of credit risk.Although concentrations of financial instruments are specifically excluded from the requirement to disclose vulner�abilities due to concentrations disclosure of market or customer concentrations may provide the necessary disclo�sure for credit risk concentrations also.

What Is a Concentration? FASB ASC 275�10�50�16 (formerly SOP 94�6) states that:

Vulnerability from concentrations arises because an entity is exposed to risk of loss greater thanit would have had it mitigated its risk through diversification.

A concentration is of concern when it involves something that cannot be easily replaced. If, for example, a companypurchases most of its raw material from a single supplier, that is not a concentration unless the supplier cannot beeasily replaced. Concentrations may not necessarily be identifiable solely on the basis of dollars. For example, if acompany purchases only a small amount of raw material from a supplier, but that raw material is critical to thecompany's production process, a concentration exists if the supplier cannot be easily replaced.

Criteria for Disclosure. Disclosure of concentrations is required only if certain criteria are met. Those criteria areas follows, and they must all be met for disclosure to be required:

� The concentration exists at the date of the financial statements.

� The concentration makes the entity vulnerable to the risk of a near�term severe impact.

� It is at least reasonably possible that the events that could cause the severe impact will occur in the nearterm.

The criteria are similar in some ways and use some of the same wording as the criteria mentioned earlier in thislesson for disclosing certain significant estimates. For example, the concentration must be an �existing condition,"and must be �at least reasonably possible." Also, the criteria are to be considered using �information known tomanagement before the financial statements are issued or are available to be issued." Those and other terms usedin both sets of criteria are discussed in prior paragraphs.

Major Customers and Foreign Operations. The third criterion discussed earlier is always considered to be met forthe following concentrations:

� Concentrations in the volume of business transacted with a particular customer.

� Foreign operations.

As a result, disclosure is required if those concentrations exist at the date of the financial statements and their losscould cause a severe impact to the company. GAAP does not prohibit the disclosure from stating that the companydoes not expect that the business relationship with the customer will be lost (or the foreign operations will bedisrupted).

Severe Impact. The second criterion discussed earlier uses the term �severe impact." It is defined in FASB ASC275�10�20 (formerly SOP 94�6) as follows:

A significant financially disruptive effect on the normal functioning of an entity. Severe impact is ahigher threshold than material. Matters that are important enough to influence a user's decisionsare deemed to be material, yet they may not be so significant as to disrupt the normal functioningof the entity .�.�.�. The concept of severe impact, however, includes matters that are less thancatastrophic.


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Thus, severe impact is a significant financially disruptive effect on the normal functioning of the company. It is morethan just material, but less than catastrophic. An example of a catastrophic event is one that would result inbankruptcy, such as the inability to obtain financing.

Loss of Owner/Manager. Individual owners/managers play a critical role in the success and viability of many smallbusinesses. The loss of such an owner/manager would in many cases have a severe impact on the business.However, disclosure of this concentration is not required. Disclosure of the risks and uncertainties associated withmanagement or key personnel is not required.

Group Concentrations. Even if a company does not have concentrations with another entity or individual, thecompany might still have group concentrations that require disclosure. Group concentrations exist if a number ofcounterparties or items that have similar economic characteristics collectively expose the reporting entity to aparticular kind of risk. So even if, for example, a company does not have a single major customer, it may have adisclosable concentration if a group of customers has similar economic characteristics. Such a concentrationwould exist if a small retail shop is located near a large resort and most of the shop's customers are visitors at theresort.

Example Disclosures. For concentrations meeting the criteria for disclosure, disclosures must include informationthat is adequate to inform financial statement users of the general nature of the risk associated with the concentra�tion. Additional specific disclosures are required for concentrations of labor subject to collective bargainingagreements and for foreign operations. The following are examples of concentrations disclosures that meet theserequirements:

Cut�Rite Tree Trimming Services conducts virtually all of its operations under a contract with a local utilitycompany.

* * * * *

A majority of the computer chips used by the Company in its manufacturing process is supplied by Extel,Inc.

* * * * *

Helena Corporation has exclusive rights in the United States to produce and sell hair dryers bearing thename of a well�known personality in the hair care industry. Approximately 85% of Helena's revenues arederived from sales of the hair dryers.

Summary of Disclosure Requirements. Exhibit 2�2 summarizes the disclosure requirements for significant risksand uncertainties.


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Exhibit 2�2

Disclosing Significant Risks and Uncertainties

Nature ofOperations

Use ofEstimates

Certain SignificantEstimates Concentrations

When ToDisclose?

Always. Always. � It is at least reason�ably possible thatthe estimate of theeffect on the finan�cial statements ofan existing condi�tion will change inthe near term dueto future confirm�ing events.

AND

� The change in esti�mate would have amaterial effect onthe financial state�ments.

� A concentrationexists at the financialstatement date.

AND

� The concentrationincreases the com�pany's vulnerabilityto the risk of a near�term severe impact.

AND

� It is reasonably pos�sible that the eventsable to cause thesevere impact couldoccur in the nearterm.

Threshold forDisclosing?

N/A N/A Potential material effecton financial statements.

Potential severe impact tothe company.

What ToDisclose?

� Description ofproducts orservices.

� Relative impor�tance of eachbusiness.

� Basis used todetermine rela�tive impor�tance of eachbusiness.

� Principal mar�kets and loca�tions of themarkets.

Explanation thatmanagementestimates areused in preparingfinancial state�ments.

� Nature of uncer�tainty.

� An indication that itis at least reason�ably possible that achange in the esti�mate will occur inthe near term.

� Concentrations inbusiness volumeconducted with aparticular customer,supplier, lender,grantor, or contribu�tor.

� Concentrations inrevenue from particu�lar products, ser�vices, or fund�raisingevents.

� Concentrations inavailable sources ofmaterials, labor, ser�vices, licenses, orrights.

� Concentrations in thegeographic area ormarkets in which acompany operates.

* * *


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Practical Considerations for Disclosing Significant Risks and Uncertainties

Paragraphs at the beginning of this section discuss the requirements for disclosing significant risks and uncertain�ties in detail. In the following paragraphs, practical guidance is offered for applying those requirements and thedisclosures typically required for small and medium�sized entities.

Nature of Operations. Using the following guidelines, a single description generally can address a company'smajor products or services, principal markets, and lines of business:

a. Major Products or Services. Describe broad product and service groups. If the income statement presentssales by major product line, either repeat the major product lines or use a broader description.

b. Principal Markets. General descriptions of industry and geographical concentrations normally give thereader enough information about principal markets, such as �sells mainly to individuals in Lane and thesurrounding counties" or �distributes soft drinks in the metropolitan area."

c. Lines of Business. Lines of business are not the same as major products and services, and most small andmedium�sized entities have only one line. If there is more than one, disclose the relative importance of eachline to the entity's financial results and describe how that determination was made. Often the most efficientapproach for drafting the disclosure is to ask management how it views the importance of the lines.Typically, management will describe the lines' relative importance with words and phrases such as �aboutequal" and �mostly" and rough percentages such as �60%/40%." Those same types of words may be usedin the note disclosure. (Some companies take the position that if the income statement clearly reflects therelative importance of the company's different lines of business, no additional disclosures are required.)

The nature of operations disclosure generally will be either in the first note, with the summary of significantaccounting policies, or combined with a note on credit risk, but may sometimes be provided as a required part ofspecialized industry disclosures.

a. Disclosed in the First Note. The heading of the first note might be �Nature of Business and (Summary of)Significant Accounting Policies," and the nature of operations disclosure might be the first disclosure in thatnote, with a heading such as �Nature of Business (Activities)." Placement in the first note often is preferablewhen the description is short or does not fit logically with other disclosures. The following is an exampleof such a disclosure:

Lane Buick�GMC Truck, Inc. (Lane) sells new and used vehicles, repair services, and partsprimarily to customers in the Chicago metropolitan area.

b. Disclosed with a Note on Credit Risk. The note might be headed �Nature of Business and Credit Risk." Thisis preferable when the nature of the company's business relates to its credit risk disclosure, as follows:

The Company's operations consist primarily of distributing beer to local customers. Substan�tially all of the Company's sales are under its distributorship agreement with Big FactoryBrewing Company. Because of laws prescribed by the state's Alcohol Beverage ControlBoard, the Company does not grant its customers credit.

c. Disclosed as Part of Specialized Industry Disclosures. Disclosures required for some businesses, such aslessors and franchisors, often can include the nature of operations disclosure, as follows:

NOTE DDESCRIPTION OF LEASING ARRANGEMENTS

Tenor Associates leases its medical office facilities under agreements primarily with compa�nies controlled by its partners. These lease agreements generally provide for a noncancelableterm followed by an option to renew on a month�to�month basis at the same rentals. Theseleases also provide for additional rentals to cover increases in the partnership's operatingcosts. Additional rentals assessed totaled $29,212 in 20X1; there were no assessments in20X0.


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Future minimum lease payments to be received under existing noncancelable operatingleases total $529,667 and are due $406,249 in 20X2 and $123,418 in 20X3. Rental incomeincludes $306,448 in 20X1 and $285,207 in 20X0 from related companies.

General Use of Estimates. The goal of disclosing the use of estimates is to alert readers that certain amountsreported in the financial statements are estimated. While the pervasiveness of estimates depends on the nature ofoperations, a brief discussion of the general use of estimates is usually the most efficient approach. The followingexceptions to disclosure of the general use of estimates may be helpful:

a. Estimates are not pervasive in the financial statements of some small, simple operations. In thosesituations, readers might want to know which amounts are estimated and that no material losses can resultfrom them.

b. If the statements have no estimates, for example, because the assets consist of cash and investments intraded securities, the disclosure is irrelevant and best practices indicate that either of two alternatives isacceptable: (1) omit the disclosure or (2) if the entity is concerned that the reader may question why anestimates note is not included, draft the note to say that there are no estimates. Best practices indicate thatthis situation will be rare.

The disclosure probably is easiest for the reader to follow if it is either presented as an accounting policy orcombined with the nature of operations description.

a. Separate Policy Note. The disclosure often will be disclosed as a separate policy within the �Summary ofSignificant Accounting Policies" note, using a subheading entitled �Use of Estimates." In that case, thefollowing disclosures may be provided:

Generally accepted accounting principles require management to estimate some amountsreported in the financial statements; actual amounts could differ.

or

Because of normal business uncertainties, management must estimate some informationincluded in the financial statements, primarily, the net amounts the Company will realize fromcollecting receivables and the percentage of completion of contracts.

or

Although the preparation of financial statements often requires estimating some information,estimates were not necessary to prepare the accompanying financial statements.

b. Combined with the Nature of Operations Description. If estimates are not pervasive, the use of estimatesdisclosure may be easily included with the nature of operations disclosure. Typically, this will be appropriatefor small, simple operations. As an illustration, assume that a car repair shop has total assets of $178,051,which consist mainly of cash of $105,691, approved insurance payments due of $45,792, and prepaidexpenses of $11,179. Its liabilities total $46,221 and consist of vendor accounts and compensation andpayroll taxes. The following disclosure would be appropriate:

Sam's Family Body Shop, Inc. (Sam's) repairs damaged automobiles and is reimbursedthrough insurance companies. Its customers are located primarily in the Denton metropolitanarea. Preparing the financial statements requires estimating the amounts that will actually bereceived from billings as well as some other amounts. Substantially all of the amounts due atyear�end were subsequently collected.

c. Combined with the Basis of Accounting Disclosure. Combining the use of estimates disclosure with thebasis of accounting disclosure is helpful when a comprehensive basis of accounting other than GAAP isused. Usually, the note is the first or second policy note and is entitled �Basis of Accounting." An appropriatedisclosure under such circumstances follows:


328

The financial statements are prepared on the basis of accounting used for federal and stateincome tax reporting. That basis differs from generally accepted accounting principles pri�marily because accrued bonuses, vacation pay, and warranty costs generally are recognizedonly to the extent they will be paid within prescribed periods. Preparing financial statementson the Company's income tax basis requires estimating these and some other amounts.Actual results normally only vary within a small range.

Certain Significant Estimates. Since variances between estimated and actual amounts will be recorded in futurefinancial statements, readers should be notified if there is a reasonable possibility that a variance from an estimatein the current statements will materially affect the following year's financial statements. Whether estimates need tobe individually identified often depends on whether they are recurring:

a. Recurring Estimates. Usually, the entity has enough history to develop an estimate that will vary only withina range of amounts that would not be material to the financial statements. Exceptions may occur in specialsituations. An example is a valuation allowance for a large balance due from a customer that announcesit is considering Chapter 11 bankruptcy shortly before issuance of the entity's financial statements.

b. New Estimates. Regardless of how much effort goes into new estimates, they often change significantly andsometimes the change is material to the financial statements. A liability under a new warranty program, theestimate of the number of new software packages that will be sold, and pending litigation are examples.

One approach to assessing the likelihood of a material change is to estimate a range and compare the maximumvariance with financial statement materiality.

The disclosure does not need to use the specific terminology such as near term and reasonable possibility. Sincethe readers of the financial statements of small and medium�sized entities probably are not familiar with suchterminology, using alternate language may result in more easily understandable information. Depending on thenature of the estimate, the disclosure might either be presented as a policy note or as a separate note.

a. Policy Note. Including the disclosure for certain significant estimates with the policy note often isappropriate for new estimates that will become recurring estimates in future years, as the followingillustrates:

In 20X1, the Company began selling machinery to foreign entities with the understanding thatit will fix all defects that occur within one year after the customer accepts the machinery. Sincethese are new arrangements, management estimated the cost of warranty claims incurredthrough the end of the year using the results of warranty arrangements with domestic custom�ers. Changes in the estimate will be reported in the results of operations of the years in whichthey occur. As the Company gains experience, it may find in 20X2 that its estimate in 20X1 wasunder or overestimated by an amount that is material to the 20X2 financial statements.

b. Separate Note. As the following illustrates, including the disclosure for certain significant estimates in aseparate note may be helpful when disclosing the effects of a material change in estimate:

In 20X0, the Company began selling machinery to foreign entities with the understanding thatit will fix all defects that occur within one year after the customer accepts the machinery. Sincethese were new arrangements, management estimated the cost of warranty claims incurredthrough the end of the year using the results of warranty arrangements with domestic custom�ers. During 20X1, management found that the estimate was understated by $382,229, whichis included in cost of sales for the year. With this new information, management has revised itsestimation procedures, and the provision at the end of 20X1 is higher than it would have beenusing the same procedures used at the end of 20X0. As the Company gains additionalexperience, it may find that it needs to further revise its estimation procedures. Changes in theestimate will be reported in the results of operations of the years in which they occur; however,management does not expect that the effect of such changes in 20X2 will be material.


329

Current Vulnerability Due to Concentrations. Disclosing current vulnerability due to concentrations informs thereader about concentrations that exist at the balance sheet date and expose the entity to the reasonable possibilityof a severe impact within one year from the balance sheet date.

This lesson interprets the term severe impact to mean a significant change in the way the entity conducts itsbusiness or provides services. That depends on the facts and circumstances. Typically, entities have contingencyplans to compensate for the loss of a concentration. Cutting staff, consolidating operating facilities, and eliminatingprograms are common responses to such a loss. In addition to the related payments such as severance pay andlease termination settlements, delays in response to the loss lead to unabsorbed overhead and detain manage�ment from other responsibilities. Such contingency plans by management probably indicate the existence ofconcentrations that should be disclosed.

Revenue from Particular Customers, Grantors, or Contributors. Deciding whether to disclose sources ofrevenue based on whether management would change operations significantly in response to their loss is recom�mended. For example, if management would eliminate staff positions in response to the loss of a major customer,the reader should be informed; otherwise, disclosure is not helpful. While disclosure depends on the facts andcircumstances, the authors believe the following guidelines are helpful:

a. If the source comprises at least 30�40% of total revenue, there is a rebuttable presumption that loss of thesource would require a significant change in operations:

(1) If 40% of revenues are from a large customer serviced through separate, dedicated facilities, onemight argue that closing the facilities would not be disruptive. However, it probably would requiresignificant changes in operations, for example, to negotiate lease termination payments andseverance arrangements with employees at the facility.

(2) If 40% of revenues come from one customer, there is a rebuttable presumption that loss of thecustomer would cause management to significantly change operations. Nevertheless, if thecustomer's account has an unusually low margin and the entity's staff and production capacity arealready strained, management might not have to change operations at all if it lost the customer.Disclosing the existence of the customer in that instance might unnecessarily alarm readers of thefinancial statements.

b. If the condition in Step a. does not exist, but loss of the source would have a material adverse effect on keyoperating statistics (such as causing violations of debt covenants or negative cash flows from operatingactivities), there is a rebuttable presumption that the loss would require a significant change in operations.For example, if a customer comprises 25% of revenues but the entity has only a marginal cash flow fromoperating activities and has excess capacity, loss of the customer probably would cause management tosignificantly change operations. This usually will be the case with not�for�profit organizations with largecontributors. Even if the contributor funds a special program, eliminating the program usually is disruptiveto normal operations. In addition, since potential donors and others might view the organization differentlyif it eliminated a program, such action often must be taken carefully.

c. If neither of the conditions in Steps a. and b. exists, there is a rebuttable presumption that loss of the sourcewould not cause a significant change in operations.

As a practical matter, the management of most small and medium�sized entities normally can readily assesswhether the loss of a source would significantly disrupt their operations.

The goal of the disclosure is to inform the reader of risk associated with concentrations of revenue. The way that isaccomplished is flexible, as indicated below:

a. Naming the customer is unnecessary. For example, the disclosure could refer to a local chain of homeimprovement stores or contracts with a state agency.

b. If the source is disclosed in the statements, such as revenue from United Way, additional disclosure in thenotes is unnecessary.


330

c. The requirement only applies to continuing relationships; it does not apply to entities that have a smallnumber of different customers each year, such as contractors. Disclosing that the entity is a contractor givessufficient notice to the reader of the risk associated with a constantly changing customer base.Nevertheless, additional disclosure may be helpful, such as when the entity has an unusually large contractor when the inability to complete a contract would require a significant change in operations (for example,because the backlog of contracts was developed considering how long the contract would take tocomplete).

d. The disclosure requirements do not apply to a contributor for a special fund�raising event, such as a capitalcampaign, but it does apply to a contributor to a recurring fund�raising event, such as the sponsor of a largeannual banquet.

e. The disclosure can be provided in a variety of ways. Although general discussions normally are sufficientlyinformative, more detailed disclosures may be helpful.

f. Even though not required, mentioning contingency plans, such as the following, may help keep the readerfrom being unnecessarily alarmed:

Approximately one�third of the revenue for each year is from a local foundation that fundsmost of the costs of the day care program. If that source of revenue were lost and othersources could not be found quickly enough, management would eliminate the program tominimize the damage to the agency's operations.

Revenue from Particular Products, Services, or Fund�raising Events. The goal of this disclosure is the same asthe disclosure of customers and similar sources of revenues. However, accountants must also consider whetherthere is a reasonable possibility that the source will be lost. If so, consider the impact of the loss; if not, no furtherconsideration is needed. Best practices indicate that the risk considerations only are relevant when providing thesource is not within management's control, as in the following situations:

a. If a car dealer sells financing and similar products, the risk of loss is irrelevant. Continuing or discontinuingthe products is entirely within management's control. On the other hand, if there is a reasonable possibilitythat a factory would take the dealer's franchise, the impact of such a loss must be disclosed if managementwould change operations significantly in response to the loss. Normally, that would be the case.

b. If a not�for�profit organization holds a fund�raising event that requires special facilities (such as a stair climbin the tallest building in town) or special permission (such as floating rubber ducks down a river), thelikelihood of not being able to use those facilities or obtain permission must be assessed. If there is areasonable possibility of that, the impact must then be assessed. On the other hand, if there are no suchspecial characteristics and holding the event is entirely within the organization's control, there is no risk todisclose.

Volume of Business with a Supplier or Lender. The reader should know if there is a reasonable possibility of theloss of a supplier or lender that would cause management to change operations significantly. Naming the supplieror lender is not required. Whether the entity is likely to lose the supplier or lender depends on whether the supplieror lender will stop doing business with the entity, not whether the entity will stop doing business with the supplier orlender, as explained below:

a. Usually, franchisees buy most of their products from their franchisor, often because the franchisor requiresit. There is little likelihood of the franchisor no longer selling to the franchisee.

b. Other suppliers usually discontinue relationships only if the entity requires special treatment, for example,unusually favorable payment terms or especially timely delivery so the entity can maintain only minimalinventories.

c. Normally, the need to change lenders is reasonably possible only if the lender has indicated that it will notrenew a line or refinance a balloon payment. The reasonable possibility of having to find new sources oflarge amounts of debt normally is something the reader should know. In that situation, disclosure is mosthelpful if combined with the debt disclosure, as follows:


331

NOTE ESHORT�TERM NOTE

The short�term note is payable to a bank under a $350,000 line of credit that expires inSeptember�20X1. Interest is payable monthly at prime plus 3%. The note is secured by theCompany's customer accounts, inventories, and property and equipment, the assignment ofan insurance policy on the life of its majority stockholder, and real estate owned by him. Thenote is guaranteed by the Company's stockholders and the wife of the majority stockholderand contains covenants that relate primarily to financial results. The bank has indicated that itwill not renew the line when it expires, and management has begun negotiations with otherbanks to refinance the note.


332


333

SELF�STUDY QUIZ


35. Comfort House includes a disclosure in the notes to its financial statements that informs financial statementusers about its reliance on sales from certain comforters for a major portion of its revenue source that may bedifficult to obtain in the near future due to a strike at their supplier. What type of disclosure is this?

a. Current vulnerability.

b. Use of certain significant estimates.

c. Use of estimates.

d. Nature of its activities.

36. Comfort House is determining which estimates require disclosure as significant estimates. For an estimate tobe significant, it must be reasonably possible that the effect an estimate has on the financial statements willchange in the near term. How is reasonably possible defined when applying this definition?

a. There is only a slight chance that the future event will occur.

b. The future event has a chance of occurring that is greater than remote but less than likely.

c. The future event that will cause the change is likely to occur.

37. When making the determination on which estimates require disclosure as significant estimates, Comfort Housewould also need to consider which of the following?

a. Disclosure of all estimates used in the financial statements is required.

b. The estimates used to determine the disclosures of gain and loss contingencies and recorded amounts.

c. Estimates resulting in no amount can be excluded from the disclosure.

d. The possibility of change that may occur within two years of the financial statement date.

38. Comfort House must also determine if it has current vulnerabilities due to concentrations that it must disclosein its financial statements. Disclosure is only necessary if three criteria are met. Which of the following is oneof those criteria?

a. The organization is vulnerable to the risk of a severe impact in the near term because of the concentration.

b. The concentration exists for Comfort House at the end of the calendar year.

c. The concentration must meet the definition laid out in FASB ASC 275�10�50�16 (formerly SOP 94�6).

39. Which of the following is a disclosure of a certain significant estimate that should be disclosed in the financialstatements?

a. Nature of uncertainty.

b. Location of principal markets.

c. Explanation that management estimates are used in preparing financial statements.

d. Description of services.


334

40. Comfort House plans to make a disclosure about the nature of its operations using a single description. It plansto put this description in the first note to the financial statements. Information about all of the following shouldgenerally be included in this note, except:

a. Comfort House's principal markets.

b. Comfort House's use of estimates.


335



35. Comfort House includes a disclosure in the notes to its financial statements that informs financial statementusers about its reliance on sales from certain comforters for a major portion of its revenue source that may bedifficult to obtain in the near future due to a strike at their supplier. What type of disclosure is this? (Page 317)

a. Current vulnerability. [This answer is incorrect. Under FASB ASC 275�10�50 (formerly SOP 94�6), entitiesmust consider disclosing certain types of concentrations, such as concentrations in revenue fromparticular products, services, or fund�raising events since they have a significant effect on the financialstatements.]

b. Use of certain significant estimates. [This answer is incorrect. Assuming the criteria are met, GAAP requiresadditional disclosures for certain significant estimates according to FASB ASC 275�10�50�1. Thedisclosure the Comfort House made, as described above, does not include that information.]

c. Use of estimates. [This answer is incorrect. This type of disclosure, as required by FASB ASC 275�10�50�1,would have to provide users an explanation that preparation of financial statements requires the use ofmanagement's estimates. The disclosure described in this scenario does not include that information.]

d. Nature of its activities. [This answer is correct. Under FASB ASC 275�10�50�1, all financialstatements should include a description of the major products or services the reporting entity sellsor provides.]

36. Comfort House is determining which estimates require disclosure as significant estimates. For an estimate tobe significant, it must be reasonably possible that the effect an estimate has on the financial statements willchange in the near term. How is reasonably possible defined when applying this definition? (Page 319)

a. There is only a slight chance that the future event will occur. [This answer is incorrect. This is the definitionof remote under FASB ASC 450�20�20. A reasonably possible event is more likely to happen than a remoteevent.]

b. The future event has a chance of occurring that is greater than remote but less than likely. [Thisanswer is correct. According to FASB ASC 450�20�20, this is the definition of reasonably possible.Consequently, reasonably possible means anything more than remote but less than likely.]

c. The future event that will cause the change is likely to occur. [This answer is incorrect. Under FASB ASC450�20�20, this is the definition of probable. A probable event is more likely to happen than a reasonablypossible event.]

37. When making the determination on which estimates require disclosure as significant estimates, Comfort Housewould also need to consider which of the following? (Page 320)

a. Disclosure of all estimates used in the financial statements is required. [This answer is incorrect. Disclosureshould be considered for every estimate in the financial statements, but disclosure is not necessarilyrequired for every estimate in the financial statements. Disclosure should generally be considered moreclosely when a condition, situation, or set of circumstances makes an estimate more susceptible to changethan it ordinarily would be.]

b. The estimates used to determine the disclosures of gain and loss contingencies and recordedamounts. [This answer is correct. The types of estimates that should be considered for disclosureare those used in the determination of the carrying amounts of assets or liabilities or in thedisclosure of gain or loss contingencies.]

c. Estimates resulting in no amount can be excluded from the disclosure. [This answer is incorrect. UnderFASB ASC 275�10�50�14, it is possible for a disclosure to be required even if no estimate is recognized inthe financial statements (that is, the estimate is zero).]


336

d. The possibility of change that may occur within two years of the financial statement date. [This answer isincorrect. Change that will occur in the near term should be considered. Near term is defined in FASB ASC275�10�20 (formerly SOP 94�6) as �a period of time not to exceed one year from the date of the financialstatements."]

38. Comfort House must also determine if it has current vulnerabilities due to concentrations that it must disclosein its financial statements. Disclosure is only necessary if three criteria are met. Which of the following is oneof those criteria? (Page 323)

a. The organization is vulnerable to the risk of a severe impact in the near term because of theconcentration. [This answer is correct. FASB ASC 275�10�50 (formerly SOP 94�6) requiresdisclosure of concentrations that meet certain criteria. All applicable criteria must be met fordisclosure to be required. One of the three criteria that the concentration must meet is that theorganization be vulnerable to the risk of a near�term severe impact.]

b. The concentration exists for Comfort House at the end of the calendar year. [This answer is incorrect. Oneof the criteria for disclosure of concentrations is that it exists at the date of the financial statements, not atthe end of the calendar year. Those dates might not be the same for all companies.]

c. The concentration must meet the definition laid out in FASB ASC 275�10�50�16 (formerly SOP 94�6). [Thisanswer is incorrect. FASB ASC 275�10�50�16 (formerly SOP 94�6) does not specifically defineconcentration. It states that, Vulnerability from concentrations arises because an entity is exposed to riskof loss greater than it would have had it mitigated its risk through diversification."]

39. Which of the following is a disclosure of a certain significant estimate that should be disclosed in the financialstatements? (Page 324)

a. Nature of uncertainty. [This answer is correct. The nature of uncertainty should be disclosed in thecertain significant estimates. This disclosure only need to be disclosed when it is at least reasonablypossible that the estimate will have an effect on the financial statements due to an existing conditionthat will change in the near term due to future confirming events, and the change in estimate wouldhave a material effect on the financial statements.]

b. Location of principal markets. [This answer is incorrect. The principal markets and location of thosemarkets should be disclosed in the nature of operations, not certain significant estimates. The location ofprincipal markets must always be disclosed.]

c. Explanation that management estimates are used in preparing financial statements. [This answer isincorrect. An explanation that management estimates are used in preparing financial statements shouldbe disclosed in the use of estimates, not certain significant estimates. This explanation must always bedisclosed.]

d. Description of services. [This answer is incorrect. A description of products or services must always bedisclosed in the nature of operations, not certain significant estimates.]

40. Comfort House plans to make a disclosure about the nature of its operations using a single description. It plansto put this description in the first note to the financial statements. Information about all of the following shouldgenerally be included in this note, except: (Page 327)

a. Comfort House's principal markets. [This answer is incorrect. This is part of the nature of activitiesdisclosure, according to the best practices developed using the practical guidance in this course. Thisguidance should help companies make appropriate disclosures, including the nature of activitiesdisclosure. When disclosing principal markets, general descriptions of industry and geographicalconcentrations normally give the reader enough information about principal markets.]

b. Comfort House's use of estimates. [This answer is correct. The goal of disclosing the use ofestimates is to alert readers that certain amounts reported in the financial statements are estimated.]


337


Lesson 2 (PFSTG103)


13. As a significant part of the financial statements, who is responsible for the accompanying note disclosures?

a. Client.

b. CPA.



14. Which of the following statements regarding the arrangement of the notes to the financial statements is correct?

a. Language is used in the notes that reference the CPA who prepared the notes.

b. Notes are presented on a separate page and arranged in the same order as the financial statementcaptions to which they apply.

c. Subsequent events notes are included in the notes section of its financial statements. This will replace thenote as the first note in the section.

d. Various formatting and capitalization for the title of the financial statement notes distinguish them from therest of the financial statements.

15. When preparing a summary of significant accounting policies to include in its financial statements accordingto the guidance in FASB ASC 235�10�50�1, where is the information usually located?

a. In the accompanying audit report.

b. It must be presented on the face of the financial statements.

c. It must be included in the first note to the financial statements.


16. Which of the following, if compared to the other methods for valuing inventory, has a material difference?

a. LIFO.

b. FIFO.

c. Weighted average.

d. Specific identification.

17. All of the following are related�party disclosures for nonpublic companies except:

a. An owner's salary.

b. Sales between affiliated entities.

c. A stockholder's pledged personal assets.

d. A company loan to a stockholder.


338

18. Which of the following statements is most accurate regarding typical leasing arrangements with related parties?

a. Related party transactions for leases only encompass transactions between parties that are either relatedby blood or marriage.

b. Leasing arrangement agreements between related parties may be written or verbal.

c. To qualify as a related party leasing arrangement, the lease must not be cancelable by both parties in theagreement.

d. In certain leasing arrangements when terms of the transaction have been significantly affected by theparties being related, GAAP requires accounting for the form of the transaction.

19. Which of the following would be excluded from the definition of a pension plan?

a. Plans that are not funded.

b. Plans existing under a well�defined but unwritten organization policy.

c. Death and disability payments that occur under a separate agreement.

d. Defined contribution and defined benefit plans.

20. Bettye's Organization is the debtor in a loan agreement that includes restrictive debt covenants. During theperiod covered by the financial statements, Bettye's did not violate any of the covenants. How should theorganization address this contingency in its financial statements?

a. Bettye must obtain a waiver against the possibility of a violation of covenant.

b. Bettye should disclose the contingency and include positive assurance of compliance.

c. Bettye should disclose the contingency, but compliance does not have to be addressed.

d. The organization should address compliance in the note disclosure and assure the reader.

21. In which of the following scenarios has the proper amount of detail been provided in the disclosures regardingcollateral arrangements?

a. Winter Wool Supplies discloses an evaluation stating that its lender's investment is protected.

b. CHP Industries substitutes disclosures for its legal agreements concerning collaterals.

c. Debbie's Dinners includes all assets obtainable for pledging in regards to it collateral arrangements.

d. High Snow Supplies includes a list of assets that are pledged as collateral for loans in its note disclosures.

22. Brown Radiology is named in a malpractice suit brought by a patient against Hope Hospital. The radiologyclinic's attorneys say this is a nuisance suit and that the damages claimed are out of proportion with damagessuffered. The lawyers are willing to state on the record that the chances of an adverse outcome for the clinicare remote. How will this lawsuit affect the clinic's financial statements?

a. The radiology clinic is not required to make any disclosures about the nuisance suit under GAAP.

b. The radiology clinic must include a statement that asserts that the contingency related to the lawsuit is notexpected to be material.

c. The radiology clinic must disclose the nature of the contingency related to the lawsuit and provide anestimate of the possible loss or range of loss (or include a statement that such an estimate cannot bemade).

d. The radiology clinic must include whatever disclosures that hospital decides to include in their financialstatements since they are both named in the lawsuit.


339

23. Which of the following is not considered key to the proper treatment of subsequent events?

a. Identifying the event.

b. Identifying the condition.

c. Effects of the event.

d. When the event arose.

24. Which of the following is an example of a type I subsequent event?

a. Product warranty reserve.

b. Business purchase.

c. Loss of equipment caused by flood.

d. Sale of capital stock issue.

25. In which of the following scenarios are the financial statements available to be issued?

a. The Allman Foundation issued their financial statements when they are publicly distributed to shareholdersfor general use and in a format according to GAAP.

b. The Phillip's Group issued their financial statements when they are compliant to GAAP standards andmanagement and/or significant shareholders approve the issuance.



26. Business combinations should be accounted for using which of the following methods?

a. Allowance.

b. Straight�line.

c. Equity.

d. Acquisition.

27. According to FASB Concepts Statement No. 6, which of the following is excluded from the definition of afinancial instrument?

a. Certificates of interest or participation in an entity.

b. The future portion of a noncancelable operating lease.

c. Short�term investments that have maturities of three months or less.

d. Currency on hand.


340

28. The Children's Foundation enters into a contract with The Lively Group. The contract obligates The Children'sFoundation to deliver a specified amount of cash to The Lively Group if a specified event that is beyond thecontrol of either entity occurs and if the condition is unfavorable to The Children's Foundation. The contractgives The Lively Group the right to receive the cash from The Children's Foundation if said event occurs onpotentially favorable terms. What type of contract is this?

a. Financial guarantee or other conditional exchange.

b. Financial option contract.

c. Conditional receivable�payable contract.

d. Unconditional receivable�payable contract.

29. MJS Industries enters into a financial option contract with Smith Brothers for MJS to provide a loan at a specifiedrate. Smith Brothers paid MJS a fee for the commitment. The market rate on the loan declines and Smith Brotherexercises the commitment. Does this contract qualify as a financial instrument?

a. Yes.

b. No.



30. The Garden Foundation has obligations to pay pension benefits to former employees. Would this obligationbe subject to the disclosure requirements found in FASB ASC 825�10�50�8 and 50�22?

a. Yes, because it is a financial instrument.

b. Yes, because it is a deferred compensation arrangement.

c. No, because it is not a financial instrument.

d. No, because it is specifically excluded by FASB ASC 825�10�50�8 and 50�22 due to concentrations of creditrisk.

31. Which of the following companies has made a required disclosure under FASB ASC 825�10�50�21?

a. The Garden Foundation discloses information about unconditional purchase obligations that are subjectto FASB ASC 440�10�50�2 (formerly SFAS No. 47, Disclosure of Long�Term Obligations) requirements.

b. The Flower Pot discloses information about warranty obligations and rights.

c. The Alpha Group discloses information about the concentrations of credit risk of their financial instrumentsif their customers are affected similarly by economic conditions.

d. The Sigma Group discloses quantitative information about the market risks related to its financialinstruments.

32. The Garden Foundation sells a significant portion of its inventory to three key companies based in the samegeographic region. Disclosures about this situation would concern a concentration of what type of risk?

a. Market risk.

b. Credit risk.

c. The risk of theft or physical loss.



341

33. The Garden Foundation plans to disclose a concentration of credit risk in its financial statements. How mustthat information be disclosed?

a. No disclosure is required in the financial statements for a concentration of credit risk.

b. The organization can make the disclosure in the way that is most efficient and effective for The GardenFoundation.

c. A separate note is required for each credit risk concentration element (cash, accounts receivable, etc.).


34. Specific lease contracts, consolidated subsidiary equity investments, and noncontrolling interest inconsolidated subsidiaries are all examples of which of the following?

a. Derivative financial instruments and hedging activities.

b. Optional disclosures.

c. Fundamental financial instruments.

d. Financial instruments excluded from the fair value disclosure requirements.

35. FASB ASC 275 (formerly SOP 94�6, Disclosure of Certain Significant Risks and Uncertainties) requires that allentities include which of the following in their financial statements?

a. Disclosure of all possible risks and uncertainties.

b. Disclosures related to management, internal control structure deficiencies, and sudden catastrophes.

c. Disclosures of risks and uncertainties that could highly affect the amount reported in the financialstatements.

d. Disclosures of estimates and current vulnerability in certain concentrations.

36. The Garden Foundation includes the following disclosure in its financial statements:

Management used assumptions and estimates to prepare the financial statements. These assump�tions and estimates affect the amounts of assets and liabilities that were reported, the contingentassets and liabilities that were disclosed, and the revenues and expenses that were reported. Actualresults could differ from the estimates.

What type of disclosure is this?

a. Current vulnerability due to certain concentrations.

b. Certain significant estimates.

c. Use of estimates.

d. Nature of operations.

37. What type of estimate is more likely to meet the disclosure criteria for a significant estimate?

a. New estimate.

b. Recurring estimate.




342

38. Which of the following companies has a disclosure for which FASB ASC 450 (formerly SFAS No. 5, Accounting

for Contingencies) applies, but FASB ASC 275 (formerly SOP 94�6) does not?

a. Comfort House has a loss contingency at the financial statement date, and it is remotely possible that theestimate for this contingency will change by a material amount within the next year.

b. The Garden Foundation has an asset that the depreciation will be recalculated due to the life of the assetsbeing extended.

c. The Summer Group has an asset that will be written down due to damage occurring to the asset that couldnot be repaired.

d. The Winter Group has an estimate that affects the financial statements without involving a contingency.

39. Which of the following companies has correctly dealt with a concentration disclosure in its financial statements?

a. Due to a concentration, E�software anticipates there will be a material effect that may influence a user'sdecisions. E�Software expects to lose the business relationship, but decides not to disclose it at this timebecause they have not lost it yet.

b. B�Bay has a concentration in the volume of business it transacts with The Spring Foundation, its biggestcustomer. It discloses this concentration in the financial statements along with a statement that it does notexpect revenue from this customer will be lost.

c. Futuristic has a group of contributors with similar economic characteristics. Because its concentration isnot with a single entity, it does not disclose the concentration in its financial statements.

d. Cross World has a significant concentration of foreign operations. However, because it does not believeit is reasonably possible for anything to occur that would cause a severe impact and disrupt foreignoperations, it does not disclose this concentration.

40. Comfort House must decide whether to disclose sources of revenue in its financial statements and how muchinformation to include if it does make the disclosure. Which of the following pieces of advice might prove helpfulin making this decision?

a. If loss of the source would adversely affect key operating statistics by a material amount, the source shouldbe disclosed.

b. If the source is to be disclosed, its name and relevant information should be included.




343

GLOSSARY

Accrued Liabilities: Estimates of the obligation for expenses that have been incurred but for which no billing hasbeen received.

Cash: Includes not only currency on hand but demand deposits with banks or other financial institutions. Cash alsoincludes other kinds of accounts that have the general characteristics of demand deposits in that the customer maydeposit additional funds at any time and also effectively may withdraw funds at any time without prior notice orpenalty.

Cash Equivalents: Short�term, highly liquid investments that (a) are readily convertible to known amounts of cashand (b) are so near their maturity that they present insignificant risk of changes in value because of changes in interestrates.

Claims�made Insurance Policy: Cover only those asserted claims and incidents that are reported to the insurancecarrier while the policy is in effect. Thus, a claims�made policy does not represent a transfer of risk for claims andincidents that have been incurred but not reported to the insurance carrier.

Current Assets: Cash and other assets that are reasonably expected to be realized in cash or sold or consumedduring one year or within the company's normal operating cycle if it is longer than a year.

Current Liabilities: Obligations whose liquidation is reasonably expected to require the use of current assets or thecreation of other current liabilities.

Debt Covenant: Part of the conditions of a loan agreement, these covenants are the promises by the managementof the borrowing firm to adhere to certain limits in the firm's operations. For example, not to allow certain balancesheet items or ratios to fall below or go over an agreed upon limit.


Deferred Income Tax Liability: Excess of income tax amount shown on an income statement over the actual taxamount, which occurs when book�income exceeds taxable income. This excess is recognized as a liability in thetaxpayer's balance sheet, and is written off in the following accounting period.

Deferred Income Taxes: Noncash expenses.

Deferred Revenue: Revenue that has been received or is receivable before it is earned.

Demand Loan: A loan payable upon the demand of the lender.

Depletion: Allocation of the cost of natural resources to expense as units is removed.

Long�term Debt: Amount owed for a period exceeding 12 months from the date of the balance sheet. It could bein the form of a bank loan, mortgage bonds, debenture, or other obligations not due for one year. A firm must discloseits long�term debt in its balance sheet with its interest rate and date of maturity. Amount of long�term debt is a measureof a firm's leverage, and is distinguished from long term liabilities which may include supply of services already paidfor.

Near Term: A period of time not to exceed one year from the date of the financial statements." That is the same timeperiod established by SAS No. 59 for evaluating an entity's ability to continue as a going concern.

Operating Cycle: The time needed to convert cash first into materials and services, then into products, then by saleinto receivables, and finally by collection back into cash.

Pension Plan: Periodic (usually monthly) payments made pursuant to the terms of the pension plan to a person whohas retired from employment or to that person's beneficiary.


344

Probable: The future event or events is likely to occur.

Reasonably Possible: The chance of the future event or events occurring is more than remote but less than likely.

Recognized (Type I) Subsequent Events: Events that provide additional evidence about conditions that existedat the balance sheet date and that affect the estimates inherent in preparing the financial statements.

Remote: The chance of a future event or events of occurring is slight.

Share�based Payment: A transaction in which an entity issues equity instruments, share options or incurs a liabilityto pay cash based on the price of the entity's equity instruments to another party as compensation for goods receivedor services rendered.

Short�term Debt: Debt payable within 12 months, it includes the current portion of the long�term debt.

Stock Dividends: Generally, an actual or constructive distribution of stock to a corporation's shareholders.

Stock Splits: Division of already issued (outstanding) shares of a firm into a larger number of shares, to make themmore affordable and thus improve their marketability while maintaining the current stockholders' proportionalownership of the firm. The aggregate value of the shares remains the same as before the split, but the price (anddividend) per share declines with the split ratio. For example, if the shares are split by a multiple of two (2:1 split),a share with a par value of $10 becomes two shares, each with a par value of $5.

Unrecognized (Type II) Subsequent Events: Events that provide evidence about conditions that did not exist atthe balance sheet date but arose after that date but before the financial statements are issued or available to beissued.


345

INDEX

A

ACCOUNTING CHANGE� Disclosures 257, 258, 283. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Presentation in statements of cash flows 220, 222. . . . . . . . . . . . .

AGENCY TRANSACTIONS� Presentation in statements of cash flows 219. . . . . . . . . . . . . . . . .

AMORTIZATION� Disclosures 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Intangible assets 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Presentation in statements of cash flows 224. . . . . . . . . . . . . . . . .

ASSET RETIREMENT OBLIGATION� Presentation of settlement in statements of cash flows 216. . . . .

B

BASIC FINANCIAL STATEMENTS� Notes 253. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

BUSINESS COMBINATIONS� Presentation in statements of cash flows 225, 232, 241. . . . . . . . � Subsequent event 280. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

C

CAPTIONS� Debt 266. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Note captions 254. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statement of cash flows 209. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Summary of significant accounting policies 256. . . . . . . . . . . . . .

CASH� Cash and cash equivalents 205, 257. . . . . . . . . . . . . . . . . . . . . . . . � Certificates of deposit 205, 230. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Concentrations of credit risk 297, 298. . . . . . . . . . . . . . . . . . . . . . . � Overdrafts 206. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Pledging 277. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CASH VALUE OF LIFE INSURANCE� Presentation in statements of cash flows 224, 235. . . . . . . . . . . . .

COMPREHENSIVE INCOME� Disclosure in the notes 258. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONCENTRATIONS OF CREDIT RISK 297, 298. . . . . . . . . . . . . . .

CONSOLIDATED OR COMBINED FINANCIAL STATEMENTS� Disclosures 258. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONSTRUCTION CONTRACTORS� Disclosures 258. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONTINGENCIES AND COMMITMENTS� Disclosures

�� Collateral arrangements 276. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Going concern 278. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Lawsuits 279. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Loss contingencies 321. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Obligations under guarantees 277. . . . . . . . . . . . . . . . . . . . . . �� Violation of loan covenants 275. . . . . . . . . . . . . . . . . . . . . . . . .

� Nuisance suits 279. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

D

DEFERRED CHARGES� Debt issue costs

�� Presentation in statements of cash flows 224, 234. . . . . . . . .

DEPLETION� Presentation in statements of cash flows 225. . . . . . . . . . . . . . . . .

DEPRECIATION� ACRS 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in method

�� Planned 258. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 256, 257, 258, 265. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Presentation in statements of cash flows 225. . . . . . . . . . . . . . . . .

DERIVATIVES� Disclosures 258, 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DISCLOSURES� Accounting changes 257, 258, 283. . . . . . . . . . . . . . . . . . . . . . . . . � Accounting policies 256, 265. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Accounting principles

�� Alternative principles 256. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Methods that approximate GAAP 256. . . . . . . . . . . . . . . . . . . . �� Unique industry practice 256. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Unusual applications of GAAP 256. . . . . . . . . . . . . . . . . . . . . .

� Advertising 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Amortization 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash equivalents 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Commitments and contingencies

�� Collateral arrangements 276. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Going concern 278. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Lawsuits 279. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Loss contingencies 321. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Obligations under guarantees 277. . . . . . . . . . . . . . . . . . . . . . �� Restrictive debt covenants 275. . . . . . . . . . . . . . . . . . . . . . . . .

� Comparative financial statements 254. . . . . . . . . . . . . . . . . . . . . . . � Comprehensive income 258. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Concentrations 322, 329. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Consolidated financial statements 258. . . . . . . . . . . . . . . . . . . . . . � Credit and market risk 297. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Debt covenants 275. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined contribution pension and other postretirement

benefit plans 275. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deposits 299. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Depreciation 256, 257, 258, 265. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Derivatives 258, 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Discontinued operations 284. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Environmental remediation costs 284. . . . . . . . . . . . . . . . . . . . . . . � Fair value 301. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Financial instruments 293. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes

�� Components of net deferred tax assets and liabilities 266, 267. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Loss carryforwards 266, 268. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Permanent differences 271. . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Reconciliation of expected and actual tax rate 266, 270. . . . . �� Tax credits 266, 271. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Tax rates 266, 270. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Temporary differences 258, 266. . . . . . . . . . . . . . . . . . . . . . . . . �� Variations in customary relationships 266, 270. . . . . . . . . . . . .

� Interest 266. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Inventories 257, 258, 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Investmentsequity method 258, 281. . . . . . . . . . . . . . . . . . . . . . . � Investment tax credits 266, 271. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Leases 274. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Long�term construction contracts 258. . . . . . . . . . . . . . . . . . . . . . . � Long�term debt 265. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Marketable securities 257, 258. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Nature of operations 317, 326. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Notes receivable 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Pension plans 274. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Prior�period adjustments 284. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Related party transactions 273. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Required by GAAP 253, 254, 255, 257. . . . . . . . . . . . . . . . . . . . . . � Risks and uncertainties 317. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Significant estimates 318, 328. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Subsequent events 280. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Use of estimates 318, 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


346

DISCONTINUED OPERATIONS� Disclosures 284. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Presentation in statements of cash flows 220, 222. . . . . . . . . . . . .

E

ENVIRONMENTAL REMEDIATION COSTS� Disclosures 284. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

EXPENSES� Advertising 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

EXTRAORDINARY ITEMS� Presentation in statements of cash flows 220. . . . . . . . . . . . . . . . . � Tax benefits of loss carryforward 258, 269. . . . . . . . . . . . . . . . . . . .

F

FAIR VALUE� Disclosures

�� Derivatives 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Financial instruments 301. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

FINANCIAL INSTRUMENTS� Derivatives 258, 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures

�� Authoritative literature 293. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Cash deposits 299. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Concentrations of credit risk 298. . . . . . . . . . . . . . . . . . . . . . . .

� Excluded from SFAS No. 107 297. . . . . . . . . . . . . . . . . . . . . . . . . . � Fair value 301. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Identifying financial instruments 293. . . . . . . . . . . . . . . . . . . . . . . . � Market risk 297, 298. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

I

INCOME TAXES� Deferred, liability method

�� Disclosure requirements 266. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Loss carryforwards 268. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Disclosures�� Components of net deferred tax assets and

liabilities 266, 267. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Loss carryforwards 266, 268. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Permanent differences 271. . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Reconciliation of expected and actual tax rate 266, 270. . . . . �� Tax credits 266, 271. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Tax rates 266, 270. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Temporary differences 258, 266. . . . . . . . . . . . . . . . . . . . . . . . . �� Variations in customary relationships 266, 270. . . . . . . . . . . . .

� Investment tax credits 266, 271. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statement of cash flows presentation 225. . . . . . . . . . . . . . . . . . . � Tax deposit to retain fiscal year 232. . . . . . . . . . . . . . . . . . . . . . . . .

INTEREST� Disclosure requirements 266. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statement of cash flows presentation 216, 232, 241. . . . . . . . . .

INVENTORIES� Accounting changes 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 257, 258, 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � LIFO

�� Change to LIFO 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Conformity regulations 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Disclosures 258, 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Parts 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Policies note 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INVESTMENTS� Common stockequity method

�� Disclosures 258, 281. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Statements of cash flows 227, 230. . . . . . . . . . . . . . . . . . . . . . .

� Partially owned subsidiary in statements of cash flows 227, 241. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Statement of cash flows presentation 227. . . . . . . . . . . . . . . . . . .

L

LANDLORD INCENTIVE ALLOWANCE� Statement of cash flows presentation 216. . . . . . . . . . . . . . . . . . .

LEASES� Related party 273, 274. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statements of cash flows 234. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIABILITIES� Accrued liabilities

�� Agency obligations 219. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Collateral arrangements 276. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Long�term debt

�� Conversion of debt to equity 239. . . . . . . . . . . . . . . . . . . . . . . . �� Disclosures 265. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Issue costs 234. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Statements of cash flows 234. . . . . . . . . . . . . . . . . . . . . . . . . . .

� Short�term debt�� Statements of cash flows 234. . . . . . . . . . . . . . . . . . . . . . . . . . .

� Violation of covenants 275. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

M

MARKETABLE SECURITIES� Disclosures 257, 258. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statements of cash flows 227, 231, 241. . . . . . . . . . . . . . . . . . . . .

N

NONCONTROLLING INTERESTS� Consideration in statement of cash flows 227. . . . . . . . . . . . . . . .

NONMONETARY TRANSACTIONS� Presentation in statements of cash flows 240, 241. . . . . . . . . . . . .

NONPROFIT ORGANIZATIONS� Basic financial statements 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Financial statements

�� Statement of cash flows 205. . . . . . . . . . . . . . . . . . . . . . . . . . . .

NOTES TO FINANCIAL STATEMENTS� Arrangement 254. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Basic financial statement 253. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Comparative statements 254. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Dating 254. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosure of certain significant risks and uncertainties

�� Certain significant estimates 318, 328. . . . . . . . . . . . . . . . . . . . �� Current vulnerability due to concentrations 322, 329. . . . . . . �� Nature of operations 317, 326. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Relationship to SFAS No. 5 321. . . . . . . . . . . . . . . . . . . . . . . . . �� Scope and applicability of SOP No. 94�6 317. . . . . . . . . . . . . �� Use of estimates 318, 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Format and style 254, 256. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Note caption headings 254, 256. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Requirements for notes 253, 255. . . . . . . . . . . . . . . . . . . . . . . . . . . � Single financial statement 255. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Summary of significant accounting policies 256. . . . . . . . . . . . . . � Title 254. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Wording 254. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

O

OTHER COMPREHENSIVE BASIS OF ACCOUNTING� Cash flows 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statement of cash flows 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P

PARTNERSHIPS� Federal tax deposit to retain fiscal year 232. . . . . . . . . . . . . . . . . . � Statement of cash flows 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PENSION PLANS� Definition 274. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


347

PRIOR�PERIOD ADJUSTMENTS� Disclosures 284. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statement of cash flows 211. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PROPERTY AND EQUIPMENT� Collateral arrangements 276. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Distributions 240. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statement of cash flows 225, 228, 238. . . . . . . . . . . . . . . . . . . . . .

PROPRIETORSHIPS� Statement of cash flows 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

R

RECEIVABLES� Disclosures 257. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Installment 226, 230. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Related party 273, 296. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Statement of cash flows 217, 226, 230, 232. . . . . . . . . . . . . . . . . .

RELATED PARTY TRANSACTIONS� Disclosures 273. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RETAINED EARNINGS� Dividends

�� Statement of cash flows 216, 232, 240. . . . . . . . . . . . . . . . . . .

REVENUE� Deferred 225. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosure requirements 258. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RISKS AND UNCERTAINTIES� Certain significant estimates 318, 328. . . . . . . . . . . . . . . . . . . . . . .

�� Relationship to SFAS No. 5 disclosures 321. . . . . . . . . . . . . . � Concentrations 322, 329. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Nature of operations 317, 326. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Scope and applicability 317. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Use of estimates 318, 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

S

S CORPORATION� Federal tax deposit to retain fiscal year 232. . . . . . . . . . . . . . . . . . � Statement of cash flows 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

STATEMENT OF CASH FLOWS� Accounting changes 220, 222. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Acquisition of noncurrent assets 228, 238. . . . . . . . . . . . . . . . . . . . � Adjustments to arrive at cash flows from operating

activities 224. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Agency transactions 219. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Amortization 224. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Authoritative basis 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Basic elements 207. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Basic financial statement 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Business combinations 232, 241. . . . . . . . . . . . . . . . . . . . . . . . . . . � Capital lease obligations 234. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions, primary 209. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash defined 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash equivalents 205, 230. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash flow per share 242. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash value of life insurance 224, 235. . . . . . . . . . . . . . . . . . . . . . . . � Certificates of deposit 205, 230. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Changes in operating current assets and liabilities 217. . . . . . . . � Comparative 210. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Conversion of debt to equity 239. . . . . . . . . . . . . . . . . . . . . . . . . . . � Conversion of stock 239. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current operating assets and liabilities 224. . . . . . . . . . . . . . . . . . � Debt issue costs 234. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deferred charges 224, 234. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deferred income taxes 225. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deferred revenue 225. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Depletion 225. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Depreciation 225. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Direct method 216. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Discontinued operations 220, 222. . . . . . . . . . . . . . . . . . . . . . . . . . � Disposal of noncurrent assets 225, 229. . . . . . . . . . . . . . . . . . . . . . � Dividends 216, 232, 233, 240. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Ending cash format 209. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Extraordinary items 220. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Federal tax deposit to retain fiscal year 232. . . . . . . . . . . . . . . . . . � Financing activities 207, 209, 233. . . . . . . . . . . . . . . . . . . . . . . . . . � Foreign operations 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Form and style 209, 216, 224, 228, 233, 237. . . . . . . . . . . . . . . . . � Gross vs. net cash flows 207, 228, 233. . . . . . . . . . . . . . . . . . . . . . � Indirect method 216, 217. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Installment sales 226, 230. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Intangible assets 224. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interest expense 216, 241. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interest income 216, 232, 241. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interim financial statements 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Investing activities 207, 209, 228. . . . . . . . . . . . . . . . . . . . . . . . . . . � Investment in partially owned subsidiary 227, 241. . . . . . . . . . . . . � Investments on the cost method 227. . . . . . . . . . . . . . . . . . . . . . . . � Investments on the equity method 227. . . . . . . . . . . . . . . . . . . . . . � Landlord incentive allowances 216. . . . . . . . . . . . . . . . . . . . . . . . . � Life insurance policies 224, 235. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Long�term borrowings 234. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Making loans 232. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Marketable securities 227, 231, 241. . . . . . . . . . . . . . . . . . . . . . . . � Netting cash flows 209, 228, 233. . . . . . . . . . . . . . . . . . . . . . . . . . . � Noncash extraordinary items 220. . . . . . . . . . . . . . . . . . . . . . . . . . . � Noncash investing and financing

transactions 207, 228, 233, 236. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Noncash operating items 224. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Noncontrolling interests 227, 241. . . . . . . . . . . . . . . . . . . . . . . . . . . � Nonmonetary transactions 240, 241. . . . . . . . . . . . . . . . . . . . . . . . . � Nonprofit organizations 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Operating activities 207, 209. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Order of presentation 209, 211. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Other comprehensive basis of accounting 205. . . . . . . . . . . . . . . � Overdrafts 206. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Partnerships 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Premium amortization and discount accretion 227. . . . . . . . . . . . � Preparing cash flow statements 242. . . . . . . . . . . . . . . . . . . . . . . . � Proprietorships 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Purchase (sale) of a business 225, 232, 241. . . . . . . . . . . . . . . . . � Reclassification and restatement 211. . . . . . . . . . . . . . . . . . . . . . . � Restricted cash 206. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � S corporations 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Settlement of an asset retirement obligation 216. . . . . . . . . . . . . . � Short�term borrowings 234. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term investments 230. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stockholder loans 241. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock issuance 233, 241. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock issue costs 233. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Title 209. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Trade�ins 228, 238. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Treasury stock 236. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Types of cash flows 207. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unclassified balance sheet 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unrealized gains and losses 227, 241. . . . . . . . . . . . . . . . . . . . . . . � When to present 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

STOCKHOLDERS' EQUITY� Statement of cash flows 233, 236, 239, 241. . . . . . . . . . . . . . . . . . � Stock conversions 239. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock issue costs 233, 241. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Subsequent events 280. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Treasury stock 236. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

SUBSEQUENT EVENTS� Disclosures 259, 280. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Type I (recognized) 280. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Type II (nonrecognized) 280. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � When financial statements are issued and available to

be issued 280. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


348


349


COURSE 4

PREPARING FINANCIAL STATEMENTS: ASSETS (PFSTG104)

OVERVIEW

COURSE DESCRIPTION: This interactive self�study course provides an introduction to the preparation of theasset portion of financial statements. Topics in the first lesson include the propercaptions, classification and valuation of current assets including inventory,receivables and marketable securities. The second lesson covers long�terminvestments and using the equity method to account for nonmarketable equitysecurities. Lesson three discusses the balance sheet presentation andclassification of property and equipment, including capital leases and thecalculation of depreciation. The last lesson is on intangible assets, the impairment ofgoodwill and application of FASB ASC 360�10 (formerly SFAS No. 144).

PUBLICATION/REVISION

DATE:

November 2010


PREREQUISITE/ADVANCE

PREPARATION:

Basic knowledge of accounting.





KNOWLEDGE LEVEL: Intermediate


Lesson 1Current Assets

Completion of this lesson will enable you to:

� Identify correct balance sheet captions for current assets such as cash, receivables, and inventory.

� Calculate and account for the value of marketable securities and treasury securities at the balance sheet date.� Determine the correct reporting for receivables and inventory.

Lesson 2Long�term Investments


� Determine the appropriate captions and valuation for long�term investments such as nonmarketable securities,cash value of life insurance policies, and property held for investment.

� Determine the accounting treatment for nonmarketable equity securities.

� Determine the correct reporting method for cash value life insurance policies.


350

Lesson 3Property and Equipment


� Identify the balance sheet presentation options for property and equipment.

� Determine the classification of and properly record assets acquired by capital lease, contribution or exchange.� Calculate depreciation.

Lesson 4Intangible Assets, Other Deferred Costs, and Long�lived Assets


� Identify the appropriate accounting for goodwill and other intangibles.� Determine when an asset is impaired.

� Determine when to apply FASB ASC 360�10 (formerly SFAS No. 144) to long�lived assets.



Thomson Reuters

Tax & AccountingR&GPFSTG104 Self�study CPE

36786 Treasury CenterChicago, IL 60694�6700



For information regarding refunds and complaint resolutions, dial (800) 431�9025 for Customer Service and your

questions or concerns will be promptly addressed.


351

Lesson 1:�Current Assets

INTRODUCTION

Current assets normally include the following items:

a. Cash available for current operations and items that are the equivalent of cash

b. Marketable securities representing the investment of cash available for current operations

c. Inventories of raw materials, goods in process, finished goods, operating supplies, and ordinarymaintenance materials and parts

d. Receivables:

(1) Trade accounts and notes

(2) Receivables from officers, employees, affiliates, and others if collectible in the ordinary course ofbusiness within one year

e. Prepaid expenses such as insurance, interest, rents, taxes, unused royalties, current paid advertisingservice not yet received, and operating supplies

In this lesson the proper captions, classification and valuation of current assets including inventory, receivables andmarketable securities are discussed.


Completion of this lesson will enable you to:� Identify correct balance sheet captions for current assets such as cash, receivables, and inventory.� Calculate and account for the value of marketable securities and treasury securities at the balance sheet date.� Determine the correct reporting for receivables and inventory.

Cash and Cash Equivalents

Cash as a balance sheet caption should ordinarily include cash on deposit with banks and other institutions andcash on hand (for example, change funds and undeposited receipts). It is generally presented as a single item, butmay be combined with short�term investments considered to be cash equivalents. When the two are combined, thecaptions should be descriptive, such as �Cash and cash equivalents." When cash and cash equivalents arepresented as a single amount, the notes to financial statements frequently disclose the components. For example:

NOTE XCASH AND CASH EQUIVALENTS

Cash and cash equivalents consist of the following:

20X2 20X1

Cash $ 50,000 $ 45,000

Certificates of deposit 100,000 �

Short�term securities 45,000 95,000

$ 195,000 $ 140,000

GAAP states that the total amount of cash and cash equivalents shown in the statement of cash flows should be thesame amount as similarly titled line items or subtotals in the balance sheet. Thus, best practices indicate that if thereare several cash accounts in the balance sheet (for example, cash on hand and money market accounts) that


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should be combined to agree with the statement of cash flows, the balance sheet should subtotal those amounts.Similarly, cash and short�term investments that are not cash equivalents should not be combined in the balancesheet.

Operating Accounts. Even though banks offer a variety of deposit instruments, small and midsize nonpublicentities ordinarily have at least one operating account. Operating accounts that bear interest typically have a lowinterest rate and do not generate significant amounts of interest income. Depending on the facts and circum�stances, however, entities may want to disclose the balances of interest�bearing operating accounts. Relevantinformation may be disclosed in a note to the financial statements or through an expansion of the asset caption,such as:

Cash, including interest�bearing accounts of$275,000, with interest averaging 3% $ 390,000

Certificates of Deposit. Certificates of deposit generally are not subject to withdrawal limitations although with�drawal before maturity usually results in a loss of a portion of the interest earned. Accordingly, best practicesindicate that certificates of deposit may be included with cash and need not be separately disclosed. Someaccountants, however, disclose the amount of certificates of deposit that have been included with cash or presentcertificates of deposit as a separate balance sheet caption as follows:

20X2 20X1

Cash, including certificates of deposit(20X2$150,000; 20X1$125,000) $ 500,000 $ 430,000

Marketable securities 100,000 200,000

or

Cash $ 55,000

Certificates of deposit 200,000

Short�term investments 250,000

A nonauthoritative AICPA Technical Practice Aid (TPA) at TIS 2130.39 states that a certificate of deposit that has anoriginal maturity of 90 days or less is generally considered cash and cash equivalents. However, the TPA indicatesa certificate of deposit with an original maturity more than 90 days would not be classified as cash and cashequivalents. Such amounts would be reported as an investment. As previously discussed, best practices indicatethat subtotals of cash and cash equivalents that agree with the amounts in the statements of cash flows should bepresented.

Money Market Accounts. Money market accounts offered by banks, savings and loan associations, and broker�age houses are typically subject to only minimal withdrawal restrictions. Therefore, they are more in the nature ofinterest�bearing checking accounts and should be included in the cash caption.

Repurchase Agreements. Repurchase agreements are short�term investments typically sold by banks as alterna�tives to certificates of deposit. Transfers to and from the fund are made daily to cover checks clearing in operatingaccounts. Accordingly, repurchase agreements should be presented in the financial statements in a manner similarto money market accounts.

Held Checks. Checks written but not released as of the balance sheet date should be reinstated on the company'sbooks, thus increasing cash as of the date of the financial statements. The offsetting entry generally increasesaccounts payable.

Overdrafts. Overdrafts are a result of either of the following situations:

a. The bank statement at the balance sheet date reports an overdraft (a real overdraft).

b. The bank statement at the balance sheet date reports a positive balance, and the overdraft, in essence,arises from �playing the float" (a book overdraft).


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However, there is no reason for captions to distinguish between a real overdraft and a book overdraft, and the singlecaption �cash overdraft" or �bank overdraft" should be used. If the company has a positive cash balance in oneyear and a negative balance in the other, the following captions would be appropriate in comparative balancesheets:

20X2 20X1

CURRENT ASSETS

Cash $ � $ 10,000

CURRENT LIABILITIES

Cash overdraft 5,000 ��

Entities frequently have cash accounts with more than one financial institution. Generally, for each financialinstitution, all cash account balances should be totaled to determine whether the entity has a net positive ornegative balance. If a net negative balance with a financial institution is immaterial, generally it may be offset againstpositive balances in other financial institutions. However, if it is material, generally it should be included with currentliabilities and either presented separately or included with accounts payable.

Restricted Cash. Cash restricted for special purposes should be segregated from cash available for generaloperations and, normally, should be excluded from current assets. However, as noted in FASB ASC 210�10�45�4(formerly Chapter�3 of ARB No. 43), it may be included in current assets when it is considered to offset maturingdebt that has been properly set up as a current liability. Examples of the presentation of restricted cash are asfollows:

a. Cash deposited with a trustee for mortgage loan payments:

CURRENT ASSETS

Cash $ 100,000

Restricted cash for mortgage loan repayment 25,000

Accounts receivable 400,000

Inventory 600,000

TOTAL CURRENT ASSETS 1,125,000

PROPERTY AND EQUIPMENT 575,000

OTHER ASSETS

Deposits 50,000

Restricted cash for mortgage loan repayment 150,000

$ 1,900,000

b. Total cash of $150,000 of which $100,000 is restricted proceeds from industrial revenue bonds:

CURRENT ASSETS

Cash $ 50,000

OTHER ASSETS

Deposits 10,000

Restricted cash from industrial revenue bonds 100,000

Note that, as in example (a), restricted cash may have both a current and noncurrent portion.

Compensating Balances. There is no GAAP requirement to disclose compensating balance agreements unlessthe agreement legally restricts the use of the funds.


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Escrow Accounts. In practice, two types of escrow accounts are often encountered:

a. Amounts on deposit that will be used to pay expenses

b. Agency accounts

A common example of the first type is the portion of debt service accumulated for payment of real estate taxes andinsurance. Typically, the company has no control over those accounts and cannot convert them into cash. Theyshould be excluded from cash and included with prepaid expenses or charged to expense if not material. Acommon example of the second type is an account maintained by realtors for deposits on real estate contracts orfor rent payments on property managed for an owner. Realtors may write checks on those accounts, but state lawsnormally prohibit them from using the cash for their own business (or personal) purposes even as a temporary loan.The realtors have custody of the funds, but do not have the legal right to them. Preferably such funds should beexcluded from the company's balance sheet, but if the accounts are material, the amount and nature of thecompany's agency obligation under the arrangement should be disclosed. To avoid cluttering the balance sheet,the disclosure may be in a note.


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SELF�STUDY QUIZ


1. Company A has the following account balances with Bank of the U.S. on 12/31/X1:

Operating account: $100,000; Money market account $50,000; Payroll account ($10,000)

Also, on 12/31/X1, Company A wrote $15,000 worth of checks from its operating account, but held on to themuntil 1/10/X2.

How much does Company A report as �Cash" on its 12/31/X1 balance sheet?

a. $105,000.

b. $140,000.

c. $155,000.

d. $165,000.

2. Which of the following is segregated from cash available for general operations?

a. Restricted cash.

b. Certificates of deposit.

c. Repurchase agreements.

d. Short�term investments.


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1. Company A has the following account balances with Bank of the U.S. on 12/31/X1:

Operating account: $100,000; Money market account $50,000; Payroll account ($10,000)

Also, on 12/31/X1, Company A wrote $15,000 worth of checks from its operating account, but held on to themuntil 1/10/X2.

How much does Company A report as �Cash" on its 12/31/X1 balance sheet? (Page 351)

a. $105,000. [This answer is incorrect. Money market accounts are in the nature of interest�bearing checkingaccounts and should be included in the cash caption.]

b. $140,000. [This answer is incorrect. Checks written but not released as of the balance sheet date shouldbe reinstated on the company's books, thus increasing cash as of the date of the financial statements.]

c. $155,000. [This answer is correct. Cash as a balance sheet caption should ordinarily include cashon deposit with banks and other institutions and cash on hand. An overdraft in an account of afinancial institution can be offset with a positive balance in another account in the same institution.Checks written but not released as of the balance sheet date should be reinstated on the company'sbooks.]

d. $165,000. [This answer is incorrect. An overdraft in an account of a financial institution can be offset witha positive balance in another account in the same institution, and be reported as cash if it is a net positivebalance.]

2. Which of the following is segregated from cash available for general operations? (Page 353)

a. Restricted cash. [This answer is correct. Cash restricted for special purposes should be segregatedfrom cash available for general operations and, normally, should be excluded from current assets.]

b. Certificates of deposit. [This answer is incorrect. CDs are generally not subject to withdrawal limitationsalthough withdrawal before maturity usually results in a loss of a portion of the interest earned. Usually, CDsare included with cash and need not be separately disclosed.]

c. Repurchase agreements. [This answer is incorrect. Repurchase agreements are alternatives to CDs soldby banks. Transfers to and from the fund are made daily to cover checks clearing in operating accounts.Repurchase agreements should be presented in the financial statements in a manner similar to moneymarket accounts.]

d. Short�term investments. [This answer is incorrect. Short�term investments that are considered cashequivalents can be combined in the balance sheet under the �Cash and cash equivalents" caption.]


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Marketable Securities

The balance sheet caption �marketable securities" includes equity securities and debt securities. Examples ofthose types of securities are:

Equity Securities Debt Securities

Common Stock Bonds

Preferred Stock Bankers Acceptances

Warrants U.S. Treasury Notes

Calls Convertible Debt

Puts Preferred Stock (that must be redeemed)

This lesson discusses both current and noncurrent marketable securities because decisions about classificationmay influence captions and, in some cases, measurement. Money market accounts, repurchase agreements, andcertificates of deposit (except for some �jumbo CD's") are not marketable securities.

FASB ASC 320�10 (formerly SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities)establishes accounting standards for both marketable equity and debt securities. This guidance requires businessentities to account for marketable equity securities and most marketable debt securities at fair value. It applies tobusiness entities other than those that use specialized accounting principles for investments, such as securitiesbrokers and dealers, defined benefit pension plans, and investment companies. (It does not apply to nonprofitorganizations, however.) Certain debt securities that entities intend to hold to maturity are accounted for atamortized cost; most marketable debt and equity securities, however, are accounted for at fair value.

Definitions. FASB ASC 320�10�20 (formerly SFAS No. 115) defines debt and equity securities as follows:

DEBT SECURITY

Any security representing a creditor relationship with an entity.

ExamplesU.S. Treasury securities, U.S. government agency securities, municipal securities,corporate bonds, convertible debt, redeemable preferred stock, commercial paper, all securi�tized debt instruments (such as collateralized mortgage obligations and real estate mortgageinvestment conduits)

EQUITY SECURITY

Any security representing an ownership interest in an entity or the right to acquire or dispose of anownership interest in an entity at fixed or determinable prices. Equity securities do not includeconvertible debt or redeemable preferred stock.

ExamplesCommon, preferred, and other capital stock; stock rights and warrants; put and calloptions

This guidance applies to equity securities whose fair value is readily determinable and all debt securities. It alsoapplies to restricted stock if the restrictions terminate within one year. It does not apply to investments in equitysecurities that would be required to be accounted for using the equity method, if not for the election of the fair valueoption under FASB ASC 825�10 (formerly SFAS No. 159, The Fair Value Option for Financial Assets and FinancialLiabilities), or to investments in consolidated subsidiaries. The fair value of an equity security is readily determin�able if:

a. sales prices or bid�and�asked quotations are currently available in:

(1) a securities exchange registered with the Securities and Exchange Commission.

(2) an over�the�counter market publicly reported by the National Association of Securities DealersAutomated Quotations systems or by Pink Sheets LLC.


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b. the security trades only in a foreign market, but that market is of a breadth and scope comparable to oneof the U.S. markets previously discussed.

c. the fair value per share or unit of a mutual fund is determined and published and is the basis for currenttransactions.

Summary of Accounting Principles. Accounting for investments depends on (a) the type of securityeither debtor equityand (b) the entity's intent and ability to hold it to maturity. At acquisition, investments should be classifiedinto one of the following categories:

� Held to Maturity. Debt securities for which the entity has both the positive intent and ability to hold to maturity.Securities for which an entity has an intent to hold for an indefinite time or a lack of an intent to sell shouldnot be classified in this category. If an entity's intent is uncertain, this category is not appropriate. In addition,a security cannot be classified as held to maturity if it can be contractually prepaid or otherwise settled suchthat the security holder would not recover substantially all of its recorded investment. A debt security withthose characteristics should be evaluated to determine whether it contains an embedded derivative thatmust be accounted for separately.

� Trading. Debt securities that do not meet the �intent�to�hold" criterion and equity securities that have readilydeterminable fair values, both of which are bought and held principally for the purpose of selling them inthe near term (e.g., the entity's normal operating cycle), and thus generally are held for only a short periodof time.

� Available for Sale. Securities that do not meet the criterion to be classified as held to maturity or trading.

Most entities classify their securities into one of two categorieseither held to maturity or available for sale. Tradingsecurities are held principally by financial institutions and similar entities, such as entities with mortgage bankingactivities. According to FASB ASC 320�10�20 (formerly Question 34 of the FASB Q&A on SFAS No. 115), suchsecurities generally have a holding period measured in hours and days rather than months or years. However,classifying securities as trading is not prohibited just because they will be held longer. Generally, as a practicalmatter, the securities activities of small and medium�sized entities normally are incidental and classifying them asavailable for sale better captures their substance. Accordingly, the provisions of FASB ASC 320�10 (formerly SFASNo. 115) as they apply to trading securities are not discussed in detail in this course.

Exhibit 1�1 summarizes the accounting for investments. For debt securities classified as held to maturity, thesecurities are carried at amortized cost (unless there is a decline in the value of individual securities that is not dueto temporary declines). Realized gains and losses are recorded in the income statement in the period that they areearned.

Debt and equity securities classified as available for sale are recorded at fair value. Generally, the fair value of thesecurities held is the product of the number of shares held and the per�share price or quotation. The fair value is notreduced for expected transaction costs or for any blockage discount. As a practical matter, if a quoted market priceis not available for an equity security, it probably is not subject to the requirements discussed in this lesson.Realized gains and losses are recorded in the income statement in the period that they are earned. Unrealizedgains and losses are reported in other comprehensive income. However, declines in value of individual securitiesbelow amortized cost that are other than temporary should be included in earnings. See further discussion ofimpairment of securities later in this lesson.


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Exhibit 1�1

Accounting for Marketable Securities

Category Type of Investment BasisReporting Unrealized

Gains and LossesBalance SheetClassification

Held tomaturity

Debtentity has posi�tive intent and ability tohold to maturity, andthe security cannot becontractually prepaid orotherwise settled suchthat the security holderwould not recover sub�stantially all of itsrecorded investment

Amortized cost,reduced fornontemporarydeclines

Charge nontemporarylosses to earnings; donot recognize otherunrealized gains andlosses

Current or noncurrentdepending on FASBASC 210�10�45 (for�merly ARB No. 43)(generally noncurrent;classify as currentwhen maturity iswithin 12 months)

Trading Debt and equityheldprincipally for sale inthe near term

Fair value Report in earnings Current or noncurrentdepending on FASBASC 210�10�45 (for�merly ARB No. 43)

Availablefor sale

Debt and equity otherthan above

Fair value Report in other com�prehensive income;charge nontemporarylosses to earnings

Current or noncurrentdepending on FASBASC 210�10�45 (for�merly ARB No. 43)

* * *

According to FASB ASC 320�10�35�33 (formerly Question 47 of the FASB Q&A on SFAS No. 115), if an entitydecides to sell an available�for�sale security that has declined in value below its amortized cost and the decline isnot considered to be temporary, the investment should be written down to its fair value in the period that thedecision to sell was made, rather than in the period in which the sale occurs. In that case, the write�down should becharged to earnings rather than recorded in other comprehensive income. The situation might be most obvious ifa company sells a security at a loss shortly after the balance sheet date. The value to which a security is writtendown becomes its new cost basis. Impairment of securities is discussed further later in this lesson.

Categorizing Securities. Categorizing securities under GAAP may be challenging. The most difficult decisions arelikely to surround whether a security meets the positive�intent and ability�to�hold criteria to classify it as held tomaturity. Unfortunately, GAAP provides no guidance on evaluating an entity's intent, so classification decisions maybe inconsistent in practice. Although many entities intend to hold securities for a long term or an indefinite period,GAAP precludes classifying debt securities as held to maturity if they would be available to be sold in response tofactors such as the following:

a. Changes in market interest rates and related changes in the securities' prepayment risk

b. Need for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrenderof insurance policies, or payment of insurance claims)

c. Changes in the availability of and the yield on alternative investments

d. Changes in funding sources and terms

e. Changes in foreign currency risk


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Transferring Securities between Categories. An entity should reconsider whether a marketable security isproperly categorized at each reporting date. Changes in circumstances, such as an entity no longer having theability to hold a debt security to maturity, may cause a security to be transferred to another category. Transferringa security to a different category requires adjusting the carrying amount of the security to its fair value at the date oftransfer so that all of the unrealized holding gain or loss is recognized as of that date. Accounting for the unrealizedholding gain or loss depends on the type of transfer, as follows:

a. Transfers from the Trading Category. For securities transferred from the trading category, the unrealizedholding gain or loss at the date of transfer is already recognized in earnings and should remain in retainedearnings after the transfer, regardless of the category to which the securities are transferred. For example,the unrealized holding gain or loss on a security transferred from the trading category to theavailable�for�sale category is included in retained earnings at the transfer date, while subsequent changesin the unrealized holding gain or loss should be included in accumulated other comprehensive income.

b. Transfers to the Trading Category. For securities transferred to the trading category, recognize in earningsthe portion of the unrealized holding gain or loss at the transfer date that has not been previouslyrecognized in earnings. For transfers of available�for�sale securities, that will entail reclassifying intoearnings amounts reported in accumulated other comprehensive income through the transfer date. Forexample, assume that an available�for�sale security has an unrealized gain of $20,000 at the beginning ofthe year and its fair value increases by an additional $5,000 to $80,000 by the transfer date. The securityfirst should be adjusted to its fair value at the transfer date by recognizing the additional $5,000 unrealizedholding gain in other comprehensive income, as follows:

Available�for�sale securities 5,000

Other comprehensive income 5,000

The carrying amount of the security is then its $80,000 fair value, and accumulated other comprehensiveincome related to the security is the $25,000 cumulative holding gain at the transfer date (of which $20,000was recognized in prior years and $5,000 was recognized in the current year). The transfer from theavailable�for�sale category to the trading category should be recorded by reclassifying the $25,000unrealized holding gain into earnings, as follows:

Trading securities 80,000



Unrealized gain on securities 25,000

Since $20,000 of the unrealized holding gain was recognized in comprehensive income in prior years (asother comprehensive income), recording the transfer only increased comprehensive income (and equity)for the current year by the $5,000 additional unrealized gain that arose during the current year through thetransfer date. The increase should be reported in two componentsa $20,000 net reduction in othercomprehensive income (the $5,000 additional unrealized holding gain less the $25,000 reclassification)and a $25,000 increase in earnings. However, if the security originally had been classified asheld�to�maturity instead of available�for�sale, none of the unrealized holding gain would have beenrecognized in comprehensive income previously, and in addition to increasing earnings by $25,000, thetransfer also would increase current year comprehensive income (and equity) by $25,000.

c. Transfers to Available�for�sale from Held�to�maturity. For debt securities transferred to the available�for�salecategory from the held�to�maturity category, recognize the unrealized holding gain or loss in othercomprehensive income at the transfer date. For example, if the fair value of a held�to�maturity security hasincreased by $20,000 to $70,000, the carrying amount of the security should be increased by $20,000 fromits $50,000 cost basis to its $70,000 fair value, with the $20,000 unrealized holding gain recognized in othercomprehensive income as follows:

Held�to�maturity securities 20,000



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The transfer then would result in reporting the security as an available�for�sale security with a carryingamount of $70,000 as follows:



Since the security previously was classified as held�to�maturity, none of the unrealized gain was recognizedin prior years, and the transfer therefore increased current year comprehensive income (and equity) by$20,000.

d. Transfers to Held�to�maturity from Available�for�sale. For debt securities transferred to the held�to�maturitycategory from the available�for�sale category, the security's fair value at the transfer date becomes its newcost basis. (Subsequent changes in the security's fair value only should be recognized when they arerealized, unless a decline in fair value is other than temporary. In that situation, the decline should berecognized immediately in earnings, and the fair value at that date becomes the security's new cost basis.)The unrealized holding gain or loss at the date of transfer should remain in accumulated othercomprehensive income but be amortized over future years as a premium or discount. (A premiumaccumulates when there is an unrealized gain at the date of transfer, and a discount accumulates whenthere is an unrealized loss.) The offset to the change in the discount or premium is an increase or decreasein other comprehensive income. Consequently, increasing a premium reduces accumulated othercomprehensive income and the carrying amount of the security, while increasing a discount increasesaccumulated other comprehensive income and the carrying amount of the security. When the securitymatures, its carrying amount will equal its face value. This accounting results in recognizing comprehensiveincome for the unrealized holding gains or losses that arise while a security is classified as available for sale.However, since those gains or losses will not be realized, comprehensive income is correspondinglyeliminated over the period from the transfer date to the security's maturity.

To illustrate, assume that an entity purchases a debt security for its $50,000 face value and classifies it asavailable�for�sale at the beginning of the year. The security bears interest at 8% and is due in three years.At the end of the year, when the security's fair value is $60,000, the entity reclassifies it as held�to�maturity.To record the realization of the amounts due under the security, the transfer to the held�to�maturity category,and the amortization of the unrealized holding gain at the transfer date, the entity should:

(1) Recognize $4,000 ($50,000 face value � 8%) interest income for the year.

Cash 4,000


(2) Increase the carrying amount of the security by $10,000 from its $50,000 cost to its $60,000 fair valueand reclassify the security to held�to�maturity at the transfer date.





(3) Compute the level effective rate that will fully amortize the $60,000 fair value at the transfer datethrough receipt of the two remaining annual interest payments and the principal that is due in twoyears. That rate is 15.71%.

(4) At the end of the following year, multiply $60,000 (the security's carrying amount) by 15.71%, andsubtract the $4,000 interest income from the $9,426 result. Record the $5,426 difference as a premiumon the debt security, with an offsetting reduction in other comprehensive income as follows:


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Cash 4,000


Premium on debt security 5,426


After that adjustment, $4,574 ($10,000 � $5,426) of the $10,000 unrealized holding gain at the transferdate remains in accumulated other comprehensive income. The carrying amount of the security is$54,574, consisting of the $60,000 fair value at the transfer date less the $5,426 accumulatedpremium.

(5) At the end of the following year, multiply the $54,574 carrying amount of the security by 15.71%, andsubtract the $4,000 interest income from the $8,574 result. Record the $4,574 difference as a premiumon the debt security, with an offsetting reduction in other comprehensive income as follows:

Cash 4,000




After that adjustment, no balance remains in accumulated other comprehensive income for the debtsecurity since the current year's amortization eliminated the $4,574 balance at the beginning of theyear. The current year's amortization correspondingly increased the�cumulative premium from $5,426to $10,000. Consequently, the carrying amount of the security is $50,000 (consisting of the $60,000fair value at the transfer date less the $10,000 accumulated premium). That equals the $50,000 receiptof principal, recorded as follows:

Cash 50,000



Transfers from the held�to�maturity category and into or out of the trading category should be rare, due to the highthreshold for classifying investments into those categories. In addition, FASB ASC 320�10�35�13 (formerly SFASNo. 115, Paragraph 81) notes that available�for�sale securities should not be automatically transferred to the tradingcategory merely because the company decides to sell the security or because the passage of time has caused thesecurity's maturity date to be within one year.

Subsequent Changes in Fair Value. The fair value measurements should be based on values at the end of thereporting period. Changes in fair value occurring after the end of the reporting period but before the financialstatements are available to be issued should not be recognized. For example, if the quoted market price of anequity security traded on a national exchange is $100,000 at the end of the reporting period but declines to $50,000prior to the financial statements being available to be issued, the security should be reported at $100,000. Thatconclusion is not affected by whether the decline in value began before the end of the reporting period.

Measurement of a security's fair value is not intended to estimate the value the reporting entity will realize; it ispurely a measure of the number of shares held multiplied by the per share price at the end of the reporting period.Fair value under FASB ASC 320�10 (formerly SFAS No. 115) does not consider factors that could affect the amountrealized (such as control premiums, blockage factors, and selling costs), nor does it consider changes in value thatwill occur before the security is sold. Accordingly, the disclosure requirements of FASB ASC 450 (formerly SFASNo. 5, Accounting for Contingencies), and FASB ASC 275�10�50 (formerly SOP 94�6, Disclosure of Certain Signifi�

cant Risks and Uncertainties), do not apply. However, FASB ASC 855�10 (formerly SFAS No. 165) presentssubsequent changes in the fair value of assets or liabilities as an example of a nonrecognized subsequent eventthat should be disclosed if failing to disclose the event would cause the financial statements to be misleading. Inthat case, the nature of the event and an estimate of its financial effect, or a statement that such an estimate cannotbe made, should be disclosed.


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Impairment of Securities. When the fair value of an available�for�sale or held�to�maturity security declines belowits amortized cost; the security is considered impaired. The reporting entity must then determine whether thatimpairment is other than temporary to properly account for, report, and disclose the security

FASB ASC 320�10�35�17 through 35�35A (formerly FSP FAS 115�1 and FAS 124�1, �The Meaning of Other�Than�Temporary Impairment and Its Application to Certain Investments") provides guidance regarding the meaning ofother�than�temporary impairment and its application to debt and equity securities. GAAP provides guidance for (a)determining when an investment is impaired, (b) determining whether the impairment is other than temporary, and(c) measuring, recognizing, presenting and disclosing an impairment loss if the impairment is deemed other thantemporary.

Determining When an Investment Is Impaired. An investment is deemed impaired if its fair value is less than its cost.For this purpose, cost includes adjustments made to an investment's cost basis for accretion, amortization,collection of cash, previous other�than�temporary impairments recognized in earnings (less any cumulative�effectadjustments), foreign exchange, and hedging, and is sometimes referred to as the amortized cost basis. Generally,an investment should be assessed for impairment each reporting period, including interim periods if interimfinancial statements are issued. If an investment is deemed impaired, the impairment should be analyzed todetermine if the impairment is other than temporary.

Determining Whether the Impairment Is Other Than Temporary. When an investment is deemed impaired, thereporting entity should determine whether the impairment is temporary or other than temporary. FASB ASC320�10�35�30 (formerly FSP FAS 115�1 and FAS 124�1) states that other than temporary does not mean permanent.When determining whether an impairment is other than temporary, the reporting entity should consider theguidance in FASB ASC 320�10�35 (formerly FSP FAS 115�1 and FAS 124�1) as well as other relevant guidance suchas FASB ASC 325�40�35 (formerly EITF Issue No. 99�20, �Recognition of Interest Income and Impairment onPurchased and Retained Beneficial Interests in Securitized Financial Assets").

GAAP addresses the determination of whether an impairment is other than temporary separately for equity securi�ties and debt securities. However, it provides more detailed guidance for debt securities than for equity securities.For example, FASB ASC 320�10�35�32A indicates a reporting entity should apply pertinent guidance, such as FASBASC 325�40�35 (formerly EITF Issue No. 99�20) in making the determination for equity securities. On the otherhand, FASB ASC 320�10�35�33A through 33I (formerly FSP FAS 115�1 and FAS 124�1) provides detailed guidancefor determining whether an other�than�temporary impairment has occurred in relation to debt securities.

Recognizing and Measuring an Other�than�Temporary Impairment Loss. When impairment is determined to beother�than�temporary, a loss should be recognized. The recognition and measurement of the loss varies dependingon whether the investment is an equity security or a debt security. For an equity security, an impairment loss shouldbe recognized in earnings for the entire difference between the cost and fair value of the security at the balancesheet date. The fair value becomes the new amortized cost basis of the security and should not be adjusted forsubsequent recoveries in fair value.

For debt securities, the amount of the other�than temporary impairment recognized in earnings depends onwhether the reporting entity intends to sell the security (or whether it is more likely than not the entity will be requiredto sell the security) before recovery of the amortized cost basis less any current�period credit loss. If the entity plansto sell the security (or more likely than not it will be required to sell the security) before recovery, the other�than�tem�porary impairment should be recognized in earnings for the entire difference between the amortized cost basis andfair value at the balance sheet date. If there is no intention to sell the security and it is not more likely than not thatthe entity will be required to sell before recovery, the other�than�temporary impairment should be separated intoamounts pertaining to (a) the credit loss and (b) all other factors. The amount related to the credit loss should berecognized in earnings while the remaining amount should be recognized in other comprehensive income (net oftaxes). The prior amortized cost basis less the other�than�temporary impairment loss recognized in earningsbecomes the new amortized cost basis of the security. That amount should not be adjusted for subsequentrecoveries in fair value, but should be adjusted for accretion and amortization.


364

Treasury Securities

Types of Treasury Securities. Many nonpublic companies invest in debt securities, and often in U.S. Treasurysecurities. The three types of Treasury securities are bills, notes, and bonds.

� Treasury bills, or T bills, are short�term obligations of the U.S. government with a term of one year or less.They require a minimum investment of $10,000 and, when initially issued, are scheduled to mature in threemonths (13 weeks or 91 days), six months (26 weeks or 181 days), or 12 months. (T bills with differentremaining maturities can also be purchased in secondary markets after they are initially issued.) T bills donot pay coupon interest; instead, they trade at a discount from their par value of $10,000 and mature at parvalue. The discount, however, is based on the quoted yield, which is similar to an interest rate (and is thebasis for determining interest rates in some agreements). The difference between purchase price and thepar value of the T bill is called �accreted interest," which is paid when the T�bill matures. Physical certificatesare not issued for T bill purchases; they are issued in book form only.

� Treasury notes are intermediate�term obligations of the U.S. government with terms of two to ten years.They are initially issued at par value and can be purchased in $1,000 denominations (although, dependingon how they are purchased, a five note minimum may be required). Treasury notes pay semiannual couponinterest, and they repay par value at maturity. Most Treasury notes are issued in book form only.

� Treasury bonds are similar to Treasury notes except that they have maturities over ten years. They areinitially issued at par value, pay semiannual coupon interest, and repay par value at maturity. Most Treasurybonds are issued in book form only.

Accounting for Treasury Bills. When purchased, T bills should be recorded at cost, which will be a discount fromtheir $10,000 par value. For example, a company would make the following entry to record the purchase of a91�day T bill on September 14, 20X1, at 97:

Short�term investments 9,700

Cash 9,700

To record the purchase of T bill.

As discussed previously, even though T bills do not pay coupon interest, the discount represents interest at theyield quoted at the date of acquisition. Accordingly, a question arises about whether the discount should beaccreted during the period the T bill is held.

Specific guidance is provided for the tax accounting of T bills. According to IRC Section 454(b)(2), the discount isnot accreted. If a T bill is held to maturity, all of the discount is reported as interest income. However, if it is sold priorto maturity, Section 1271(a)(3) requires the following:

� Recognizing interest income in the amount of the discount that would have been accreted through the saledate

� Treating the remainder of the difference between the sales proceeds and the acquisition cost as ashort�term capital gain or loss

Since tax rules view the discount as interest income and capital gain or loss is recognized only for value changesother than discount accretion, best practices indicates that IRC Section 454's approach of not accreting thediscount probably results from the view that accretion normally is not material.

For financial reporting, the only guidance that addresses accounting for T bills is found in accounting textbooks andsimilar publications, and they differ in their conclusions about whether to accrete the discount. If the effect would bematerial to the financial statements, best practices indicate accreting the discount because that is consistent withthe general accounting for other discounts. As a practical matter, however, since T bills normally have low yieldsand mature over short periods, best practices indicates that the effect of discount accretion normally is not materialto the financial statements.


365

To illustrate the accounting considerations, if the discount on the T bill in the immediately previous example, wereaccreted and the company's year ends in October, interest income of $155 would be recognized for the year, asfollows:

� Number of days since September 14 (date T bill was purchased) 47

� Number of days T bill is outstanding 91

� Discount ($10,000 par value less $9,700 acquisition cost) $ 300

� Discount accreted at the end of October ($300 � 47/91) $ 155

The following entry would record the accretion:

Short�term investments 155

Interest income 155

To accrete interest income on T bill.

After that entry, the balance of the T bill would be $9,855 ($9,700 + $155).

If the T bill were classified as a held�to�maturity security, it would be recorded in the company's financial statementsat $9,855 if the discount were accreted and at $9,700 if it were not. (Even though the financial statements wouldonly report a net amount, separate general ledger accounts may be maintained for the par value and the discount.)If the T bill were classified as available�for�sale, GAAP requires it to be recorded at fair value. Accordingly, thecompany would make an entry debiting or crediting the carrying amount of the T bill with a corresponding entry toother comprehensive income for the unrealized gain or loss.

Determining Fair Value. FASB ASC 820�10 (formerly SFAS No. 157 ) provides guidance on measuring fair value.In many cases, quoted market prices will be used to measure fair value. T bills are quoted in terms of bid and askedprices. Instead of specifying a price for T bills, however, they are quoted at a discount from par value. For example,financial publications, such as the Wall Street Journal, often show market prices of T bills as follows:

MaturityDays toMaturity Bid Asked Chg. Yield

Oct 10 'X6 97 5.18 5.16 +0.05 5.31

The first two columns indicate the date on which the T bills mature and the number of days remaining to maturity.As explained above, the bid and asked prices are quoted at discounts from par. In this example, the bid pricemeans an entity could sell a T bill from its portfolio maturing on October 10, 20X6, at a discount of 5.18% below par;it could purchase that T bill at a discount of 5.16% below par.

Best practices are to use the last bid price on the balance sheet date to estimate the fair value. Using the quotationsin the preceding paragraph, fair value of a $10,000 T bill would be determined as follows:

Fair�Value�� $10, 000��($10, 000� .0518� 97)

360�� $9, 860.43

Applying the yield to the fair value over the period until the T bill matures will accrete it to $10,000:

Quoted yield 5.31

Fair value $9,860.43

Interest income that would be earned if the investment wereheld for a year at the quoted yield = $9,860.43 � .0531 $523.59

Number of days until maturity 97

Number of days in the denominator (while 360 days are usedto calculate the price of a T bill, 365 days are used tocalculate its yield) 365


366

Interest that would be earned by holding the T bill untilmaturity = $523.59 � 97/365 $139.15

Accreted value at maturity = $9,860.43 + $139.15 (plus arounding difference of $.42) $10,000.00

Accounting for Treasury Notes and Bonds. Treasury notes and bonds may be purchased either at par ($1,000)or above or below par, depending on market conditions. Like investments in corporate or municipal bonds,Treasury notes and bonds should be recorded at cost, and any discount or premium amortized to income using theinterest method over the life of the securities. According to FASB ASC 835�30�20; 835�30�35�2; and 35�3 (formerlyAPB Opinion No. 12) the interest method arrives at periodic interest, including amortization, that represents a leveleffective rate on the sum of the face amount of the investment plus or minus the unamortized premium or discount.For convenience, an investment account is typically debited for the par value of the bond or note, and relateddiscount or premium is recorded in a separate account. For financial reporting, however, the investment accountshould be shown as a net amount.

To illustrate, a company would make the following entry to record the purchase of 10 five�year Treasury notesat�129:

Investment in Treasury notes 10,000

Premium on Treasury notes 2,900

Cash 12,900

To record the purchase of Treasury notes.

The yield implicit in the purchase price is 3.245% calculated on a semiannual basis (which is 6.49% interest). Thatis the rate that will discount 10 semiannual payments of $668.75 (see entries following Exhibit 1�2) and a singlepayment of $10,000 due 10 semiannual periods from the purchase date to $12,900. To find the premium amortiza�tion for the first six months, subtract interest calculated using the yield from the coupon interest. (A spreadsheet forcalculating amortization of premium and discount is illustrated in Exhibit 1�2.)

Coupon interest $ 668.75

Interest using the yield ($12,900 � 3.245%) 418.60

Premium amortization $ 250.15

Exhibit 1�2

Calculating Premium Amortization or Discount Accretion

Premium amortization or discount accretion is the difference between the interest at the coupon rate and interest atthe yield quoted when the Treasury obligation was bought. It can be calculated using a simple spreadsheet suchas the following, which assumes 10 five�year notes totaling $10,000 are purchased at 129 and bear coupon interestat 13.375% annually.

Par value $ 10,000.00

Purchase price $ 12,900.00

Period to maturity

Number of years 5

Number of semiannual periods 10

Coupon rate

Annual 13.3750 %

Semiannual 6.6875 %

Semiannual interest payments $ 668.75


367

Quoted yield at the date of purchase

Annual 6.4900 %

Semiannual 3.2450 %

InvestmentBalance

InterestIncome

Using YieldPremium

AmortizationPrincipalReceived

Initial Payment $ 12,900.00

1 12,649.85 $ 418.60 $ 250.15

2 12,391.59 410.49 258.26

3 12,124.95 402.11 266.64

4 11,849.65 393.45 275.30

5 11,565.42 384.52 284.23

6 11,271.97 375.30 293.45

7 10,969.00 365.78 302.97

8 10,656.19 355.94 312.81

9 10,333.23 345.79 322.96

10 0.00 335.52 333.23 $ 10,000.00

$ 3,787.50 $ 2,900.00

Notes:

1. The premium amortization is computed by subtracting the interest income calculated using the yield from thecoupon interest.

2. The investment balance is calculated by subtracting the premium amortization and principal received.

3. The method used in this illustration normally will result in a small balance at maturity. This should be chargedor credited to interest income for the year of maturity. In this illustration, that adjustment increases interestincome of the final period by $.21.

4. As an alternative, the investment balance could be calculated using present values, with premiumamortization generally computed as the change in the investment balance. That requires present valuecalculations of the number of remaining interest payments and the single payment of par value at maturity.

5. The following illustrates the accounting entries:

Treasury notes at par value 10,000.00

Premium on Treasury notes 2,900.00

Cash 12,900.00

To record acquisition of the Treasury notes.

Cash 668.75

Premium on Treasury notes 250.15

Interest income 418.60

To record receipt of the first interest payments.

Cash 10,668.75

Treasury notes at par value 10,000.00



To record receipt of the final interest payments and the par value.


368

6. Over the period the notes are held, the following would be recorded:

Cash received from 10 interest payments of $668.75 $ 6,687.50

Excess of $12,900.00 cash paid for the notes over the $10,000.00received for their par value (2,900.00 )

Interest income recognized $ 3,787.50

* * *

Every six months, the company would record interest on the note and amortization of premium or discount. If thenote had a coupon rate of 133/8, semiannual interest and premium amortization for the first six months would berecorded as follows:

Cash 668.75



To record semiannual income on Treasury note($10,000 � 0.13375/2) and premium amortization.

The entry would result in the following amounts at the end of the first six months:

� Unamortized premium ($2,900.00 initial amount less $250.15) $ 2,649.85

� Investment ($10,000.00 initial balance plus $2,649.85 unamortized premium) $ 12,649.85

(The $12,649.85 investment balance is the present value of nine semiannual interestpayments of $668.75 and a single payment of $10,000 due nine semiannual periodsfrom now, calculated using a semiannual yield of 3.245%.)

� Interest income ($668.75 coupon less $250.15 using yield) $ 418.60

Because Treasury notes and bonds pay coupon interest, it should be accrued and any premium or discount shouldbe amortized as of the balance sheet date. In addition, if notes or bonds are purchased between interest dates, thepurchase of accrued interest also should be recorded. Similar to Treasury bills, when Treasury notes or bondsmature, an entry debiting cash and crediting investments should be made If notes or bonds are sold beforematurity, any related premium or discount would be eliminated, and accrued interest should be recorded if the saleoccurs between interest dates.

If Treasury notes or bonds are classified as held�to�maturity securities at the balance sheet date, they should berecorded at amortized cost (that is, cost less amortization of premium or discount). If, on the other hand, they areclassified as available for sale, GAAP requires them to be recorded at fair value. In that circumstance, the companywould record the fair value adjustment by debiting or crediting the carrying amount of the Treasury note or bondwith a corresponding entry to other comprehensive income for the unrealized gain or loss.

Determining Fair Value. The fair value of Treasury bonds or notes at the financial statement date may bedetermined by reference to the last quoted bid price at that date. Financial publications, such as the Wall Street

Journal, might report information such as the following:

RateMaturityMo/Yr Bid Asked Chg. Ask Yield

67/8 July X9n 101:05 101:07 �7 6.43

The first column indicates the coupon ratein this case, 67/8%. The second column indicates that maturity of theTreasury note is July 20X9. (The �n" annotation indicates that this is a Treasury note rather than a bond.) The bidand asked quotes are not stated in percentages, as they are in the case of Treasury bills. Instead, numbers to theright of the colon represent 32nds of one point. In this case, the bid quote (the price at which an entity could sell)


369

translates to 1015/32 or $1,011.56, and the asked quote (the price at which an entity could purchase) translates to1017/32 or $1,012.19. The �ask yield" represents the yield to maturity on the note. Accordingly, the fair value of fivenotes maturing July 20X9 would be $5,057.80 ($1,011.56 � 5). If the Treasury note were classified as available forsale, the fair value adjustment would be recorded by debiting or crediting the carrying amount of the investments(cost plus or minus any related premium or discount) with a corresponding entry to other comprehensive incomefor the unrealized gain or loss.

Presenting Unrealized Gains and Losses. As explained earlier in this lesson, companies should debit or creditthe carrying amount of investments in available�for�sale marketable securities, with a corresponding entry to othercomprehensive income, to record unrealized gains and losses on the securities and report them at fair value in thefinancial statements. GAAP (as amended) also requires the notes to the financial statements to disclose thefollowing, by major security type, for available�for�sale securities: (a) aggregate fair value, (b)�total gains forsecurities with net gains in accumulated other comprehensive income, and (c) total losses for securities with netlosses in accumulated other comprehensive income. For securities classified as held�to�maturity, the followingdisclosures, by major security type, are required: (a) the aggregate fair value, (b) gross unrecognized holdinggains, (c) gross unrecognized holding losses, (d) the net carrying amount, and (e) the gross gains and losses inaccumulated other comprehensive income for any derivatives that hedged the forecasted acquisition of theheld�to�maturity securities. To keep track of that information, some companies may prefer to use more than oneaccount for available�for�sale securities (for example, initially recording all securities at cost and recording unreal�ized gains and losses in a separate account). While that practice is acceptable, the financial statements shouldpresent available�for�sale securities at a net amountfair valuenot cost plus or minus a valuation allowance.

GAAP requires unrealized gains and losses on available�for�sale securities to be recorded in other comprehensiveincome. Accordingly, the equity section of a company's balance sheet might appear as follows:


Capital stock$1.00 par value; 16,000 shares authorized; 15,832shares issued and outstanding

15,832

Additional paid�in capital 7,509,076

Net unrealized gain on marketable securities 4,675

Members' (deficit) (4,555,357 )

2,974,226


370


371

SELF�STUDY QUIZ


3. Company B purchased 20 $1,000 face value bonds on January 1, 20X2 at an amortized cost of $985 per bond.Company B will hold the bonds until maturity, 10 years later, unless there are changes in the yield on alternativeinvestments that make it advantageous to sell the bonds. On December 31, 20X9, the bonds have a marketvalue of $960 per bond. What does Company B report as the value of the bonds on the December 31, 20X9balance sheet, and how is the unrealized, temporary loss reported?

a. $19,200; report in earnings.

b. $19,200; report in other comprehensive income.

c. $19,700; no loss is reported.

d. $20,000; no loss is reported.

4. A company purchases a debt security at its $80,000 face value and classifies it as available�for�sale. Thesecurity bears interest at 10%, and is due in five years. On December 31, 20X1, the security's fair value is$85,000 and the company reclassifies the security as held�to�maturity. On January 31, 20X2, the security's fairvalue is $90,000. The 20X2 financial statements are issued on March 15, 20X2. What amount does the companyreclassify from available�for�sale to held�to�maturity?

a. $8,000.

b. $80,000.

c. $85,000.

d. $90,000.

5. Company C held bonds with a carrying amount of $30,000 which were originally classified as held�to�maturity.On December 31, 20X2, the company transfers the bonds to the available�for�sale category. On that day, themarket value of the bonds was $35,000. How much does Company C report as other comprehensive incomedue to this transfer?

a. $0.

b. $5,000.

c. $30,000.

d. $35,000.

6. A company purchases four 52�week $10,000 Treasury bills (T bills) at 98. The company classifies the T bills asavailable for sale. At the end of the year, the Wall Street Journal reports the following information regarding theT bills: Days to maturity: 85; Bid 6.2; Ask 6.3; Yield 6.55. What amount is reported as the value of the bondson its year�end financial statements?

a. $38,626.15.

b. $39,200.00.

c. $39,405.00.

d. $39,414.44.


372

7. How should an entity present available�for�sale securities on its balance sheet?

a. The net fair value.

b. Amortized cost.

c. Cost plus or minus a valuation allowance.

d. Cost less any non�temporary declines in value.


373



3. Company B purchased 20 $1,000 face value bonds on January 1, 20X2 at an amortized cost of $985 per bond.Company B will hold the bonds until maturity, 10 years later, unless there are changes in the yield on alternativeinvestments that make it advantageous to sell the bonds. On December 31, 20X9, the bonds have a marketvalue of $960 per bond. What does Company B report as the value of the bonds on the December 31, 20X9balance sheet, and how is the unrealized, temporary loss reported? (Page 358, Exhibit 1�1)

a. $19,200; report in earnings. [This answer is incorrect. The loss would be reported in earnings if the bondsare held for trading.]

b. $19,200; report in other comprehensive income. [This answer is correct. The bonds should beclassified as available�for�sale since the company would consider selling the bonds in somecircumstances. Bonds that are available for sale with an unrealized loss should report the loss inother comprehensive income.]

c. $19,700; no loss is reported. [This answer is incorrect. Since the company would consider selling thebonds in certain circumstances, the bonds are not treated as held�to�maturity and should be reported atfair value.]

d. $20,000; no loss is reported. [This answer is incorrect. The bonds are originally recorded at their amortizedcost, the basis of the bonds either remains the same or is adjusted based on their market value, dependingon their classification.]

4. A company purchases a debt security at its $80,000 face value and classifies it as available�for�sale. Thesecurity bears interest at 10%, and is due in five years. On December 31, 20X1, the security's fair value is$85,000 and the company reclassifies the security as held�to�maturity. On January 31, 20X2, the security's fairvalue is $90,000. The 20X2 financial statements are issued on March 15, 20X2. What amount does the companyreclassify from available�for�sale to held�to�maturity? (Page 360)

a. $8,000. [This answer is incorrect. This is the amount of interest the company earns on the investment,which is recognized as interest income.]

b. $80,000. [This answer is incorrect. Debt securities transferred to the held�to�maturity category from theavailable�for�sale category are adjusted to a new cost basis; the original cost or amortized cost is not thebasis of the reclassified security.]

c. $85,000. [This answer is correct. The security's value at the transfer date becomes its new costbasis. Changes in value subsequent to the report date, but before the issuance of the financialstatements should not be recognized. Subsequent changes in value are recognized when realized.]

d. $90,000. [This answer is incorrect. Changes in value subsequent to the report date, but before the issuanceof the financial statements should not be recognized.]

5. Company C held bonds with a carrying amount of $30,000 which were originally classified as held�to�maturity.On December 31, 20X2, the company transfers the bonds to the available�for�sale category. On that day, themarket value of the bonds was $35,000. How much does Company C report as other comprehensive incomedue to this transfer? (Page 360)

a. $0. [This answer is incorrect. The carrying amount of the bonds is increased to its current value on thetransfer date. The other side of the entry is other comprehensive income.]

b. $5,000. [This answer is correct. To transfer the bonds from held�to�maturity to available�for�sale, thebonds are first adjusted to their market value. The other side of the entry is to other comprehensiveincome. The bonds can then be reclassified to available�for�sale at their new carrying amount.]


374

c. $30,000. [This answer is incorrect. The original carrying amount of the bonds is already recorded at itscarrying amount of $30,000. This amount should be adjusted to its market value at the transfer date, witha corresponding entry to other comprehensive income.]

6. A company purchases four 52�week $10,000 Treasury bills (T bills) at 98. The company classifies the T bills asavailable for sale. At the end of the year, the Wall Street Journal reports the following information regarding theT bills: Days to maturity: 85; Bid 6.2; Ask 6.3; Yield 6.55. What amount is reported as the value of the bondson its year�end financial statements? (Page 365)

a. $38,626.15. [This answer is incorrect. The fair value is not calculated using the discounted cost of the Tbills.]

b. $39,200.00. [This answer is incorrect. This is the amount that would be reported if the T bills were classifiedas held to maturity.]

c. $39,405.00. [This answer is incorrect. Although GAAP does not specify whether the bid price, the askedprice, or some combination of the two represents the fair value, the best method to determine the fair value,generally is not the asked price.]

d. $39,414.44. [This answer is correct. Best practices are to use the last bid price on the balance sheetdate to estimate the fair value. The calculation of fair value is determined as: $40,000 � (($40,000� .062 � 85)/360).]

7. How should an entity present available�for�sale securities on its balance sheet? (Page 369)

a. The net fair value. [This answer is correct. Some companies prefer to use more than one accountfor available�for�sale securities to keep track of the original cost and unrealized gains and losses.However, the financial statements should present available�for�sale securities at a net amountfairvaluenot cost plus or minus a valuation allowance.]

b. Amortized cost. [This answer is incorrect. Securities that are classified as held�to�maturity are reported attheir amortized cost per GAAP.]

c. Cost plus or minus a valuation allowance. [This answer is incorrect. According to GAAP, some companieschoose to keep track of their available�for�sale securities in separate accounts, but these accounts shouldnot be shown separately on the financial statements.]

d. Cost less any non�temporary declines in value. [This answer is incorrect. According to GAAP, market valuedeclines in securities that are classified as available�for�sale are reported even if the change is temporary.]


375

Receivables

Receivables is a broad term that includes amounts due from others as a result of sales of merchandise, services,or other assets, or as a result of a loan. Receivables may be divided into three categories: trade, nontrade, andrelated party. This lesson considers the financial statement presentation of certain specific types of receivables andthe presentation and calculation of the allowance for doubtful accounts.

Balance Sheet Captions. The captions used in presenting receivables vary according to the types of receivablesand the level of detail to be presented on the face of the balance sheet. The captions should be accuratedescriptions of the accounts included. The most frequently used are:

� Accounts receivable

� Trade accounts receivable

� Receivables

The first two generally refer to trade accounts. The captions also are appropriate when nontrade receivables areinsignificant or are presented in a separate caption. �Receivables" is a more appropriate caption when significantnontrade receivables are combined with trade receivables. In such cases, disclosure of the types of receivablesthat have been combined should be considered.

Trade Receivables. Trade receivables include open accounts, notes, and installment contracts representingclaims for goods and services sold in the ordinary course of business. Frequently, open accounts and current notesare combined under the caption �Trade accounts and notes receivable." However, it is generally good practice todisclose the amounts and terms of trade notes or installment receivables, particularly when the notes or installmentcontracts significantly extend the normal collection period. When space allows, many accountants use separatecaptions on the balance sheet to set out the amounts of trade notes or installment receivables. For example:

Trade receivables


Short�term installment contracts 675,000

Less allowance for doubtful contracts 50,000

925,000

GAAP requires certain other disclosures that apply to receivables. Those disclosures are generally made in notesto the financial statements.

Gross profit deferred under the installment method is in substance a valuation allowance of the related receivablebecause of collection concerns.

a. FASB ASC 605�10�25�4 (APB 10, Para. 12) says:

There may be exceptional cases where receivables are collectible over an extended period oftime and, because of the terms of the transactions or other conditions, there is no reasonablebasis for estimating the degree of collectibility. When such circumstances exist, and as long asthey exist, either the installment method or the cost recovery method of accounting may be used.

b. Under FASB ASC 360�20�40�31; 40�34; and 40�48 (formerly SFAS No. 66) the installment method is usedwhen there is concern about realization of the receivable because:

� The initial investment is not adequate, but recovery of the cost of the property sold is assured;

� The initial investment is adequate, but the continuing investment is not adequate and annualpayments are not sufficient; or

� There is a partial sale, and collection is not assured


376

Offsetting would therefore be required by FASB ASC 310�10�45�4 (formerly APB 12, Para. 3), which requires, assetvaluation allowances for losses to be deducted from the assets or groups of assets to which they relate.

Nontrade Receivables. To make financial statements more informative and useful, nontrade receivables, if mate�rial, should be separately classified. Nontrade receivables are items such as:

a. tax refund claims,

b. receivables from sales not part of the operating cycle, such as sales of plant or equipment, and

c. dividends receivable.

If nontrade receivables are not individually material, they may be classified together, for example, �Accountsreceivableother" or �Other receivables." If immaterial in the aggregate, they may be included with trade accountsor notes. Best practices indicate that nontrade receivables also may include the current portion of deferred taxassets; the noncurrent portion, however, should be presented with other noncurrent assets.

Related Party Receivables. FASB ASC 850�10�50 (formerly SFAS No. 57) requires material amounts of notes andaccounts receivable from related parties including stockholders, officers, management, or affiliates to be disclosed.The disclosure normally may be provided using a balance sheet presentation such as the following:

Cash 10,000

Accounts receivable

Trade 65,000

Related parties 25,000

or

Cash 10,000

Marketable securities 15,000


Due from related parties 35,000

Tax refund claim 20,000

The caption �Due from Related Parties" is useful when several types of related party receivables are present. Whenonly one type of receivable is present, a more descriptive caption is often used, e.g., �Officer notes receivable,"�Due from affiliates," or �Due from stockholders." GAAP also requires other disclosures about related partytransactions, which are usually provided in a note to the financial statements.

Transfers of Receivables Prior to Adoption of New Requirements. FASB ASC 860 (formerly SFAS No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities) is the authoritativeliterature on reporting by transferors for transfers of receivables. Transfers of receivables in which the transferorsurrenders control over the receivables should be recorded as sales (to the extent that the consideration receivedfor the transferred receivables does not include beneficial interests in those receivables). The transferor is consid�ered to have surrendered control over the transferred receivables only if all of the following conditions are met:

a. The transferred receivables must be isolated from the transferor (i.e., the receivables must be beyond thereach of the transferor and its creditors, even in bankruptcy or other receivership).

b. The transferee obtains the right to pledge or exchange the transferred receivables without constrainingconditions that provide more than a trivial benefit to the transferor.

c. The transferor must not maintain effective control over the transferred receivables through (1) an agreementthat entitles and obligates the transferor to repurchase the receivables before their maturity or (2) the abilityto unilaterally cause the holder to return specific transferred receivables other than when the cost ofservicing the receivables becomes burdensome in relation to the benefits of servicing them, often referredto as a �cleanup call."


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Transactions that do not meet the above criteria for a sale should be accounted for as a secured borrowing withpledge of collateral.

Upon completion of a transfer of receivables meeting the criteria listed above to be accounted for as a sale, thetransferor should:

a. Derecognize (i.e. remove from the balance sheet) all receivables sold.

b. Recognize all assets received and liabilities incurred in consideration for the transferred receivables asproceeds from the sale.

c. Measure the assets obtained and liabilities incurred at fair value.

d. Recognize any gain or loss on the sale in earnings.

For any transfer of receivables, including those accounted for as sales, GAAP requires the transferor to continue tocarry in its balance sheet any retained interest in the transferred receivables by allocating the previous carryingamount between the receivables sold (if any) and the retained interests (if any), based on their relative fair values atthe date of the transfer. Examples of retained interests include securities backed by the transferred receivables andundivided interests. If the transferor cannot determine whether an asset represents a retained interest or proceedsfrom the sale, the asset should be treated as proceeds from the sale.

When an entity transfers receivables to another entity (the transferee), it often does so with recourse. In that case,the transferee has the right to receive payment from the transferor or the transferor must�repurchase the receivablesif the debtor defaults. Transfers of receivables with recourse must meet the conditions previously listed to beaccounted for as a sale. The effect of�recourse provisions on the application of the conditions listed previously mayvary by jurisdiction. In some jurisdictions, the transfer of receivables with full recourse may not place the transferredreceivables beyond the reach of the transferor and its creditors. However, transfers with limited recourse may. Whenaccounting for a transfer of receivables with recourse as a sale, the proceeds of the sale should be reduced by thefair value of the recourse obligation. To illustrate how to record a transfer of receivables with recourse that isrecognized as a sale, assume that:

� A $100,000 note is sold for $95,000, with the transferor retaining recourse for $25,000.

� There is no fee for the transfer.

� The transferor estimates that losses under the recourse provision will total $5,000.

The transferor would record the following journal entry:

Cash 95,000

Loss on sale of receivable 10,000

Note receivable 100,000

Recourse obligation 5,000

If the transfer of receivables with recourse does not meet the conditions previously listed to be accounted for as asale, the transfer should be accounted for as a secured borrowing and pledge of collateral.

Transfers of Receivables after Adoption of New Requirements. FASB ASC 860 (formerly SFAS No. 140)provides accounting and reporting standards for transfers and servicing of financial assets. Those standards applyto transfers of receivables. In June 2009, the FASB issued SFAS No. 166, Accounting for Transfers of FinancialAssets, which amended the guidance in FASB ASC 860 (formerly SFAS No. 140). The new standard is effective asof the beginning of an entity's first annual reporting period beginning after November 15, 2009. Earlier applicationis prohibited. The recognition and measurement provisions of the new standard should be applied to transfers thatoccur on or after the effective date. After it was issued, SFAS No. 166 was integrated into the FASB AccountingStandards Codification by ASU 2009�16, Transfers and Servicing (Topic 860): Accounting for Transfers of FinancialAssets.


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GAAP discusses transfers of financial assets in terms of transfers of an entire financial asset, a group of entirefinancial assets, or a participating interest in an entire financial asset, which are collectively referred to as transferredfinancial assets. One of the primary considerations in determining the proper accounting for transfers of financialassets is whether the transferor (and its consolidated affiliates) has surrendered control over the assets transferred.Generally, if the transferor surrenders control over the transferred financial assets, the transfer is accounted for asa sale and the related assets are removed from the transferor's balance sheet. According to FASB ASC860�10�40�5, a transferor is considered to have surrendered control over transferred financial assets if all of the

following conditions are met:

a. The transferred financial assets (i.e., the transferred receivables) have been isolated from the transferor(that is, put beyond the reach of the transferor and its creditors, even if the transferor is in bankruptcy orother receivership).

b. Each transferee (or third�party holder of beneficial interests if the transferee solely engages in securitizationor asset�backed financing activities and is constrained from pledging or exchanging the assets it receives)has the right to pledge or exchange the transferred assets (or beneficial interests) it received, and nocondition both (1) constrains the transferee (or third�party holder) from taking advantage of that right, and(2) provides more than a trivial benefit to the transferor.

c. Effective control over the transferred financial assets (or related third�party beneficial interests) is notmaintained by the transferor, its consolidated affiliates, or its agents. A transferor's effective control may bemaintained through agreements such as the following: (1) one that entitles and obligates the transferor torepurchase or redeem the assets before their maturity, (2) one that gives the transferor the unilateral abilityto cause the holder to return specific financial assets and a more�than�trivial benefit related to that ability(other than through a clean�up call) and, (3) one that allows the transferee to require the repurchase oftransferred financial assets by the transferor at a price so favorable to the transferee that it is probable thatthe repurchase will occur.

Accounting for Transfers of Participating Interests. As noted earlier, transfers of financial assets may involvetransfers of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financialasset. GAAP provides different accounting guidelines for transfers of participating interests than for transfersinvolving entire financial assets or groups of entire financial assets. Accordingly, it is important to understand whatconstitutes a participating interest. According to FASB ASC 860�10�40�6A, a participating interest has all of thefollowing characteristics:

a. It represents, from the date of the transfer, a proportionate (pro rata) ownership interest in an entire financialasset. The transferor's percentage of ownership interests may change over time if certain conditions aremet.

b. From the transfer date, all cash flows received from the entire financial asset are divided between theparticipating interest holders in proportion to their ownership share. Certain cash flows allocated ascompensation for services performed, if any, and some proceeds received by the transferor for thetransferred portion are excluded from this determination.

c. Each participating interest holder (including the transferor) has rights of equal priority and no interest issubordinated to another participating interest holder's interest.

d. The entire financial asset may not be pledged or exchanged without the agreement of all participatinginterest holders.

If a transferred interest in an entire financial asset has the characteristics of a participating interest, the transferorshould analyze the transfer to determine if it satisfies the conditions for surrendered control. If the transferor of theparticipating interest has surrendered control, the transfer should be accounted for as a sale according to theprovisions of FASB ASC 860�20�40�1A. Upon completion of the transfer, the transferor should:

a. Allocate the entire financial asset's previous carrying amount between the participating interests sold andthe participating interest retained by the transferor based on their relative fair values at the transfer date.


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b. Derecognize (that is, remove from the balance sheet) the participating interests sold.

c. Recognize and initially measure at fair value all assets received and liabilities incurred in the sale.

d. Recognize any gain or loss on the sale in earnings.

e. Report any participating interest or interests that the transferor retains as the difference between the priorcarrying amount of the entire financial asset and the amount derecognized.

The transferee should recognize and initially measure at fair value the participating interest and any other assetsreceived or liabilities incurred.

If a transferred interest in an entire financial asset does not have the characteristics of a participating interest, thetransferor and the transferee should account for the transfer as a secured borrowing and pledge of collateral. Thetransfer should also be accounted for as a secured borrowing and pledge of collateral if the transferred interest hasthe characteristics of a participating interest but the transfer does not satisfy the conditions to be accounted for asa sale.

If the transferor transfers an entire financial asset in multiple interests that do not individually qualify as participatinginterests, the transferor should evaluate whether the entire financial asset transferred should be accounted for as asale when all interests have been transferred.

Accounting for Transfers of an Entire Financial Asset or Group of Entire Financial Assets. For transfers of an entirefinancial asset or a group of entire financial assets that meet the conditions for sale accounting, the transferorshould do the following upon completion of the transfer according to the provisions of FASB ASC 860�20�40�1B:

a. Derecognize (that is, remove from the balance sheet) the transferred financial assets.

b. Recognize and initially measure at fair value all assets received and liabilities incurred in the sale.

c. Recognize any gain or loss on the sale in earnings.

The transferee should record any assets obtained and liabilities incurred at fair value.

If a transfer of an entire financial asset or a group of entire financial assets does not meet the conditions to beaccounted for as a sale in its entirety, upon completion of the transfer the transferor should account for the transferas a secured borrowing and pledge of collateral.

Accounting for Secured Borrowings. A transfer of an entire financial asset, a group of entire financial assets, or aparticipating interest in an entire financial asset may not meet the conditions for sale accounting. In those situations,the transferor and the transferee should account for the transfer as a secured borrowing with pledge of collateral.Likewise, if a transfer involves part of an entire financial asset and that partial transfer does not have the characteris�tics of a participating interest, the transfer also should be accounted for as a secured borrowing with pledge ofcollateral. That accounting requires the transferor to continue to report the transferred financial assets on itsbalance sheet without changing how it measures those assets.

Transfers of Receivables with Recourse. When an entity transfers receivables (including an entire receivable, agroup of entire receivables, or part of an entire receivable) to another entity (the transferee), it often does so withrecourse. When there is recourse, the transferee has the right to receive payments from the transferor or thetransferor must repurchase the receivables in certain cases, such as when the debtor defaults. Transfers of entirereceivables with recourse must meet the conditions to be accounted for as a sale. However, a transfer of a portionof a receivable with recourse is not considered a participating interest and must be accounted for as a securedborrowing.

The effect of recourse provisions on the application of the requirements may vary by jurisdiction. In some jurisdic�tions, the transfer of receivables with full recourse may not place the transferred assets beyond the reach of thetransferor, its consolidated affiliates, and its creditors; however, transfers with limited recourse may. If a transfer of


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entire receivables with recourse meets the conditions, the transfer should be accounted for as a sale with theproceeds of the sale reduced by the fair value of the recourse obligation. If a transfer of entire receivables withrecourse does not meet those conditions, the transfer should be accounted for as a secured borrowing.

Inventories

Inventories, according to FASB ASC 330�10�20 (formerly ARB No. 43, Chapter 4), include the following items:

a. Items held for sale in the ordinary course of business

b. Items in the process of production for sale

c. Items to be consumed in the production of goods or services to be available for sale

Operating supplies not directly entering into the production of the product should be treated as prepaid expensesrather than inventories. Also, in some industries, most notably construction, items that might appear to be invento�ries receive special accounting treatment and are not presented in the financial statements as inventories, forexample, costs and estimated earnings in excess of billings on contracts in progress.

Balance Sheet Captions. Inventories are normally presented in the balance sheet at the lower of cost or market.The retail inventory method used by department stores and some other retailers approximates lower of cost ormarket. Some specialized industries, such as agricultural products, state inventories above cost, but those excep�tions are rare. GAAP requires the following to be disclosed:

a. Basis upon which the inventory classifications are stated

b. Method of determining costs

It is common practice to disclose the inventory basis and method of determining cost within the balance sheetcaption. For example:

Inventories, at the lower of first�in, first�out cost or market.

However, the disclosures may be made in the notes rather than on the face of the balance sheet.

Components of Inventory. There is no requirement to disclose the components or types of inventory, but, inpractice, disclosure is almost universal in the following situations:

a. Manufacturing inventories in various stages of completion

b. Inventories of distinct product lines

Examples of disclosure of inventory components, which may be made on the face of the balance sheet or in thenotes, are as follows:

20X2 20X1

Inventories

Raw materials 75,000 60,000

Work in process 25,000 30,000

Finished goods 50,000 40,000

20X2 20X1

Inventories

New vehicles 200,000 225,000

Used vehicles 150,000 175,000

Parts and accessories 150,000 150,000


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20X2 20X1

Inventories

Gasoline 15,000 17,000

Groceries 60,000 75,000

Other 10,000 5,000

Determining Inventory Cost. There are two aspects of determining inventory costs that must be considered:

a. What costs are properly charged to inventory?

b. In what sequence should those costs be charged to cost of sales as inventory is sold?

Companies that do not manufacture a product, such as retailers and wholesalers, generally incur only directmaterial costs in acquiring their inventories. Inventory costs of manufacturing companies include three compo�nents:

a. Direct materials, including invoice cost, freight�in, and tooling charges from vendors

b. Direct laborpayroll costs of personnel whose efforts directly result in manufacture of the product

c. Indirect costs, including factory facility costs, utilities, indirect manufacturing labor and related costs, butexcluding general and administrative expenses

The proper allocation of indirect costs between inventory and cost of sales is a key factor in determining inventorycost.

Generally accepted accounting principles essentially permit four ways of determining the sequence of costs to becharged to cost of sales.

a. Specific Identification. The cost of each unit is tracked and charged to cost of sales when the unit is sold.

b. First�in, First�out (FIFO). Inventory sold is considered to be the oldest inventory available for sale;conversely, ending inventory is considered to be the latest inventory purchased.

c. Last�in, First�out (LIFO). Inventory sold is considered to be the latest inventory purchased; conversely,ending inventory is considered to be the oldest inventory available for sale.

d. Average Cost. The cost of items in inventory is determined on the basis of the average cost of all similaritems available during the period.

Most companies use either the FIFO or LIFO method. Inventory methods such as standard cost or the retail methodare generally accepted conventions used in applying one of the four methods allowed by GAAP. Disclosing thoseconventions is not required and, if disclosed, usually is included in the notes rather than on the face of the balancesheet.

Applying Lower of Cost or Market. The lower of cost or market rule basically requires recognizing an unrealizedloss when historical cost will not be recovered through the expected selling price. Generally, FASB ASC 330�10�20(formerly ARB No. 43) requires writing inventory down to current replacement cost (market value) except in thefollowing instances:

� Market value should not be less than net realizable value reduced by an allowance for an approximatelynormal profit margin. (Thus, cost should be used to value inventory if the net realizable value will providefor an approximately normal gross profit, even if current replacement cost is lower than historical cost.)

� Market value should not exceed the inventory's net realizable value. (In other words, net realizable valueshould be used to value the inventory if it is lower than current replacement cost.) Net realizable value isthe estimated selling price less costs of completion and disposal.


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To illustrate, assume that an item costs $40, sells for $50 (which provides for normal profit margin of $10) and at theend of 20X2, its current replacement cost drops to $30.

� If the selling price is unaffected (perhaps because of firm sales commitments), the inventory would becarried at $40 since the selling price will recover cost plus the normal profit margin.

� If the selling price drops to $40, the inventory would be carried at $30. The income statement for 20X2 wouldshow a loss (through a charge to cost of sales) of $10 for the loss in value, and the income statement for20X3 would show a profit of $10 resulting from the sale.

� If the net realizable value (selling price less costs of completion and disposal) drops to $25, the inventorywould be stated at $25.

Obsolescence. Excess and obsolete inventory should be written down to its net realizable value, which may bescrap value, even if the inventory is not actually scrapped or even segregated. Many companies establish reservesfor obsolete and slow moving inventory by using a formula based on supply and past sales history. Inventory valuesare generally presented in the financial statement as a net amount, that is, the reserves are not presented on theface of the balance sheet. It may, however, be appropriate to disclose the methods used to determine the reservein the accounting policies note.

The Need for Physical Counts. Most accountants agree that inventories should be adjusted to physical count atleast annually. The one exception generally accepted in annual financial statements is the use of inventory amountsderived from well�maintained perpetual inventory records. (However, many accountants will not rely on perpetualrecords unless they are systematically tested by periodic physical counts.) The inability to obtain reliable counts ofinventory at year end either by physical count or perpetual records may cause significant problems for accountantsin practice, who may be required by professional standards to modify their report or, in compilation and reviewengagements, to withdraw from the engagement. As explained in the next section, inventory amounts may beestimated by appropriate methods such as the gross profit method in interim financial statements.

InventoriesInterim Financial Statements

In interim financial statements, several modifications of the accounting standards for inventory are permitted orrequired.

Gross Profit Method. The gross profit method is the most common method of estimating inventories at interimdates when physical inventories are not taken. The use of this method to determine inventory and cost of goodssold, although not an acceptable accounting method in annual statements, is an acceptable method for interimfinancial statements according to FASB ASC 270�10�45�6 (formerly APB Opinion No. 28). However, the interimfinancial statements should disclose the method used to value inventory and any significant adjustments that resultfrom reconciliation with the annual physical inventory.

Market Declines. Even when the gross profit method is used, it may be obvious that market is below cost.Temporary declines in the market value of inventory to values below cost need not be recognized in interim financialstatements if the market decline can reasonably be expected to be restored by the end of the fiscal year. If, however,the company cannot reasonably expect a decline at an interim date to reverse by year end, inventory should beadjusted to market value at the interim date. A subsequent recovery in value before year end should be recognizedin the interim period during which the recovery takes place. However, the inventory, once adjusted downward tomarket, should not be written up above original cost.

LIFO Approximations. Many companies compute LIFO inventory values only on an annual basis. At interim dates,a FIFO basis is used. In that case, the following considerations apply:

� If the difference between LIFO and FIFO values as of the interim date is immaterial, the inventory basis maybe identified as LIFO.

� If the difference is material and the financial statements are issued with inventories on a FIFO basis, thestatements are not in conformity with GAAP because they do not use the same method as used in the


383

year�end statements. The preparer also should be concerned about potential violation of various IRSregulations regarding LIFO, particularly Reg.�1.472�2(e)(6), holding that in certain cases a series of interimstatements presenting results of operations on a non�LIFO basis constitutes presentation of annual resultson a non�LIFO basis.

� If the difference between LIFO and FIFO values is material, the preparer may want to approximate anadjustment to LIFO and present the statements with inventory stated at the estimated LIFO value. Thatapproach parallels the use of gross profit percentages at interim dates. Best practices indicate such anapproach is proper and is not a departure from GAAP if the estimation method has a reasonable basis. Ofcourse, the estimation method used to value the inventories should be disclosed.

LIFO Inventory Liquidations. When there is a liquidation of a LIFO layer in an interim period, a determination mustbe made of whether the liquidation is temporary or permanent. If the liquidation is permanent, the interim periodfinancial statements should disclose the effect on net income resulting from the liquidation. If the liquidation istemporary, the inventory at the interim reporting date should not give effect to the LIFO liquidation, and cost of salesshould include the expected cost of replacement of the liquidated LIFO layer. The temporary nature of theliquidation should be disclosed in the financial statements.

Standard Cost System. Planned variances expected to be absorbed by the end of the fiscal year should ordinarilybe deferred in interim financial statements. Unanticipated variances that are not expected to be absorbed should,however, be reported in interim financial statements.


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385

SELF�STUDY QUIZ


8. A bakery has a note receivable of $150,000 due from a grocery store. The bakery sells the receivable to a bankfor $140,000, with the bakery retaining recourse for $20,000. The bakery estimates that losses under therecourse provision will total $15,000. When recording the journal entry to record the sale of the note prior toadoption of SFAS No. 166, the loss on the sale is debited for what amount?

a. $10,000.

b. $15,000.

c. $20,000.

d. $25,000.

9. Which of the following inventory costs is typically the only type incurred by a retailer?

a. Direct labor.

b. Direct materials.

c. Indirect costs.

d. Work in process.

10. The cost of an item of inventory is $30 and its selling price is $45. At the end of the year, its replacement costis $25. The net realizable value is $35. Due to firm sales commitments, the sales price has not changed. At whatamount is the inventory stated?

a. $25.

b. $30.

c. $35.

d. $45.


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8. A bakery has a note receivable of $150,000 due from a grocery store. The bakery sells the receivable to a bankfor $140,000, with the bakery retaining recourse for $20,000. The bakery estimates that losses under therecourse provision will total $15,000. When recording the journal entry to record the sale of the note prior toadoption of SFAS No. 166, the loss on the sale is debited for what amount? (Page 377)

a. $10,000. [This answer is incorrect. Although it may appear the loss is $10,000 ($140,000 received for a$150,000 note), the recourse obligation is factored into the loss amount recorded.]

b. $15,000. [This answer is incorrect. This is the amount of recourse obligation, not the amount of the loss.]

c. $20,000. [This answer is incorrect. Although the bakery may be liable for up to $20,000 if the grocery storedefaults on the note, the recourse retained is not included in the journal entry, or in the amount of the loss.]

d. $25,000. [This answer is correct. The loss is the amount of recourse obligation recorded ($15,000)plus the amount that would be the loss if there was no recourse obligation ($140,000 � $150,000).]

9. Which of the following inventory costs is typically the only type incurred by a retailer? (Page 381)

a. Direct labor. [This answer is incorrect. Direct labor, which includes payroll costs of personnel whose effortsdirectly result in manufacture of the product, are inventory costs of a manufacturing company.]

b. Direct materials. [This answer is correct. Direct materials are inventory costs for both manufacturersand retailers and wholesalers. Direct materials include invoice cost, freight�in, and tooling chargesfrom vendors.]

c. Indirect costs. [This answer is incorrect. Indirect costs, including factory facility costs, utilities, indirectmanufacturing labor and related costs, are inventory costs of manufacturers.]

d. Work in process. [This answer is incorrect. Work in process is a component of direct materials, and wouldtypically only be recorded in manufacturing companies.]

10. The cost of an item of inventory is $30 and its selling price is $45. At the end of the year, its replacement costis $25. The net realizable value is $35. Due to firm sales commitments, the sales price has not changed. At whatamount is the inventory stated? (Page 381)

a. $25. [This answer is incorrect. If the selling price drops to $30, the inventory would be carried at $25.]

b. $30. [This answer is correct. The lower of cost or market rule basically requires recognizing anunrealized loss when historical cost will not be recovered through the expected selling price.Generally, GAAP requires writing inventory down to current replacement cost (market value) exceptin the following instances: (1) market value should not be less than net realizable value reduced byan allowance for an approximately normal profit margin, and (2) market value should not exceed theinventory's net realizable value.]

c. $35. [This answer is incorrect. If the net realizable value drops below the replacement cost, then inventoryis stated at the net realizable value.]

d. $45. [This answer is incorrect. The sales commitments would not cause a company to state inventory atan amount greater than its cost.]


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Lesson 1 (PFSTG104)


1. A home appliance company has the following balances on December 31, 20X1, in its accounts with SecondBank: Operating account $150,000; certificate of deposit $50,000; cash restricted for mortgage payment$100,000 (does not offset a current liability); and money market account $10,000. The company also has anaccount at Fourth Bank with a book balance of ($25,000). The negative balance is due to the controller writingchecks in the amount of $40,000 on December 31, 20X1, but held them and did not mail them until January2, 20X2. What amount does the appliance company report as �Cash" on its December 31, 20X1 balance sheet?

a. $175,000.

b. $210,000.

c. $225,000.

d. $325,000.

2. Which type of account is typically included as a prepaid expense, and should be excluded from cash?

a. Restricted cash accounts.

b. Overdraft accounts.

c. Compensating balance accounts.

d. Escrow accounts.

3. Which of the following is considered a marketable security?

a. Warrants.

b. Money market accounts.

c. Repurchase agreements.

d. Certificates of deposit.

4. A television station owns common stock in several other communications companies. Assuming the equitymethod is not used to report these other companies, what basis does the television station use to report thevalue of the common stock owned in the companies, and how are unrealized gains and losses reported?

a. Amortized cost; unrealized gains and losses are not recognized.

b. Fair value; unrealized gains and losses are reported in earnings.

c. Fair value; unrealized gains and losses are reported in other comprehensive income.

d. Amortized cost; unrealized gains and losses are reported in earnings.


388

5. On January 1, 20X1, an entity purchased bonds with a face value of $100,000 at a premium of $110,000, andclassified the bonds as available�for�sale. On December 31, 20X1, when the bonds' value is $115,000, the entityreclassifies the bonds as held�to�maturity. The bonds value increases to $120,000 on February 28, 20X2, andon March 31, 20X2, the entity's 20X1 financial statements are issued. What amount does the entity report asthe value of the bonds on the 20X1 financial statements?

a. $100,000.

b. $110,000.

c. $115,000.

d. $120,000.

6. A company purchases 12�month T bills for $1,000,000. At the end of the year, The Wall Street Journal reportsthe following information: Days to maturity40; Bid4.38; Ask 4.40; Yield4.49. What is the value of the Tbills?

a. $995,011.11.

b. $995,111.11.

c. $995,133.33.

d. $999,878.33.

7. What information does GAAP require disclosure of, by major security type, for available�for�sale securities?

a. Gross unrecognized holding gains.

b. Aggregate fair value.

c. Net carrying amount.

d. Original cost of securities.

8. Assuming each of the following types of receivable has a material balance, which of the following will bepresented in the �Trade Receivables" caption?

a. Dividends receivable.

b. Tax refunds receivable.

c. Related party receivable.

d. Accounts receivable.

9. Which of the generally accepted methods of determining the sequence of costs to be charged to cost of salestracks the cost of each unit and charges the cost to cost of sales when the unit is sold?

a. Specific identification.

b. First�in, first�out.

c. Last�in, first�out.

d. Average cost.


389

10. Which method of estimating inventory is an acceptable method to use during interim periods, but not anacceptable method in annual statements?

a. Last�in, first�out.

b. Lower of cost or market.

c. Gross profit method.

d. Standard cost.


390


391

Lesson 2:�Long�term Investments

INTRODUCTION

The long�term investments caption of the balance sheet may include the following types of holdings:

a. Noncurrent marketable equity and debt securities

b. Nonmarketable equity and debt securities

c. Property and equipment held for investment purposes

d. Cash value of life insurance

This lesson covers long�term investments and using the equity method to account for nonmarketable equity securi�ties.


Completion of this lesson will enable you to:� Determine the appropriate captions and valuation for long�term investments such as nonmarketable securities,

cash value of life insurance policies, and property held for investment.� Determine the accounting treatment for nonmarketable equity securities.� Determine the correct reporting method for cash value life insurance policies.

Nonmarketable Equity Securitiesthe Equity Method

The accounting treatment of holdings of equity securities, whether marketable or nonmarketable, is influenced bythe percentage of voting stock held. (Using the equity method is not affected by whether the equity securities aremarketable or nonmarketable, but blocks of stock large enough to require the equity method are typically nonmar�ketable.) Generally, the relationships are as follows:

� Less Than 20%. Holdings of less than 20% of marketable voting stock are accounted for at fair value asprescribed by FASB ASC 320�10 (formerly SFAS No. 115). Holdings of less than 20% of nonmarketable

voting stock are accounted for at cost. Cost is reduced for permanent declines in value, and dividends aretreated as income when received.

� More Than 50%. A holding of more than 50% of the voting stock of another company generally constitutescontrol and may require presentation of consolidated financial statements.

� Between 20% and 50%. There is a presumption, according to FASB ASC 323�10�15�8 (formerly APBOpinion No. 18, The Equity Method of Accounting for Investments in Common Stock), that the holder(investor) of 20% to 50% of the voting stock of another company (investee) has the ability to exercisesignificant influence over the investee and should account for the investment using the equity method.

The appropriateness of using the equity method and the effect on the investor's financial statements are explainedin the following paragraphs.

Should the Equity Method Be Used? Holding 20% or more of voting stock does not create an absolute require�ment to use the equity method for an investment. The 20% line is usually a reasonable presumption for significantinfluence over a public company. However, for a nonpublic company, ownership of considerably more than 20%may be necessary, as a practical matter, to exercise significant influence.

GAAP notes that determination of whether there is significant influence requires an evaluation of all the facts andcircumstances. However, holdings of 20% or more are presumed to indicate significant influence absent predomi�


392

nant evidence to the contrary (emphasis added). FASB ASC 323�10�15�10 (formerly FASB Interpretation No. 35,�Criteria for Applying the Equity Method of Accounting for Investments in Common Stock") provides the followingtwo examples as possible indicators of lack of significant influence that are not unusual for nonpublic companies:

� Majority ownership of the investee is concentrated among a small group of shareholders who operate theinvestee without regard to the views of the investor.

� The investor needs or wants more financial information to apply the equity method than is available to theinvestee's other shareholders�.�.�.�, tries to obtain that information, and fails.

Situations such as those described above are not conclusive indications of lack of significant influence. All of theattendant facts and circumstances must be evaluated.

FASB ASC 323�10 (formerly APB Opinion No. 18) addresses applying the equity method to investments in votingcommon stock. FASB ASC 323�10�15�13 through 15�19 (formerly EITF Issue No. 02�14, �Whether an InvestorShould Apply the Equity Method of Accounting to Investments Other Than Common Stock") expands the applica�tion of the equity method to investments that are in�substance common stock. An investment may be consideredin�substance common stock if it has risk and reward characteristics that are substantially similar to the entity'scommon stock. An investment is considered to be in�substance common stock if all of the following characteristicsare substantially similar to the entity's common stock:

� Subordination features, such as liquidation preferences.

� Risks and rewards of ownership, such as participation in earnings, losses, and appreciation anddepreciation in value.

� Obligation to transfer value, such as a mandatory redemption provision.

� Future changes in its fair value is expected to vary directly with changes in the common stock's fair value.

If any of these characteristics are not met, the investment is not considered in�substance common stock and shouldnot be accounted for using the equity method.

Measurement Using the Equity Method. Under the equity method, the investment is initially recorded at costfollowing the requirements in FASB ASC 805�50�30 [formerly SFAS No. 141(R)], and is subsequently increased bythe investor's proportionate share of the investee's net income and reduced by dividends and the investor'sproportionate share of the investee's net loss. However, the investment is not reduced below zero unless theinvestor is committed to provide financial support to the investee. If there is a difference between the cost of theinvestment and the investor's proportionate equity in the investee's net assets at acquisition, the difference shouldfirst be related to specific assets of the investee based on their fair market value. Any difference that cannot berelated to specific assets is considered to be attributable to goodwill. The investor should adjust the investmentaccount and investment earnings by an amount that represents the additional depreciation or amortization relatedto the difference as if it were actually recorded by the investee. (As a practical matter, unless the difference ismaterial, it usually is accounted for as goodwill, instead of attempting to associate it with specific assets andrecording the related depreciation.) The equity method is sometimes referred to as a �one�line consolidation"because stockholders' equity and net earnings of the investor generally should be the same whether the equitymethod is used or the two companies are consolidated. Thus, the amortization of the difference between cost andproportionate equity in net assets and other transactions and events follow essentially the same GAAP as consoli�dation, for example, intercompany profits should be eliminated.


393

An Example of Equity Calculations. Assume the following facts for ABC Company (an equity investee):

Net Book Value

Earnings Dividends 100% 40%

Acquisition $ 75,000 $ 30,000

End of Year:

1 $ 25,000 $ � 100,000 40,000

2 30,000 10,000 120,000 48,000

3 35,000 15,000 140,000 56,000

4 30,000 5,000 165,000 66,000

5 15,000 � 180,000 72,000

If CAS, Incorporated (CAS) buys 40% of the stock of ABC at book value, its statements would reflect the following:

Increasefor

Earnings

Decreasefor

Dividends Investment

Acquisition $ 30,000

End of Year:

1 $ 10,000 $ � 40,000

2 12,000 4,000 48,000

3 14,000 6,000 56,000

4 12,000 2,000 66,000

5 6,000 � 72,000

To illustrate the mechanics of applying the equity method, the following entries would be made by CAS for year 2:

Cash 4,000

Investment 4,000

To record receipt of dividend.

Investment 12,000

Equity in earnings of ABC 12,000

To record earnings on investment.

An Example with Intra�entity Profits. FASB ASC 323�10�35�7 (formerly Paragraph 19a of APB Opinion No. 18)requires eliminating all intra�entity profits or losses until realized by the investor or investee as if the investee wereconsolidated. (Note that if the investee is consolidated, GAAP requires the elimination of all intra�entity income orloss, even though the investor owns less than 100% of the stock.) Listed below is guidance on eliminatingintra�entity profits and losses under the equity method:

a. Only intra�entity profits or losses on assets held by the investor or investee are candidates for elimination.

b. Upstream sales, i.e., the investee sells to the investor:

(1) Eliminate all intra�entity profit or loss less the related tax effect from the investee's net income or lossbefore computing the equity pick�up. The tax effect is the difference between the investee's taxprovision computed with and without the intra�entity profit or loss.

(2) Compute the equity in the investee's earnings following the guidance previously discussed.


394

c. Downstream sales, i.e., the investor sells to the investee:

(1) The investor should eliminate from its net income all of the intra�entity profit or loss less the related taxeffect. The tax effect is the difference between the investor's tax provision computed with and withoutthe intra�entity profit or loss.

(2) Record the eliminated profit or loss in a deferred account, such as deferred revenue, and the tax effectof the eliminated profit or loss in a deferred tax account, such as deferred tax benefit.

(3) Compute the equity in the investee's earnings following the guidance previously discussed. Note thatthe intra�entity profit or loss does not affect computation of the equity pick�up.

The preceding guidance differs from the provisions of FASB ASC 323�10�35�9 and 35�10 (formerly AICPA Inter�pretation No. 1 of APB Opinion No.�18) about how to recognize intra�entity profit or loss permitted from downstreamsales when the investor holds less than a controlling financial interest. Essentially, recognition of a portion of theintra�entity profit or loss is permitted when the sale is on an arm's�length basis. In that circumstance, the controllingfinancial interest is, in effect, treated as a third party, and intra�entity profit or loss is recognized in proportion to thecontrolling financial interest. Nevertheless, entities could choose to adopt a blanket policy of deferring all profit orloss on intra�entity sales because it complies with the provisions and also avoids the need to make subjectiveevaluations of whether sales are on an arm's�length basis.

The examples in the following two paragraphs illustrate how to apply the preceding guidance in accounting forupstream and downstream sales. Both assume that the investor holds 40% of the investee's voting stock, aneffective tax rate of 30%, and anticipated ultimate distribution of investee earnings in the form of dividends subjectto the 80% exclusion. Company P's investment is presented in the first column using the equity method. Althoughthe conditions for consolidation are not met, consolidated results also are presented in the last column to illustratethat accounting conforms with GAAP by producing generally the same net income and equity interest for CompanyP under both the equity and consolidation methods. In each case, the only differences between the equity methodand consolidation are the deferred tax on the equity pick�up, which represents the benefit gained from consolida�tion by excluding all dividends rather than just 80%, and recording of noncontrolling interests for consolidationpurposes.

The following assumes the investee recognized intra�entity profit of $20,000 from a sale of inventory included in theinvestor's balance sheet (i.e., upstream sale):

COMPANYP

COMPANYS

ELIMINA�TIONS

CONSOLI�DATED

ASSETS

Investment $ 22,400 $ � (d) $ (22,400 ) $ �

Other 250,000 100,000 (a) (20,000 ) 330,000

$ 272,400 $ 100,000 $ (42,400 ) $ 330,000

LIABILITIES

Taxes

Current $ 75,000 $ 30,000 (b) $ (6,000 ) $ 99,000

Deferred 1,344 � (c) (1,344 ) �

EQUITY

Retained earnings 196,056 70,000 (68,656 ) 197,400

Noncontrolling interests � � (e) 33,600 33,600

$ 272,400 $ 100,000 $ (42,400 ) $ 330,000


395

CONSOLI�DATED

ELIMINA�TIONS

COMPANYS

COMPANYP

EARNINGS

Pretax $ 250,000 $ 100,000 (a) $ (20,000 ) $ 330,000

Equity in investee's earnings 22,400 � (d) (22,400 ) �

272,400 100,000 (42,400 ) 330,000

Taxes

Current 75,000 30,000 (b) (6,000 ) 99,000

Deferred 1,344 � (c) (1,344 ) �

76,344 30,000 (7,344 ) 99,000

196,056 70,000 (35,056 ) 231,000

Noncontrolling interests � � (e) (33,600 ) (33,600 )

Net income $ 196,056 $ 70,000 $ (68,656 ) $ 197,400

Equity in the investee's earnings in the amount of $22,400 is computed by eliminating $14,000 from Company S'snet income, i.e., $20,000 intra�entity profit less the related $6,000 tax effect, and multiplying the remaining $56,000by the investor's 40% interest. Deferred taxes related to the equity pick�up in the amount of $1,344 are computedby multiplying the portion of the equity pick�up that will eventually be taxed, i.e., 20% of $22,400 = $4,480, by the30% tax rate. The elimination entries to obtain consolidated results for the preceding example are explained asfollows:

a. To eliminate intra�entity profit of investee (Co. S)

b. To eliminate the tax effect of the intra�entity profit

c. To eliminate deferred taxes related to the taxable portion of equity pick�up as a result of excluding alldividends in consolidation rather than 80%

d. To eliminate the equity pick�up

e. To record minority interests ($56,000 � 60%)

The following assumes the investor recognized intra�entity profit of $20,000 from a sale of inventory included in theinvestee's balance sheet (i.e., downstream sale):

COMPANYP

COMPANYS

ELIMINA�TIONS

CONSOLI�DATED

ASSETS

Investment $ 28,000 $ � (f) $ (28,000 ) $ �

Deferred tax benefit 6,000 � (c) (6,000 ) �

Other 250,000 100,000 (a) (20,000 ) 330,000

$ 284,000 $ 100,000 $ (54,000 ) $ 330,000

LIABILITIES

Taxes

Current $ 75,000 $ 30,000 (b) $ (6,000 ) $ 99,000

Deferred 1,680 � (d) (1,680 ) �

Deferred revenue 20,000 � (e) (20,000 ) �

EQUITY

Retained earnings 187,320 70,000 (68,320 ) 189,000

Noncontrolling interests � � (g) 42,000 42,000

$ 284,000 $ 100,000 $ (54,000 ) $ 330,000


396

CONSOLI�DATED

ELIMINA�TIONS

COMPANYS

COMPANYP

EARNINGS

Pretax $ 250,000 $ 100,000 (a) $ (20,000 ) $ 330,000

Equity in investee's earnings 28,000 � (f) (28,000 ) �

Intra�entity (20,000 ) � (e) 20,000 �

258,000 100,000 (28,000 ) 330,000

Taxes

Current 75,000 30,000 (b) (6,000 ) 99,000

Deferred

Investee's earnings 1,680 � (d) (1,680 ) �

Intra�entity (6,000 ) � (c) 6,000 �

70,680 30,000 (1,680 ) 99,000

187,320 70,000 (26,320 ) 231,000

Noncontrolling interests � � (g) (42,000 ) (42,000 )

Net income $ 187,320 $ 70,000 $ (68,320 ) $ 189,000

Equity in the investee's earnings in the amount of $28,000 represents 40% of Company S's net income of $70,000.Note that the intra�entity profit, i.e., $20,000 less the related tax effect of $6,000, is eliminated from Company P's netincome and deferred through a deferred tax benefit and a deferred revenue account. Deferred taxes related to theequity pick�up in the amount of $1,680 are computed by multiplying the portion of the equity pick�up that willeventually be taxed, i.e., 20% of $28,000 = $5,600, by the 30% tax rate. The elimination entries to obtain consoli�dated results for the preceding example are explained as follows:

a. To eliminate intra�entity profit in inventory (Co. P)

b. To eliminate the tax effect of the intra�entity profit

c. To eliminate the deferred tax benefit recorded by Co. P on the equity method

d. To eliminate deferred taxes related to the taxable portion of equity pick�up as a result of excluding alldividends in consolidation rather than 80%

e. To eliminate the deferred revenue recorded by Co. P on the equity method

f. To eliminate the equity pick�up

g. To record noncontrolling interests ($70,000 � 60%)


397

SELF�STUDY QUIZ


11. A nonpublic company owns the following percentages of voting common stock. Which of these investmentsis accounted for at fair value?

a. 10% of stock owned in a telephone company.

b. 20% owned in an internet company.

c. 50% owned in a software company.

d. 100% owned in an advertising agency.

12. DEF Company owns 30% of the voting common stock of GHI Inc. The cost of the investment on January 1, 20X1was $30,000. During 20X1, GHI's earnings were $200,000 and dividends paid were $50,000. The market valueof GHI's common stock was $150,000 on December 31, 20X1. What is the balance of DEF's investment in GHIat the end of 20X1 if the equity method is used?

a. $45,000.

b. $75,000.

c. $90,000.

d. $105,000.

13. Up Co. owns 40% of Down Co. Down recognized a profit of $20,000 from the sale of fishing equipment recordedas inventory on Up's balance sheet. Down's net income, after taxes, is $70,000. Assuming the effective tax rateis 30%, if Up and Down prepare consolidated financial statements, what amount is eliminated as pretaxintra�entity profit?

a. $20,000.

b. $28,000.

c. $70,000.

14. Up Co. owns 40% of Down Co. Down recognized a profit of $20,000 from the sale of fishing equipment recordedas inventory on Up's balance sheet. Down's net income, after taxes, is $70,000. Assuming the effective tax rateis 30%, and the anticipated ultimate distribution of Down's earnings in the form of dividends is subject to the80% exclusion, if Up and Down prepare consolidated financial statements, what amount is eliminated fromdeferred taxes on the equity pick�up?

a. $1,344.

b. $3,360.

c. $5,376.

d. $6,000.


398

15. Big Co. owns 40% of Small Co. Big recognized a profit of $20,000 from the sale of books recorded as inventoryon Small's balance sheet. Small's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%,if Big and Small prepare consolidated financial statements, what amount of equity pick up is eliminated?

a. $1,680.

b. $5,600.

c. $28,000.

d. $70,000.

16. Big Co. owns 40% of Small Co. Big recognized a profit of $20,000 ($180,000 sales price, less $160,000 costof goods sold) from the sale of inventory included in Small's balance sheet. Small's net income, after taxes, is$70,000. Assuming the effective tax rate is 30%, if Big and Small prepare consolidated financial statements,which of the following statements is most accurate?

a. Since this is a downstream sale, intra�entity sales are not eliminated.

b. The equity pick�up is eliminated.

c. Net profit is reduced by $126,000.

d. The equity pick�up is $22,400.


399



11. A nonpublic company owns the following percentages of voting common stock. Which of these investmentsis accounted for at fair value? (Page 391)

a. 10% of stock owned in a telephone company. [This answer is correct. Holdings of less than 20% ofmarketable voting stock are accounted for at fair value as prescribed by FASB ASC 320�10 (formerlySFAS No. 115). Nonmarketable voting stock are accounted for at cost.]

b. 20% owned in an internet company. [This answer is incorrect. Although holding 20% or more of votingstock does not create an absolute requirement to use the equity method for an investment, the 20% lineis usually a reasonable presumption for significant influence over a public company.]

c. 50% owned in a software company. [This answer is incorrect. When 50% of the voting stock of anothercompany is owned there is a presumption that there is an ability to exercise significant influence over theinvestee. Therefore, the equity method is used.]

d. 100% owned in an advertising agency. [This answer is incorrect. When a company holds more than 50%of the voting stock of another company, the financial statements are consolidated.]

12. DEF Company owns 30% of the voting common stock of GHI Inc. The cost of the investment on January 1, 20X1was $30,000. During 20X1, GHI's earnings were $200,000 and dividends paid were $50,000. The market valueof GHI's common stock was $150,000 on December 31, 20X1. What is the balance of DEF's investment in GHIat the end of 20X1 if the equity method is used? (Page 392)

a. $45,000. [This answer is incorrect. This would be the value of the investment if the DEF accounted for theinvestment under GAAP and classifies the investment as available for sale.]

b. $75,000. [This answer is correct. Under the equity method, the investment is initially recorded atcost, is increased (decreased) by the investor's proportionate share of the investee's net income(loss), and is reduced by dividends ($30,000 + ($200,000 � 30%) � ($50,000 � 30%)).]

c. $90,000. [This answer is incorrect. The dividends are included in the measurement of the investment.According to FASB ASC 805�50�30 [formerly SFAS No. 141(R)], dividends are not recorded as incomewhen the equity method is used to account for investments.]

d. $105,000. [This answer is incorrect. According to FASB ASC 805�50�30 [formerly SFAS No. 141(R)],dividends received do not increase the investment account.]

13. Up Co. owns 40% of Down Co. Down recognized a profit of $20,000 from the sale of fishing equipment recordedas inventory on Up's balance sheet. Down's net income, after taxes, is $70,000. Assuming the effective tax rateis 30%, if Up and Down prepare consolidated financial statements, what amount is eliminated as pretaxintra�entity profit? (Page 394)

a. $20,000. [This answer is correct. When eliminating the intra�entity profit, both revenue and inventoryare reduced by the amount of profit recognized from intra�entity sales.]

b. $28,000. [This answer is incorrect. The investor's share of the investee's net income (before any eliminationentries) is not the same as intra�entity profit.]

c. $70,000. [This answer is incorrect. The entire net income of the investee is not eliminated whenconsolidated statements are prepared, unless 100% of the investee's sales are upstream sales.]


400

14. Up Co. owns 40% of Down Co. Down recognized a profit of $20,000 from the sale of fishing equipment recordedas inventory on Up's balance sheet. Down's net income, after taxes, is $70,000. Assuming the effective tax rateis 30%, and the anticipated ultimate distribution of Down's earnings in the form of dividends is subject to the80% exclusion, if Up and Down prepare consolidated financial statements, what amount is eliminated fromdeferred taxes on the equity pick�up? (Page 394)

a. $1,344. [This answer is correct. Deferred taxes related to the equity pick�up are computed bymultiplying the portion of equity pick�up that will eventually be taxed (20% of $22,400), by the taxrate of 30%. The $22,400 is calculated by reducing Down's profit of $70,000 by the intra�entity profitof $20,000 less the tax effect of $6,000 ($20,000 � 30%) and multiplying by Up's interest ($70,000� ($20,000 � $6,000)) � 40%.]

b. $3,360. [This answer is incorrect. The equity pick�up that will eventually be taxed is Up's share of Down'snet income reduced by the intra�entity profit.]

c. $5,376. [This answer is incorrect. The equity pick�up is excluded by 80%.]

d. $6,000. [This answer is incorrect. The tax effect of the intra�entity profit is not the amount of deferred taxesrelated to the taxable portion of the equity pick�up.]

15. Big Co. owns 40% of Small Co. Big recognized a profit of $20,000 from the sale of books recorded as inventoryon Small's balance sheet. Small's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%,if Big and Small prepare consolidated financial statements, what amount of equity pick up is eliminated?(Page 395)

a. $1,680. [This answer is incorrect. This is the amount of deferred taxes related to the taxable portion of theequity pick up.]

b. $5,600. [This answer is incorrect. This is the amount of equity pick up that will eventually be taxed.]

c. $28,000. [This answer is correct. Because this is a downstream sale, the equity pick up is Big's shareof Small's net income.]

d. $70,000. [This answer is incorrect. This is the entire net income of Small. Big only picks up its share.]

16. Big Co. owns 40% of Small Co. Big recognized a profit of $20,000 ($180,000 sales price, less $160,000 costof goods sold) from the sale of inventory included in Small's balance sheet. Small's net income, after taxes, is$70,000. Assuming the effective tax rate is 30%, if Big and Small prepare consolidated financial statements,which of the following statements is most accurate? (Page 395)

a. Since this is a downstream sale, intra�entity sales are not eliminated. [This answer is incorrect. Intra�entityprofits are eliminated in both upstream and downstream sales when preparing consolidated financialstatements.]

b. The equity pick�up is eliminated. [This answer is correct. In both upstream and downstream salesthe equity pick�up is eliminated when consolidated statements are prepared. However, thecalculation of the equity pick�up differs between the two types of intra�entity sales.]

c. Net profit is reduced by $126,000. [This answer is incorrect. According to GAAP, the amount eliminatedfrom net profit is not the gross sales amount less the tax effect.]

d. The equity pick�up is $22,400. [This answer is incorrect. According to GAAP, this is the amount of equitypick if this were an upstream sale.]


401

Cash Value Life Insurance Policies

Cash value life insurance policies (which are sometimes called permanent life insurance) have an investmentelement with low to moderate risk and a rate of return that is often higher than other investments of similar risk,primarily because its value appreciates tax�free. The two most common forms of cash value policieswhole lifeand universal lifediffer primarily in that premiums are fixed under a whole life policy, but they may vary for auniversal life policy.

GAAP requires an investment in a life insurance contract to be reported as an asset. According to FASB ASC325�30�35�1 and 35�2 (formerly FASB Technical Bulletin No. 85�4, Accounting for Purchases of Life Insurance), theasset should be reported at the amount that could be realized under the insurance contract at the balance sheetdate. That amount differs depending on whether the company buys the policy for itself, which this course refers toas a traditional arrangement, or to provide benefits for the insured under a split dollar arrangement. The amount ofthe asset equals the policy's cash surrender value in many traditional arrangements and some split dollar arrange�ments.

While the amount of the asset to be reported can equal the policy's cash surrender value, there can be instanceswhere a different amount should be recognized. FASB ASC 325�30�55 (formerly EITF Issue No. 06�5, �Accountingfor Purchases of Life InsuranceDetermining the Amount That Could Be Realized in Accordance with FASBTechnical Bulletin No. 85�4") provides further guidance on this issue and addresses individual�life policies pur�chased for a number of employees and a group life policy that has multiple certificates.

This guidance indicates an entity should consider any additional amounts included in the terms of the insurancepolicy in assessing the amount that could be realized under the contract. An entity also should generally assumethat individual�life policies or certificates in a group policy are surrendered individually, rather than all at the sametime, when determining the amount that could be realized. However, if a group of individual�life policies or a grouppolicy only permits the surrender of all the policies or certificates as a group, the amount that could be realizedunder the contract should be determined on a group basis. EITF Issue No. 06�5 also discusses when it isappropriate to discount amounts that could be realized under insurance contracts.

Because of its investment element, cash value policies are attractive instruments for funding a variety of long�termcommitments, such as buy�out and nonqualified deferred compensation arrangements. When accounting for cashvalue policies, accountants should also consider whether they are funding commitments for which a liability shouldbe recognized.

Asset under a Traditional Arrangement. When the company buys the policy for itself, the amount that it couldrealize at the balance sheet dateand, accordingly, the asset to be recordedis generally the policy's cashsurrender value, which equals its cash value reduced by policy loans and surrender charges [however, see theprevious discussion of FASB ASC 325�30 (formerly EITF Issue No. 06�5)]. Cash value arises from two sources:

a. Premiums paid by the owner of the policy and those that are financed through loans against the policy

b. Dividends declared by the insurance carrier and allowed to accumulate, used to offset the cost ofpremiums, or used to buy additional insurance (Generally, dividends paid to the policy owner or allowedto accumulate are taxable, but dividends used to offset premiums or to buy additional insurance are nottaxable.)

GAAP does not address the balance sheet presentation of cash value of life insurance. Best practice recommenda�tions include the following:

a. Based on FASB ASC 210�10�45�4 (formerly ARB No. 43, Chapter 3, Paragraph 6), the asset is normallyclassified as noncurrent unless the cash value is reasonably expected to be realized within the next year.Accordingly, it typically should be presented with other investments.

b. Since the asset is measured as the amount of cash available through settlement at the balance sheet date,the caption �Cash surrender value of life insurance" is the most precise caption. However, best practicesindicate that the caption �Cash value of life insurance" also is acceptable.


402

c. Loans against a policy's cash value are used as a source of cash for the owner of the policy and to financepremiums and interest in excess of dividends. However, best practices indicate that the asset recognizedis the amount that could be realized from the policy, and, thus, loans are netted against the cash value inthe balance sheet. The amount of cash that could be realized normally is the only amount in which a readerof the financial statements is interested, especially when loans are part of the policy's design. If theaccountants believe that the amount of loans is of interest to the reader, they should be disclosed in thenotes to the financial statements or through a descriptive balance sheet caption such as �Cash surrendervalue of life insurance after policy loans of $7,500 in 20X2 and $6,000 in 20X1."

d. Unpaid interest on policy loans should be included with other accrued interest if management expects torepay it; otherwise, it should be included with policy loans. Since interest on policy loans normally is paidalong with premium payments or is recognized through the adjustment of cash surrender value, it issometimes classified as insurance expense. However, unless the amount is significant, it generally is notnecessary to reclassify the interest from insurance expense to interest expense nor to include interestexpense on the policy loan with the disclosure of interest expense and interest payments.

Asset under a Split Dollar Arrangement. Split dollar arrangements are a method of paying for insurance ratherthan a type of insurance (although such arrangements are sometimes referred to as split dollar insurance). Similarto traditional arrangements discussed previously, split dollar arrangements also use cash value policies, eitherwhole life or universal life. The two arrangements differ, however, in the cash consequences to the employer. In thetraditional arrangement, the employer pays all premiums and is entitled to all of the cash value and death proceeds.The economic substance of split dollar arrangements, however, is to provide a benefit to the employee at no costto the employer. Thus, in split dollar arrangements, the employer usually pays most of the premiums until the policyis self�sustaining and recovers those payments through loans against the policy's cash value or death proceeds.

In split dollar arrangements, the employer may own the insurance policy through an endorsement arrangement, orthere may be a collateral assignment of a policy not owned by the employer. The two forms are described asfollows:

a. Endorsement. Under endorsement arrangements, the employer owns the policy, pays the premiums, andis reimbursed by the employee for a portion of the premiums. The endorsement document filed with theinsurance carrier specifies how the cash value and death proceeds are allocated between the employerand the employee. Typically, no more than a small portion of the cash value is allocated to the employee.

b. Collateral Assignment. Under collateral assignments, an employee or a third party, such as an irrevocabletrust, owns the policy. The premium payments are, in form, financed through interest�free loans from theemployer that generally are repaid through the death proceeds. The collateral assignment document thatis filed with the insurance carrier effectively pledges the policy as security for the employer's loans.

Responsibility for premium payments and allocations of policy proceeds vary under split dollar arrangements. Forexample:

a. The employer may pay all of the premiums, annual premiums equal to the increase in cash value, or someother portion of premiums.

b. The cash value allocated to the employer normally does not exceed premiums paid; however, some splitdollar arrangements allocate all of it to the employer without regard to the amount of premiums paid.

c. Some arrangements, for which the term roll out often is used, transfer (or roll out) the policy to the employeeor a third party, such as a trust, in the future. In other arrangements, which are sometimes referred to asfrozen arrangements, the cash value allocated to the employer reaches its maximum at a specified date(usually sometime after seven years), but the employer cannot recover any of it until the insured dies andthe death proceeds are distributed.

Thus, under some split dollar arrangements, the amount that could be realized by the employer is limited topremiums paid. Under other arrangements, however, the employer could realize the cash value of the policy, whichmight be more or less than premiums paid.


403

Since the employer owns the policy under both traditional arrangements and endorsement split dollar arrange�ments, asset measurement considerations are the same, and FASB ASC 325�30�25�1; 325�30�35�1 and 35�2(formerly FASB Technical Bulletin 85�4) applies to both. Under a split dollar arrangement with a collateral assign�ment, however, the employer does not own the policy. FASB ASC 715�60�35�177 through 35�185; 715�60�55�176through 55�181 (formerly EITF Issue No. 06�10, �Accounting for Collateral Assignment Split�Dollar Life InsuranceArrangements") addresses accounting for the asset in a collateral assignment split�dollar life insurance arrange�ment. Under this guidance, an employer should measure and recognize an asset based on the nature andsubstance of the collateral assignment split�dollar arrangement. That is, because the employee or a third partyowns the policy, the employer should consider any future cash flows the employer is entitled to, as well as theemployee's recognition of the obligation and his/her ability to repay the employer. For example, if the employer mayonly recover the amount of the policy's cash surrender value at the balance sheet date, the employer should onlyrecognize an asset equal to the cash surrender value, even if the employer's loan to the employee to pay theinsurance policy premiums exceeds the cash surrender value.

Income Tax Considerations. Whether split dollar arrangements involve endorsements or collateral assignments,IRS Rev. Rul. 64�328 indicates that the substance of both is an investment to provide death or retirement benefits tothe employee at no cost to the employer. Accordingly, they are treated the same for income tax purposes, and IRCSec. 264 applies equally to both forms in determining deductions for interest on policy loans. Generally, policy loaninterest is nondeductible (except that a limited amount of interest may be deducted on policy loans covering a �keyperson," i.e., an officer or 20% owner, to the extent that the aggregate amount of policy loans covering that persondoes not exceed $50,000). Premiums paid by a company for any life insurance policy are not deductible if thecompany is directly or indirectly a beneficiary under the policy.

Other Long�term Investments

Other long�term investments may be presented as part of the investment caption or included in other assets.

Cost Method Investments. Certain investments in equity securities (a) do not have readily determinable fair valuesand (b) do not qualify for consolidation or the equity method. Such investments are accounted for using the costmethod. Accounting literature provides only limited guidance on accounting for cost method investments. Ordi�narily, the investment is originally recorded at cost with dividends recorded as income in the period received.

Impairment of Cost Method Investments. An investment is deemed impaired if its fair value is less than its cost. If acost method investment is other�than�temporarily impaired, its carrying amount is reduced to fair value through acharge to current period income. FASB ASC 320�10�35�17 through 35�35 (formerly FSP FAS 115�1 and FAS 124�1)provides guidance regarding the meaning of other�than�temporary impairment and its application to cost methodinvestments. GAAP provides guidance for (a) determining when an investment is impaired, (b) determining whetherthe impairment is other than temporary, and (c) measuring, recognizing, presenting, and disclosing an impairmentloss if the impairment is deemed other than temporary.

The fair value of an investment in equity securities accounted for using the cost method is not readily determinable.An investor that has estimated the fair value, for example, to disclose financial instrument information required byFASB ASC 825�10�50 (formerly SFAS No. 107, Disclosures about Fair Value of Financial Instruments) must deter�mine whether that fair value is less than cost and, if so, determine whether the decline in fair value below cost istemporary or other than temporary. Other than temporary does not mean permanent.

An entity that has evaluated a cost method investment for impairment in a prior period but concluded that thedecline in fair value below cost was temporary must continue to estimate the fair value of the investment andevaluate whether the decline in fair value is temporary or other than temporary until either

a. The investment experiences a recovery of fair value at least up to its cost, or

b. The entity recognizes an other�than�temporary impairment loss.

An entity that has not estimated the fair value of a cost method investment should evaluate whether an event orchange in circumstances has occurred during the period that may have a significant adverse effect on the fair value


404

of the investment. FASB ASC 320�10�35�27 (formerly FSP FAS 115�1�FAS 124�1) gives five examples of impairmentindicators:

a. A significant deterioration in the earnings performance, credit rating, asset quality, or business prospectsof the investee.

b. A significant adverse change in the regulatory, economic, or technological environment of the investee.

c. A significant adverse change in the general market conditions of either the geographic area or the industryin which the investee operates.

d. A bona fide offer to purchase (whether solicited or unsolicited), an offer by the investee to sell, or acompleted auction process for the same or similar security for an amount less than the cost of theinvestment.

e. Factors that raise significant concerns about the investee�s ability to continue as a going concern, such asnegative cash flows from operations, working capital deficiencies, or noncompliance with statutory capitalrequirements or debt covenants.

If an impairment indicator is present, the entity should estimate the fair value of the investment and, if the estimatedfair value is less than its cost, determine whether the decline in fair value below cost is temporary. The guidance onthe impairment of equity securities also applies to cost method investments.

Property and Equipment Held for Investment. This balance sheet caption typically includes the following:

a. Real estate acquired primarily for speculation

b. Property and equipment retired from operations

c. Real estate that is currently unused but that may be developed and sold or may be used for operatingfacilities

Property and equipment held for investment normally should be reported at cost. However, if a long�lived asset ispotentially impaired, the requirements of FASB ASC 360�10 (formerly SFAS No. 144, Accounting for the Impairment

or Disposal of Long�Lived Assets) should be followed. The balance sheet caption should provide a generaldescription of the assets, for example, �Real estate." If the caption is included with other assets, it should beexpanded to indicate that it is being held as an investment, for example, �Real estate held for investment." If thecaption is included with investments, it does not need expansion.


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SELF�STUDY QUIZ


17. What amount of cash value life insurance policies is reported as an asset under a traditional arrangement?

a. Cash surrender value.

b. The cumulative amount of premiums paid.

c. Dividends declared and allowed to accumulate.

d. The amount of policy loans available.

18. Which of the following is true regarding recommendations made in this course for the presentation of cash valuelife insurance policies on the balance sheet?

a. The asset is normally classified as current.

b. �Investment in life insurance" is an appropriate caption.

c. Loans against a policy's cash value should be classified as a current liability.

d. Unpaid interest on policy loans may be included with accrued interest.

19. What are split dollar arrangements when referring to life insurance policies?

a. A type of insurance.

b. A payment method.

20. Light Co. owns 10% of the common stock of Bulb Co. Bulb's stock is considered nonmarketable. What amountdoes Light record as its investment in Bulb, and how are dividends treated?

a. Both amounts are eliminated in consolidation.

b. Investment is recorded at market value, and dividends are recorded as income.

c. Investment is recorded at cost, and dividends are recorded as income.

d. Investment is recorded at cost, increased (decreased) by net profits (losses) of Bulb, decreased bydividends received.


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17. What amount of cash value life insurance policies is reported as an asset under a traditional arrangement?(Page 401)

a. Cash surrender value. [This answer is correct. When the company buys the policy for itself, theamount that it could realize at the balance sheet date, and the asset to be recorded, is generally thepolicy's cash surrender value, which equals its cash value reduced by policy loans and surrendercharges.]

b. The cumulative amount of premiums paid. [This answer is incorrect. Premiums paid by the owner of thepolicy and those that are financed through loans against the policy, are a component of the amountrecorded as an asset.]

c. Dividends declared and allowed to accumulate. [This answer is incorrect. Dividends declared by theinsurance carrier and allowed to accumulate, used to offset the cost of premiums, or used to buy additionalinsurance, are a component of the amount recorded as an asset.]

d. The amount of policy loans available. [This answer is incorrect. Policy loans are a reduction in the amountrecorded as an asset.]

18. Which of the following is true regarding recommendations made in this course for the presentation of cash valuelife insurance policies on the balance sheet? (Page 401)

a. The asset is normally classified as current. [This answer is incorrect. Based on ARB No. 43, the asset isnormally classified as noncurrent unless the cash value is reasonably expected to be realized within thenext year.]

b. �Investment in life insurance" is an appropriate caption. [This answer is incorrect. Since the asset ismeasured as the amount of cash available through settlement at the balance sheet date, the caption �Cashsurrender value of life insurance" is the most precise caption.]

c. Loans against a policy's cash value should be classified as a current liability. [This answer is incorrect. Bestpractices indicate that the asset recognized is the amount that could be realized from the policy, and, thus,loans are netted against the cash value in the balance sheet.]

d. Unpaid interest on policy loans may be included with accrued interest. [This answer is correct.Unpaid interest on policy loans should be included with other accrued interest if managementexpects to repay it; otherwise, it should be included with policy loans.]

19. What are split dollar arrangements when referring to life insurance policies? (Page�402)

a. A type of insurance. [This answer is incorrect. Although this type of arrangement is sometimes referred toas split dollar insurance, a split dollar arrangement is not a type of insurance. The type of insurance wouldbe a cash value policy, either whole life or universal life.]

b. A payment method. [This answer is correct. Split dollar arrangements are a method of paying forinsurance rather than a type of insurance. The economic substance of split dollar arrangements isto provide a benefit to the employee at no cost to the employer. Thus, in split dollar arrangements,the employer usually pays most of the premiums until the policy is self�sustaining and recoversthose payments through loans against the policy's cash value or death proceeds.]


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20. Light Co. owns 10% of the common stock of Bulb Co. Bulb's stock is considered nonmarketable. What amountdoes Light record as its investment in Bulb, and how are dividends treated? (Page 403)

a. Both amounts are eliminated in consolidation. [This answer is incorrect. This investment does not qualifyfor consolidation because Light owns less than 50% of Bulb.]

b. Investment is recorded at market value, and dividends are recorded as income. [This answer is incorrect.Since there is no readily determinable market value, the asset cannot be recorded at a market value.]

c. Investment is recorded at cost, and dividends are recorded as income. [This answer is correct.Investments in equity securities that do not have a readily determinable market value and do notqualify for consolidation or the equity method are accounted for using the cost method.]

d. Investment is recorded at cost, increased (decreased) by net profits (losses) of Bulb, decreased bydividends received. [This answer is incorrect. This investment does not qualify for the equity method. Theequity method applies when 20%�50% of equity securities are owned.]


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Lesson 2 (PFSTG104)


11. A local restaurant chain owns the following percents of voting common stock. Which of these will be accountedfor using the equity method?

a. 5% of stock owned in a restaurant supply company.

b. 45% of stock owned in a fish market.

c. 55% of stock owned in a printing company.

d. 100% of stock owned in another restaurant.

12. Ocean Inc. owns 25% of the voting common stock of Lake Co. The initial cost of the investment on January 1,20X1 was $25,000. During 20X1, Lake had earnings of $150,000, and paid dividends totaling $20,000. Themarket value of Lake's common stock was $80,000 on December 31, 20X1. What amount does Ocean includeas its investment in Lake in its 20X1 financial statements?

a. $20,000.

b. $38,750.

c. $57,500.

d. $62,500.

13. Push Co. owns 40% of Pull Co. Pull recognized a profit of $20,000 from the sale of inventory included on Push'sbalance sheet. Pull's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%, if Push and Pullprepare consolidated financial statements, what amount is reported as �minority interests"?

a. $22,400.

b. $33,600.

c. $56,000.

d. $42,000.

14. Push Co. owns 40% of Pull Co. Pull recognized a profit of $20,000 from the sale of inventory included on Push'sbalance sheet. Pull's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%, and ananticipated ultimate distribution of Pull's earnings in the form of dividends subject to the 80% exclusion, if Pushand Pull prepare consolidated financial statements, what amount is eliminated from current taxes as the taxeffect of the intercompany profit?

a. $1,344.

b. $4,656.

c. $6,000.

d. $7,344.


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15. Thrill Co. owns 40% of Seeker Co. Thrill recognized a profit of $20,000 from the sale of inventory included onSeeker's balance sheet. Seeker's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%,if Thrill and Seeker prepare consolidated financial statements, what amount is reported as �minority interests"?

a. $20,000.

b. $28,000.

c. $42,000.

d. $56,000.

16. Thrill Co. owns 40% of Seeker Co. Thrill recognized a profit of $20,000 ($100,000 sale less $80,000 cost ofgoods sold) from the sale of inventory included on Seeker's balance sheet. Seeker's net income, after taxes,is $70,000. Assuming the effective tax rate is 30%, if Thrill and Seeker prepare consolidated financialstatements, what amount is eliminated from pretax revenue?

a. $14,000.

b. $20,000.

c. $70,000.

d. $100,000.

17. Which of the following characteristics of cash value life insurance is true regarding whole life policies, but notuniversal life policies?

a. The premiums are fixed.

b. There is an investment element of low to moderate risk.

c. Value appreciates tax�free.

d. The rate of return is higher than other investments of similar risk.

18. Which type of life insurance policy is owned by the employee rather than the employer?

a. Traditional arrangements.

b. Split�dollar with collateral assignment.

c. Endorsement split�dollar arrangements.


19. Sun Co. owns 5% of the common stock of Moon Co. Moon Co. does not have a readily determinable fair valueof its stock. Sun's investment in Moon was $10,000 on January 1, 20X1. During 20X1, Moon incurred a loss of$5,000, but managed to pay dividends of $8,000. What amount does Sun include as its investment in Moonon its 20X1 balance sheet?

a. $9,350.

b. $9,600.

c. $9,750.

d. $10,000.


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20. Day Inc. has accounted for its share of ownership in Night Inc. using the cost method. After determining thatthe impairment of the investment in Night is other�than�temporary, Day reduces the investment in Night to itsfair value. Which of the following is affected by the entry to reduce the investment?

a. Common stock.

b. Other comprehensive income.

c. Prior period adjustment.

d. Current period income.


411

Lesson 3:�Property and Equipment

INTRODUCTION

Property and equipment includes all assets used in a company's operations that have an estimated useful lifelonger than one year. The following is a listing of items commonly included:

� Land on which operating facilities are located

� Buildings used as operating facilities

� Machinery and other production equipment

� Office furniture and other administrative equipment

� Items leased from others under capital leases

� Items leased to others under operating leases

� Buildings being constructed for use as operating facilities

� Idle facilities

� Leasehold improvements

� Computer hardware and software

Items originally acquired as property and equipment but later used for other purposes, for example, items retiredand held for resale, should be removed from the property and equipment caption. The change is equivalent to achange in estimate, and prior�period statements should not be restated.

Accounting for property and equipment includes both routine and complex areas. This lesson discusses the basicsof balance sheet presentation and the following accounting topics related to property and equipment:

� Capital leases

� Contributed and exchanged assets

� Interest capitalization

� Leasehold improvements

� Questions related to depreciation

� Impairment of long�lived assets


Completion of this lesson will enable you to:� Identify the balance sheet presentation options for property and equipment.� Determine the classification of and properly record assets acquired by capital lease, contribution or exchange.� Calculate depreciation.


412


Cost Basis. Under GAAP, acquired property and equipment is stated at acquisition cost, including all costsnecessary to bring the asset to its location in working condition such as the following:

� Sales tax

� Freight

� Installation costs

� Direct and indirect costs (including interest) incurred by an entity in constructing its own assets

Thus, stating property and equipment above cost is a departure from GAAP. (However, if depreciable assets arereported at appraisal values, depreciation must be computed on the appraisal values rather than on cost. Appraisalvalues may be disclosed in a note without causing those measurement problems.) If fully depreciated assets are nolonger on hand, the assets and related accumulated depreciation should be removed from the balance sheet.

Costs to remove, contain, neutralize, or prevent existing or future environmental contamination generally shouldnot be capitalized, however, FASB ASC 410�30�25�16 through 25�19 (formerly EITF Issue No. 90�8, �Capitalizationof Costs to Treat Environmental Contamination") states that those costs should be expensed when incurred unlessthe costs are recoverable and at least one of the following conditions is met:

a. The costs extend the life, increase the capacity, or improve the safety or efficiency of property owned bythe company. In addition, the costs improve the property as compared to its condition when constructedor acquired.

b. The costs mitigate or prevent environmental contamination that has not occurred but may otherwise resultfrom future operations or activities. In addition, the costs improve the property as compared to its conditionwhen constructed or acquired.

c. The costs prepare for sale property that is currently held for sale.

Costs incurred to treat or remove asbestos may be capitalized regardless of whether the building was acquired witha known asbestos problem or the problem was discovered in an existing building if the above criteria are met.

Choosing Balance Sheet Captions. Historically, the term �fixed assets" has been used to refer to these assets.The term is still acceptable, but many preparers now use more descriptive terms. Some preparers use the term�Property, plant, and equipment." Although the term is acceptable, it will not fit all situations and the terms�Property" and �plant" are redundant. Best practices indicate the following recommendations:

� Property and equipmentappropriate whenever the company has both real and personal property.

� Equipmentappropriate whenever the company has only personal property.

� Equipment and leasehold improvementsappropriate whenever the company has only personal propertyand leasehold improvements.

�Land" and �Buildings" are normally sufficient captions for the components of property. Improvements to land (forexample, landscaping and paving) and to buildings (for example, wings and porches) are capitalized as a cost ofthe item. The reader has no particular need to distinguish improvements, so there is no need to expand thecaptions whenever improvements are made, for example, �Buildings and improvements." Also, best practicesindicate that all cost components should be presented together even if they have not yet been depreciated, forexample, construction�in�progress. �Equipment" is a catch�all caption for all personal property. The following arecommon captions for its components:

� Machinery


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� Vehicles

� Transportation equipment

� Furniture and fixtures

� Production equipment

Since depreciation is a method of allocating cost rather than a valuation allowance, the caption �Accumulateddepreciation" is preferable to �Allowance for depreciation." However, both are acceptable. Since leaseholdimprovements are included with depreciable assets, depreciation of leasehold improvements should simply beincluded in accumulated depreciation. There is no need to use a separate �accumulated amortization" account forleasehold improvements.

Secondary Captions Are Optional. Presentation in the balance sheets may be limited to a primary caption asfollows:

20X2 20X1

PROPERTY AND EQUIPMENT,less accumulated depreciation of$75,000 in 20X2 and $60,000 in 20X1 295,000 270,000

GAAP requires the balances of major classes of depreciable assets at the balance sheet date to be disclosed.Secondary captions may be presented either in a note or on the face of the balance sheets as follows:

20X2 20X1

PROPERTY AND EQUIPMENT

Land 50,000 50,000

Building 250,000 150,000

Production equipment 40,000 30,000

Vehicles and other equipment 30,000 25,000

Construction in progress � 75,000

370,000 330,000

Accumulated depreciation (75,000 ) (60,000 )

295,000 270,000


414


415

SELF�STUDY QUIZ


21. Which of the assets would be classified as property and equipment?

a. Buildings used as operating facilities.

b. Supplies on hand at the end of the year.

c. Equipment retired and held for resale.

22. A manufacturing company bought a piece of equipment for $105,000, of which $5,000 was sales tax. It costthe company $2,500 to install. During the year, the company spent $1,000 on maintenance for the equipment.The company expects a salvage value of $15,000 at the end of the useful life of the equipment. What amountis presented on the balance sheet for the equipment?

a. $90,000.

b. $100,000.

c. $106,000.

d. $107,500.

23. A computer repair store owns computers that it sells, as well as uses in its operations. The store also owns otheroffice equipment that it uses in operations. The store rents its office space. What is the best balance sheetcaption the store should use for its fixed assets?

a. Property and equipment.

b. Equipment and leasehold improvements.

c. Equipment.

d. Equipment and inventory.


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21. Which of the assets would be classified as property and equipment? (Page 411)

a. Buildings used as operating facilities. [This answer is correct. Buildings used as operating facilities,as well as buildings being constructed for use as operating facilities, are classified as property andequipment.]

b. Supplies on hand at the end of the year. [This answer is incorrect. Property and equipment includes allassets used in a company's operations that have an estimated useful life of one year or longer. Suppliesmost likely do not meet the one year or longer criteria. Supplies on hand at the end of they year would beclassified as a prepaid expense, if material.]

c. Equipment retired and held for resale. [This answer is incorrect. Items originally acquired as property andequipment but later used for other purposes, such as items retired and held for resale, should be removedfrom the property and equipment caption.]

22. A manufacturing company bought a piece of equipment for $105,000, of which $5,000 was sales tax. It costthe company $2,500 to install. During the year, the company spent $1,000 on maintenance for the equipment.The company expects a salvage value of $15,000 at the end of the useful life of the equipment. What amountis presented on the balance sheet for the equipment? (Page 412)

a. $90,000. [This answer is incorrect. According to GAAP, the salvage value is used when calculatingdepreciation, not when capitalizing the asset.]

b. $100,000. [This answer is incorrect. According to GAAP, sales tax is capitalized with the cost of theequipment.]

c. $106,000. [This answer is incorrect. According to GAAP, the cost of maintenance is not capitalized.]

d. $107,500. [This answer is correct. Under GAAP, acquired property and equipment is stated atacquisition cost (cost basis), including all costs necessary to bring the asset to its location inworking condition such as sales tax, freight, and installation costs. The cost of routine maintenancewould be expensed. Salvage value reduces the depreciable basis, not the amount to be capitalized.]

23. A computer repair store owns computers that it sells, as well as uses in its operations. The store also owns otheroffice equipment that it uses in operations. The store rents its office space. What is the best balance sheetcaption the store should use for its fixed assets? (Page 412)

a. Property and equipment. [This answer is incorrect. The company does not own any real property;therefore, the term �property" is inappropriate.]

b. Equipment and leasehold improvements. [This answer is incorrect. Since the company rents its facilities,it is possible they may have leasehold improvements, but the question does not state the companycurrently has any.]

c. Equipment. [This answer is correct. The caption �equipment" is appropriate whenever the companyonly has personal property. If the company makes any leasehold improvements to the rentedproperty, they may change the caption to �equipment and leasehold improvements."]

d. Equipment and inventory. [This answer is incorrect. Computers that are considered inventory are currentassets and would be captioned as �inventory" on the balance sheet.]


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Capital Leases

FASB ASC 840 (formerly SFAS No. 13, Accounting for Leases) addresses accounting for leases both by lessors(those who rent to others) and lessees (those who rent from others). For lessees it requires classifying all leases aseither capital leases or operating leases. It distinguishes between the two by defining when a lease must beaccounted for as a capital lease and defining all other leases as operating leases.

Basic Requirements for Capital Lease Treatment. A capital lease is treated as a purchase that is financed overthe lease term. Capital lease treatment is required if the lease has at least one of the following characteristics:

a. It passes title to the lessee by the end of the lease term.

b. It contains a bargain purchase option.

c. The lease term is at least 75% of the asset's estimated economic life.

d. The present value of the minimum lease payments at the beginning of the lease term is at least 90% of theasset's fair value.

The 75% test and 90% test should not be considered if the lease term begins within the last 25% of the leasedasset's total estimated economic life. Leases for less than a 12�month period ordinarily would not be considered forcapital lease treatment.

Understanding the Basic Requirements. Normally, the most efficient way to gather the information to determinehow leases should be classified is to obtain a copy of the lease agreement. In applying the criteria above, problemsoften are encountered in defining lease term, estimated economic life, minimum lease payments, and fair value,and in making present value computations.

Lease term is defined as the fixed, noncancellable portion of the lease, plus all periods

a. covered by bargain renewal options.

b. for which failure to renew imposes enough of a penalty on the lessee that renewal is reasonably assured.

c. for which the lease can be renewed or extended at the option of the lessor.

d. covered by ordinary renewal options

(1) during which the lessee guarantees any of the lessor's debt that is directly or indirectly related to theleased asset. (It is assumed that the lessee will not terminate the lease if the lease payments are beingused by the lessor to pay debt the lessee has guaranteed.)

(2) during which a loan from the lessee to the lessor is outstanding. (This relates primarily tosale�leaseback transactions.)

(3) that precede the exercise date of a bargain purchase option. (It is assumed that the bargain purchaseoption will be exercised, so it is also assumed that all renewal options up to that date will be exercised.)

If the lease agreement includes a bargain purchase option, the lease term cannot extend past the date the optionbecomes exercisable, since it is assumed that the option will be exercised and the lease will end at that time. Inaddition, a lease term is considered noncancellable if it may be canceled only (a) on the occurrence of someremote contingency, (b) with the permission of the lessor, (c) if the lessee enters into a new lease with the samelessor, or (d) if cancellation imposes enough of a penalty on the lessee that continuation of the lease appearsreasonably assured. Some of the more common cancellation provisions are those that permit the lessee toterminate the lease under either of the following conditions:

� At any time during the lease term with a prescribed amount of notice, for example, one month's notice

� Up to a prescribed amount of time before the end of a period (Typically, such leases will automatically renewfor an additional year unless the lessee cancels in writing 60�90 days before the end of the year.)


418

Some leases provide for a noncancellable period followed by cancelable renewal periods (typically on a year�to�year basis). Only the noncancellable period should be considered when determining how to classify the lease.

Estimated economic life is similar to the GAAP concept of estimated useful life. Basically, it is the period an assetwould be economically useable, with normal repairs and maintenance, for the purpose intended at the inception ofthe lease, regardless of the lease term. For computers and other items subject to rapid obsolescence, estimatedeconomic life often is no longer than the original lease term.

Minimum lease payments include all rentals called for during the lease term plus any residual value guaranteed bythe lessee. Residual value is similar to the GAAP concept of salvage value. Guaranteed residual values arecommon in vehicle leases, which typically specify a value and require one of the following at the end of thenoncancellable lease term:

a. The lessee buys the vehicle for the specified amount.

b. The lessee returns the vehicle to the lessor and, provided its fair market value is at least the specifiedamount, the lessee has no further obligation.

c. If the fair market value is less than the specified amount, the lessee must pay the lessor the difference if thelessee decides not to buy the vehicle.

In addition to residual value guaranteed by the lessee, GAAP specifically includes and excludes the following fromminimum lease payments:

a. Includes any payment the lessee must make for not renewing or extending the lease, including arequirement to purchase the asset.

b. Excludes:

(1) any guarantee by the lessee of the lessor's debt.

(2) the portion of the rent payments representing executory costs (e.g., insurance, maintenance, andtaxes) and any related profit.

(3) any penalty for which the lease term has been extended.

(4) contingent rentals (i.e., those rentals that depend on factors other than the passage of time such asfuture sales volume, future inflation rate, or future property taxes).

If the lease contains a bargain purchase option, however, the previous criteria should be disregarded. In that case,minimum lease payments consist only of the rental payments to the date the option is exercisable (excludingexecutory costs and profit thereon) and the option amount.

An Example Applying Capital Lease Requirements. To illustrate capital lease computations, assume the follow�ing facts for a car lease with a rental company:

� noncancellable lease term48 months.

� Monthly rent payments$371.

� Guaranteed residual value$5,200.

� Cost of vehicle per lease agreement$15,062. (Since the lessor is not a manufacturer or dealer, this is usedfor fair value computations.)

� Lessee pays all executory costs directly; therefore, none are included in the monthly rent payments.


419

� The option to purchase the car for $5,200 does not constitute a bargain purchase option.

� The lease provides for renewal on a year�to�year basis at the same rental, but this does not constitute abargain renewal option.

� Estimated economic lifesix years.

Minimum lease payments include the following:

Monthly rentals (48 � $371) $ 17,808

Guaranteed residual value 5,200

$ 23,008

The implicit rate is the rate that causes the present value of the minimum lease payments to equal the $15,062 cost.Using a trial and error method, the implicit rate is 18% (or 1.5% per month) as illustrated by the following:

Present value of 48 payments of $371 discounted at 1.5% $ 12,630

Present value of a payment of $5,200 due at the end of 48months discounted at 1.5% 2,545

Rounding difference (113 )

$ 15,062

If the lessee could have financed the acquisition through a bank at a 15% rate (1.25% per month), the present valuewould have been:

Present value of 48 payments of $371 discounted at 1.25% $ 13,331

Present value of a payment of $5,200 due at the end of 48months discounted at 1.25% 2,864

$ 16,195

Note that the lease does not pass title, does not contain a bargain purchase option, and the noncancellable leaseterm is less than 75% of the estimated economic life (4/6 = 67%). However, the lease meets the 90% test asillustrated by the following:

Present value of minimum lease payments using theincremental borrowing rate since it is less than theimplicit rate $ 16,195

90% of the lessor's cost of $15,062 $ 13,556

Since the present value of minimum lease payments exceeds the 90% computation, the lease is a capital lease.

Calculating the Asset and Liability for the Example. In determining the amount to be capitalized, the lesseewould use the lower of:

Present value of minimum lease payments using theincremental borrowing rate $ 16,195

Cost to lessor (fair value) $ 15,062

Since the cost (fair value) is less than the present value of the minimum lease payments using the incrementalborrowing rate, the asset and liability are recorded at cost, and the liability is amortized monthly using the implicitrate as illustrated by the following:


420

Total LeasePayment

InterestExpense

Reduction ofLease

ObligationTotal

Liability

Inception $ 15,175

End of first 12 months $ 4,452 $ 2,582 $ 1,870 13,305

End of second 12 months 4,452 2,217 2,235 11,070

End of third 12 months 4,452 1,779 2,673 8,397

End of fourth 12 months 4,452 1,255 3,197 5,200

The liability at inception of $15,175 is set at an amount that enables amortization at the implicit rate. (The $113difference is immaterial.) The same amount is used to record the asset.

GAAP prescribes the following depreciation policies for assets under capital leases:

� If the lease passes title or has a bargain purchase optionlessee's normal depreciation method over theestimated economic life

� If the lease does not pass title or have a bargain purchase optionlessee's normal depreciation methodover the lease term

Accordingly, because this lease does not pass title and does not have a bargain purchase option, it would bedepreciated over four years rather than six years. If the lessee normally uses the straight�line method, annualdepreciation would be $2,494 [($15,175 � $5,200 residual = $9,975) � 4 = $2,494] and accounting for the assetwould be as follows:

Asset CostAccumulatedDepreciation

Cost LessDepreciation

Inception $ 15,175 $ � $ 15,175

End of first 12 months 15,175 2,494 $ 12,681

End of second 12 months 15,175 4,988 10,187

End of third 12 months 15,175 7,482 7,693

End of fourth 12 months 15,175 9,975 5,200

Note that at the end of the lease, both the asset and liability equal the guaranteed residual value. If the car has avalue of $5,200 and is returned, the following entry would be made:

Liability 5,200

Accumulated depreciation 9,975

Asset cost 15,175

If the car has a value of $4,500 and the lessee returns it and pays the $700 difference, the following entry would bemade:

Liability 5,200


Rent expense 700

Asset cost 15,175

Cash 700

If the car has a value of $4,500 and the lessee buys it for $5,200, the following entry would be made:

Liability 5,200

Cash 5,200

Note that book value should not be written down to fair value. The $5,200 book value should be depreciated overthe remaining two years of its estimated economic life unless a change in the estimated life is warranted.


421

Modification of Lease Terms. FASB ASC 840�30�35�18 through 35�20; 840�40�15�6 [formerly Paragraph 14(a) ofSFAS No. 13] addresses how a lessee should account for certain modifications to a capital lease agreement. If themodifications result in a new agreement classified as an operating lease, the transaction should be accounted foras a sale�leaseback transaction.


422


423

SELF�STUDY QUIZ


24. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months, and theestimated economic life is also 5 years. Monthly rental payments are $200, and the guaranteed residual valueis $5,000. The present value of the minimum lease payments is $8,000. The cost of the vehicle per the leaseagreement is $10,000. The vehicle does not pass title at the end of the lease term. Does the lease qualify forcapital lease treatment, and why or why not?

a. Yesit meets the present value test.

b. Yesit meets the lease term test.

c. Nothere is no bargain purchase option present.

d. Noit does not pass title at the end of the lease term.

25. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months. Monthlyrental payments are $200, and the guaranteed residual value is $5,000. Which of the following represents theminimum lease payments?

a. $5,000.

b. $12,000.

c. $17,000.

d. $37,000.

26. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months, and theestimated economic life is also 5 years. Monthly rental payments are $200, and the guaranteed residual valueis $5,000. The present value of the minimum lease payments is $8,000. The cost of the vehicle per the leaseagreement is $10,000. What amount does the computer repair store capitalize as an asset?

a. $8,000.

b. $10,000.

c. $12,000.

d. $17,000.

27. The computer repair store decides to lease a vehicle. The noncancellable lease term is 36 months, and theestimated economic life is 4 years. The recovery period under MACRS is 5 years. Monthly rental payments are$200, and the guaranteed residual value is $2,000. The present value of the minimum lease payments is $8,000.The cost of the vehicle per the lease agreement is $7,000. Title does not pass to the lessee at the end of leaseterm, and there is no bargain purchase option. How many years, if any, is the vehicle depreciated over for GAAPpurposes?

a. 0it is an operating lease.

b. 3.

c. 4.

d. 5.


424



24. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months, and theestimated economic life is also 5 years. Monthly rental payments are $200, and the guaranteed residual valueis $5,000. The present value of the minimum lease payments is $8,000. The cost of the vehicle per the leaseagreement is $10,000. The vehicle does not pass title at the end of the lease term. Does the lease qualify forcapital lease treatment, and why or why not? (Page 417)

a. Yesit meets the present value test. [This answer is incorrect. In order to meet the present value test, thepresent value of the minimum lease payments at the beginning of the lease term must be at least 90% ofthe assets fair value. In this case the fair value is the cost of the vehicle per the lease agreement. $10,000� 90% = $9,000.]

b. Yesit meets the lease term test. [This answer is correct. The vehicle qualifies for capital leasetreatment because the lease term is at least 75% of the vehicle's estimated economic life (60months/60 months = 100%). The lease only needs to meet one of four tests in order to qualify forcapital lease treatment.]

c. Nothere is no bargain purchase option present. [This answer is incorrect. If a bargain purchase optionwas present, the lease would qualify for capital lease treatment. But the lease is not automatically anoperating lease just because a bargain purchase option is not present.]

d. Noit does not pass title at the end of the lease term. [This answer is incorrect. The asset does not needto pass title to the lessee by the end of the lease term in order to qualify for capital lease treatment.]

25. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months. Monthlyrental payments are $200, and the guaranteed residual value is $5,000. Which of the following represents theminimum lease payments? (Page 418)

a. $5,000. [This answer is incorrect. The guaranteed residual value is a component of the minimum leasepayments, but it is not the only amount.]

b. $12,000. [This answer is incorrect. The minimum lease payments include any guaranteed residual value.]

c. $17,000. [This answer is correct. The minimum lease payments include the amount of all rentalscalled for during the lease (60 months � $200 = $12,000), plus any guaranteed residual valueguaranteed by the lessee ($5,000).]

d. $37,000. [This answer is incorrect. The guaranteed residual value is not multiplied over the lease term inyears.]

26. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months, and theestimated economic life is also 5 years. Monthly rental payments are $200, and the guaranteed residual valueis $5,000. The present value of the minimum lease payments is $8,000. The cost of the vehicle per the leaseagreement is $10,000. What amount does the computer repair store capitalize as an asset? (Page 419)

a. $8,000. [This answer is correct. In determining the amount to be capitalized, the lessee uses thelower of the present value of minimum lease payments ($8,000) or the cost to the lessor (fair value)($10,000).]

b. $10,000. [This answer is incorrect. Under this scenario, the cost to the lessor (fair value) is not the correctcapitalization amount.]


425

c. $12,000. [This answer is incorrect. The amount of rental payments is not one of the options whencapitalizing a leased asset.]

d. $17,000. [This answer is incorrect. The minimum lease payments are not considered when determiningthe amount to be capitalized.]

27. The computer repair store decides to lease a vehicle. The noncancellable lease term is 36 months, and theestimated economic life is 4 years. The recovery period under MACRS is 5 years. Monthly rental payments are$200, and the guaranteed residual value is $2,000. The present value of the minimum lease payments is $8,000.The cost of the vehicle per the lease agreement is $7,000. Title does not pass to the lessee at the end of leaseterm, and there is no bargain purchase option. How many years, if any, is the vehicle depreciated over for GAAPpurposes? (Page 420)

a. 0it is an operating lease. [This answer is incorrect. Even though there is no bargain purchase option ortitle passing at the end of the lease term, the lease is a capital lease because it meets the lease term test(3/4 = 75%) and the present value of the minimum lease payments is greater the asset's fair value (therequirement is 90% or more).]

b. 3. [This answer is correct. Since the lease does not pass title or contain a bargain purchase option,the vehicle is depreciated over the lease term of 36 months.]

c. 4. [This answer is incorrect. If the lease passed title or contained a bargain purchase option, the vehiclewould be depreciated over the estimated economic life.]

d. 5. [This answer is incorrect. The recovery period provided by the IRS is not considered when creating aGAAP policy for depreciation.]


426

Contributed and Exchanged Assets

Obtaining property and equipment by contribution is a nonmonetary transaction. FASB ASC 845�10 (formerly APBOpinion No.�29, Accounting for Nonmonetary Transactions) [Note: FASB ASC 845�10 (formerly APB Opinion No.29) does not apply to companies under common control.] requires recording contributed property and equipmentat fair value at the date of the contribution. [Note: FASB ASC 958�605 (formerly SFAS No. 116, Accounting for

Contributions Received and Contributions Made) requires that contributions be recognized when an unconditionalpromise to give is made. Thus, if an unconditional promise to give exists, the contribution would be recorded as areceivable before it is actually received.] In some cases, income tax regulations require recording those items at theprevious owner's basis. Accordingly, the basis of the items for financial statement reporting may differ from their taxbasis, resulting in a temporary difference.

This guidance also addresses accounting for exchanges of nonmonetary assets, such as property and equipment.An exchange of nonmonetary assets should be recorded based on the fair value of the assets involved, and a gainor loss should be recognized on the transaction, unless any of the following three conditions exists:

a. Neither the fair value of the asset received nor the asset surrendered can be reasonably determined.

b. The exchange transaction facilitates sales to customers.

c. The exchange transaction lacks commercial substance. An exchange lacks commercial substance if thefuture cash flows of the entity are not expected to change significantly as a result of the exchange.

If any of those conditions exist, the exchange transaction should be measured based on the recorded amount ofthe asset surrendered and not on the fair values of the assets exchanged. However, the recorded amount should bereduced if there is an indicated impairment of value. To be considered an exchange subject to the provisions ofFASB ASC 845�10 (formerly APB Opinion No. 29), the transferor of a nonmonetary asset must have no substantialcontinuing involvement with the transferred assets. In other words, the transferor must have transferred the usualrisks and rewards of ownership of the asset.

An exchange of nonmonetary assets should generally be measured using the fair value of the assets involved in theexchange. If a company receives an asset in a nonmonetary exchange, the company should record the cost of theasset acquired using the fair value of the asset surrendered. However, if the fair value of the asset received is moreclearly evident, it should be used to record the asset received. Furthermore, GAAP states if one of the parties to thenonmonetary exchange transaction could have chosen to receive cash in lieu of the nonmonetary assets, theamount of cash that could have been received may be evidence of the fair value of the nonmonetary assetsexchanged.

An Example of an Exchange of Assets Measured at Fair Value. Assume that a company exchanges machinerywith a net book value of $10,000 for a parcel of land with a fair value of $20,000 and that because of the specializednature of the machinery, there is no readily determinable fair value for sale in its present condition. The exchangewould be recorded using the following entry:

Investment in land 20,000

Machinerynet 10,000

Gain on exchange 10,000

If the preceding example were revised to exchange the land for the machinery, and the land had a cost of $12,000,the following entry would be made to record the exchange:

Machinery 20,000

Land 12,000

Gain on exchange 8,000


427

An Example of an Exchange Measured at Recorded Amounts Involving Monetary Consideration. If a com�pany exchanges property and equipment through a transaction that would otherwise be measured at recordedamounts and the transaction involves monetary consideration, the following rules apply:

a. The company receiving the monetary consideration should recognize a portion of the gain in the ratio ofcash received to total consideration received, i.e., cash plus fair value of asset received;

b. The company paying monetary consideration should not recognize any gain, i.e., the new asset shouldbe recorded at the book value of the asset surrendered plus any payments; and

c. Any losses on the exchange should be recognized.

See later discussion for guidance that applies in certain cases.

To illustrate, assume that ABC Co. acquires a truck for $25,000 (book value $21,000) from DEF Mfg. for a trade�inof a truck with a book value of $20,000 (cost $30,000 and accumulated depreciation of $10,000) plus an additionalcash payment of $2,000. Assuming the fair value of the old truck is $23,000, the entries to record the trade wouldbe as follows:

ABC Co.

New truck [$20,000 book value of old truck + $2,000 cashpayment]

22,000


Old truck 30,000

Cash 2,000

DEF Mfg.

Cash 2,000

New truck [$23,000 less $3,680 deferred gain ($4,000 �$320)]

19,320

Old trucknet 21,000

Gain � $2, 000

$2, 000� $23, 000� ($25, 000� $21, 000 � $4, 000)� 320

If ABC Co. had paid cash of $6,000 (assuming a trade�in allowance on the old truck of only $19,000 was allowed),it would have made the following entry:

New truck 25,000


Loss ($20,000 book value of old truck less $19,000 fair valueof old truck)

1,000

Old truck 30,000

Cash 6,000

Additional Guidance on Accounting for Exchanges of Nonmonetary Assets. In FASB ASC 845�10 (formerlyEITF Issue No. 01�2, �Interpretations of APB Opinion No. 29"), the EITF reached the following conclusions regard�ing exchanges of nonmonetary assets:

� If an exchange of nonmonetary assets involves monetary consideration (boot) of 25% or more of the fairvalue of the exchange, the transaction should be considered a monetary transaction, and fair valueaccounting would be required for both parties. If boot is less than 25%, the guidance in the example stillapplies. (FASB ASC 845�10�25�6)


428

� If a company acquires control of a subsidiary through an exchange of securities, the exchange should beaccounted for as a business combination following the guidance of FASB ASC 805 (formerly SFAS No.141).

DepreciationGeneral

Accounting Terminology Bulletin No. 1 defines depreciation as a means of spreading the cost of an asset over theperiods benefited. It also emphasizes that depreciation is not a valuation method. Since depreciation is a methodof allocating cost rather than a valuation allowance, the caption �Accumulated depreciation" is preferable to�Allowance for depreciation." However, both are acceptable. Since leasehold improvements are included withdepreciable assets, depreciation of leasehold improvements should simply be included in the �accumulateddepreciation" caption. There is no need to use a separate �accumulated amortization" caption for leaseholdimprovements. (See earlier discussion.) Recognizing depreciation under GAAP involves a determination of each ofthe following:

a. Estimated useful life

b. Pattern of decline in value

c. Salvage value

d. Depreciation method

Estimated Useful Life. The depreciation period for GAAP is normally the estimated useful life. (Exceptions occurfor certain capital leases and leasehold improvements.) It is the time the company intends to use the asset, and itwill vary depending on factors such as the company's maintenance policy and obsolescence of the asset. Forexample, some companies buy trucks with the intention of having minimal maintenance costs and trading thembefore repairs become a problem. Others buy them with the intention of holding them for a long time andconsequently pay greater attention to maintenance. The estimated useful life for trucks would vary for each of thoseapproaches. As another example, computer technology advances so rapidly that regardless of the maintenancephilosophy, the hardware quickly becomes obsolete. To remain competitive, companies have found that for asmaller investment they can acquire computer systems that have expanded capacities, and therefore, it is nolonger feasible to keep the old system. Accordingly, the companies typically depreciate the costs of their systemover a relatively short period. Useful lives may be estimated for individual acquisitions, or ranges may be estab�lished for types of assets that the company regularly acquires, such as vehicles.

Pattern of Decline in Value. Even though depreciation is not a valuation process, the depreciation method usedshould typically reflect the decline in value. Therefore, using an accelerated method would conceptually beappropriate only if an asset's value declines faster in the early years than in the later years. Methods are usuallyselected for components of depreciable assets and all assets within that component are depreciated using thesame method. For example, assume that a company's depreciable assets consist of a building, productionmachinery, and office equipment. It could use a different depreciation method for each component, for example,150% declining balance for the building, sum�of�the�years' digits for the production machinery, and straight�line forthe office equipment. However, all items within a component would normally be depreciated using the samemethod, for example, all office equipment would be depreciated using the straight�line method.

Salvage Value. Some assets have value at the end of their useful life that the company can realize through sale ortrade�in. By depreciating to salvage value, a company is actually spreading the net cost (acquisition cost lesssalvage value) over the period it uses the assets. If it depreciates the asset to zero, there will be a gain when thesalvage value is realized. However, the gain really only represents a �catch�up" adjustment of prior depreciationexpense. Salvage value often fluctuates with market conditions. For example, during recessionary periods, themarket for used vehicles increases and their salvage values increase. However, for computers and other deprecia�ble assets subject to rapid obsolescence, there may be no market for older assets. Also, for many depreciableassets, salvage value is minor, particularly if there is no market for used assets, such as machinery, and thecompany tends to keep them until they are scrapped. If salvage value is minor, there is no need to complicate theaccounting by considering it in the computation.


429

Depreciation Methods. Generally accepted accounting principles recognize basically two approaches to allocat�ing the cost of an asset over periods benefited:

� Straight�line. The cost less salvage value is allocated evenly over the estimated useful life.

� Accelerated. The cost is allocated disproportionately over the useful life so that the early years are chargedwith most of the cost.

There are a number of permissible allocation formulas for accelerated methods. They are sometimes calleddecreasing charge methods and include sum�of�the�years' digits and double declining balance. For example,double declining balance is a depreciation rate that is twice the straight�line rate, which means that if an asset hasan estimated useful life of five years, the straight�line rate would be 20% per year (1/5) and the double decliningbalance rate would be 40%. Comparative computations for depreciation methods are illustrated in the nextparagraph.

Planned Change in Depreciation Method. Since declining balance methods do not depreciate to zero, somecompanies adopt a policy of using a declining balance method until it drops below what straight�line would havebeen and then switch to straight�line. The book value of the asset when the change is made is depreciated on astraight�line basis over the remaining useful life. To illustrate, assume that a machine is bought for $15,000, has anestimated useful life of five years, and will have only a minor salvage value. The following compares the doubledeclining balance method (DDB) with the straight�line method (SL).

DDB SL

Depreciation Book Value Depreciation Book Value

Acquisition $ 15,000 $ 15,000

End of Year:

1 $ 6,000 9,000 $ 3,000 12,000

2 3,600 5,400 3,000 9,000

3 2,160 3,240 3,000 6,000

4 1,296 1,944 3,000 3,000

5 778 1,166 3,000 �

$ 13,834 $ 15,000

Note that the straight�line rate is 20% and the double declining balance rate is 40%.

The company may, therefore, establish a policy that for this type of asset, it will use DDB for the first two years, thenswitch to SL. Depreciation based on that policy would be as follows:

Depreciation Book Value

Acquisition $ 15,000

End of Year:

1 $ 6,000 9,000

2 3,600 5,400

3 1,800 3,600

4 1,800 1,800

5 1,800 �

$ 15,000

The preceding policy is acceptable for GAAP and actually reflects the economic decline in value of many assets.FASB ASC 250�10�45�20 (formerly SFAS No. 154, Accounting Changes and Error Corrections) specifically statesthat the consistent application of a policy to change to the straight�line method at a specific point in the service lifeof an asset does not constitute a change in accounting principle, and, therefore, accounting change disclosurerequirements do not apply.


430

Change in Salvage Value and Estimated Useful Life. Changes in salvage value and estimated useful life arenormally changes in estimates caused by things such as changing market conditions and better information. FASBASC 250�10�45�7 through 45�20 (formerly SFAS No. 154) discusses changes in estimates and distinguishes themfrom a correction of an error arising from misuse of facts available at the time of acquisition. A change in estimateis either recorded entirely in current earnings or current and future periods if the change affects both.

For example, assume that a repair shop buys a press for $12,000 and estimates that it will have a useful life of fiveyears. However, at the end of the fourth year, management believes it can use the press for four more years. Usingthe original estimate, annual depreciation is $2,400 ($12,000 divided by 5), but using the revised estimate, annualdepreciation should have been $1,500 ($12,000 divided by 8). As a result, there is an overstatement of depreciationof $900 ($2,400 � $1,500) for each of the first four years (for a total of $3,600), which should be spread overdepreciation of years five through eight. The undepreciated cost at the time of the change in estimate of $2,400($12,000 � $9,600) should be allocated to the remaining four years at $600 per year as follows. Note: The�catch�up" method, which would reduce depreciation by $3,600 in the year of change, is a departure from GAAP.

Year Depreciation

1 $ 2,400

2 2,400

3 2,400

4 2,400

5 600

6 600

7 600

8 600

$ 12,000

Adoption of a New Depreciation Method. Many factors affect the depreciation method selected, and thosefactors may change. Consequently, a new depreciation method may be adopted in response to those changes.GAAP refers to a change in method of depreciation for long�lived, nonfinancial assets as a change in accountingestimate effected by a change in accounting principle. Such changes are accounted for as changes in estimates.Changes in estimates are accounted for in the period of change if the change only affects that period or in theperiod of change and future periods if the change affects both. A change in depreciation method is only permittedif the new method can be justified on the basis that it is preferable.


431

SELF�STUDY QUIZ


28. Ham Inc. acquires a piece of machinery for $50,000 from Beans Inc. for a trade�in of machinery with a bookvalue of $30,000, plus cash of $5,000. The fair value of the machinery traded�in by Ham was $45,000, and thebook value of the machinery acquired by Ham was $40,000 on Beans' books. What amount does Bean's recordas its new piece of machinery?

a. $35,000.

b. $36,000.

c. $40,000.

d. $44,000.

29. An accounting firm purchases new laptops for its employees. The total cost of the laptops is $15,000, and theestimated useful life is 3 years. The firm believes that at most, the salvage value will be $600 at the end of 3 years,but may be less. The laptops qualify for the Section 179 deduction. Using straight�line depreciation, what is thedepreciation expense in the acquisition year?

a. $4,800.

b. $5,000.

c. $10,000.

d. $15,000.

30. An accounting firm purchases new laptops for its employees. The total cost of the laptops is $15,000, and theestimated useful life is 3 years. At the beginning of the second year, the firm estimates that the laptops can beused for 4 more years (for a total of 5 years). What will the depreciation be for year 2 if the straight�line methodis used?

a. $2,000.

b. $2,500.

c. $3,000.

d. $5,000.


432



28. Ham Inc. acquires a piece of machinery for $50,000 from Beans Inc. for a trade�in of machinery with a bookvalue of $30,000, plus cash of $5,000. The fair value of the machinery traded�in by Ham was $45,000, and thebook value of the machinery acquired by Ham was $40,000 on Beans' books. What amount does Bean's recordas its new piece of machinery? (Page 427)

a. $35,000. [This answer is incorrect. This is the amount Ham will record as its new asset.]

b. $36,000. [This answer is incorrect. The amount of recognized gain is not subtracted from the fair value ofthe asset received.]

c. $40,000. [This answer is incorrect. This is the book value of the old piece of machinery on Beans' books.This is the net amount credited from the machinery account.]

d. $44,000. [This answer is correct. Bean's records the new machinery as the fair value of themachinery received ($45,000), less the deferred gain of $1,000 ($5,000/($5,000 + $45,000)) �($50,000 � $40,000).]

29. An accounting firm purchases new laptops for its employees. The total cost of the laptops is $15,000, and theestimated useful life is 3 years. The firm believes that at most, the salvage value will be $600 at the end of 3 years,but may be less. The laptops qualify for the Section 179 deduction. Using straight�line depreciation, what is thedepreciation expense in the acquisition year? (Page 428)

a. $4,800. [This answer is incorrect. In this case, the salvage value is not taken into consideration since it isminor, and there may not be a market for the laptops at the end of the third year.]

b. $5,000. [This answer is correct. The salvage value is not factored into the calculation ofdepreciation; therefore straight�line depreciation is calculated as $15,000/3 = $5,000.]

c. $10,000. [This answer is incorrect. This would be the depreciation amount in the acquisition year if thedouble declining balance was used.]

d. $15,000. [This answer is incorrect. The depreciation recorded on the books is not the same as thedepreciation taken for federal income tax purposes.]

30. An accounting firm purchases new laptops for its employees. The total cost of the laptops is $15,000, and theestimated useful life is 3 years. At the beginning of the second year, the firm estimates that the laptops can beused for 4 more years (for a total of 5 years). What will the depreciation be for year 2 if the straight�line methodis used? (Page 430)

a. $2,000. [This answer is incorrect. This would be the amount depreciated if the undepreciated cost of theasset at the end of year 1 was depreciated over another 5 years, not 4 years.]

b. $2,500. [This answer is correct. The undepreciated amount of the laptops, $10,000 ($15,000 �$5,000), is depreciated over the remaining useful life of the laptops ($10,000/4 years = $2,500).]

c. $3,000. [This answer is incorrect. This is the amount that would have been depreciated if the laptops wereoriginally given an estimated useful life of 5 years. A change in the estimated useful life is not a correctionof an error.]

d. $5,000. [This answer is incorrect. This is the amount of depreciation in the year of acquisition. The firm isallowed to change its estimated useful life, therefore, the amount of depreciation taken in the second yearwill change.]


433


Lesson 3 (PFSTG104)


21. Which of the following assets would be classified as �property and equipment," rather than �property andequipment held for investment"?

a. Land on which operating facilities are located.

b. Real estate acquired primarily for speculation.

c. Property and equipment retired from operations.

d. Unused real estate to be developed for operating facilities.

22. A film production company bought the latest camera on the market for $17,500 on January 1, 20X1. Sales taxon the camera was an additional $875, and freight charges were $200. The production company believes thecamera has a $5,000 salvage value at the end of its useful life. On December 31, 20X1, the camera has a marketvalue of $19,000. What amount does the company present on its balance sheet as its basis in the camera?

a. $13,575.

b. $17,500.

c. $18,575.

d. $19,000.

23. A manufacturing facility owns the land and building it occupies. It also owns several pieces of large and smallequipment. What is the best caption the company should use on its balance sheet to present the fixed assets?

a. Property, plant, and equipment.

b. Equipment and leasehold improvements.

c. Property and equipment.

d. Land, building, improvements, and equipment.

24. The manufacturing facility leases a large piece of equipment. The fixed, noncancellable portion of the lease is5 years. The lease can be extended at the option of the lessor for an additional 2 years, with a bargain renewaloption at the end of a third year extension, if the lease is extended for the 2 years. The estimated economic lifeis 10 years. What is the lease term of this equipment?

a. 5 years.

b. 7 years.

c. 8 years.

d. 10 years.


434

25. The manufacturing facility leases a large piece of equipment. The fixed, noncancellable portion of the lease is5 years. The lease can be extended at the option of the lessor for an additional 2 years. The estimated economiclife is 10 years. The present value of the minimum lease payments is $85,000 and the asset's fair value is$100,000. There is no bargain option at the end of the lease term. The equipment's title passes to the lesseeat the end of the lease term. Does the equipment qualify for capital lease treatment, and why or why not?

a. Yesit passes title at the end of the lease term.

b. Yesit meets the present value test.

c. Noit does not meet the lease term test.

d. Nothere is no bargain option at the end of the lease term.

26. The manufacturing facility leases a large piece of equipment. The fixed, noncancellable portion of the lease is5 years. The lease can be extended at the option of the lessor for an additional 2 years. The estimated economiclife is 10 years. The present value of the minimum lease payments is $85,000 and the asset's fair value is$100,000. The minimum lease payments are $110,000. There is no bargain option at the end of the lease term.The equipment's title passes to the lessee at the end of the lease term. What amount, if any, does the facilitycapitalize as an asset?

a. $0it is an operating lease.

b. $85,000.

c. $100,000.

d. $110,000.

27. The manufacturing facility leases a large piece of equipment. The fixed, noncancellable portion of the lease is5 years. The lease can be extended at the option of the lessor for an additional 2 years. The estimated economiclife is 10 years. The recovery period under MACRS is 5 years. The present value of the minimum lease paymentsis $85,000 and the asset's fair value is $100,000. The minimum lease payments are $110,000. There is nobargain option at the end of the lease term. The equipment's title passes to the lessee at the end of the leaseterm. For GAAP purposes, over how many years is the equipment depreciated (if any)?

a. 0it is an operating lease.

b. 5.

c. 7.

d. 10.

28. Bob recently started his own accounting firm. Bob contributed the computer and related peripherals he waspreviously using for personal purposes to the company. The computer and peripherals cost Bob $5,000. If Boboriginally purchased the equipment for business use, its book value (cost less depreciation) would be $4,000.The fair value of the equipment on the day of conversion to business use was $3,500. What amount does Bob'sfirm record as its contributed equipment?

a. $0.

b. $3,500.

c. $4,000.

d. $5,000.


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29. A company has a policy of calculating depreciation using the double declining balance for office equipmentpurchased, and switching to the straight�line method when the depreciation drops below what straight�linewould have been, over a five year period. During the year, the company acquired $20,000 in office equipment.What is the depreciation in year 2?

a. $2,400.

b. $4,000.

c. $4,800.

d. $8,000.

30. A company has a policy of calculating depreciation using the double declining balance for office equipmentpurchased, and switching to the straight�line method when the depreciation drops below what straight�linewould have been, over a five year period. During the year, the company acquired $20,000 in office equipment.What is the depreciation in year 3?

a. $1,728.

b. $2,400.

c. $2,880.

d. $4,000.


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437

Lesson 4:�Intangible Assets, Other Deferred Costs,and Long�lived Assets

INTRODUCTION

This balance sheet caption includes noncurrent assets that are not covered in this lesson. Although there is aconceptual difference between intangible assets and deferred costs, most readers are not particularly interested inthem because they are not a source of cash. Instead they are viewed as a cost of business, which is �frozen" in thebalance sheet and amortized over future periods.


Completion of this lesson will enable you to:� Identify the appropriate accounting for goodwill and other intangibles.� Determine when an asset is impaired.� Determine when to apply FASB ASC 360�10 (formerly SFAS No. 144) to long�lived assets.

Goodwill and Other Intangible Assets

FASB ASC 805 [formerly SFAS No. 141(R), Business Combinations] provides guidelines for goodwill and otherintangible assets acquired in a business combination at acquisition. FASB ASC 350 (formerly SFAS No. 142,Goodwill and Other Intangible Assets) addresses intangible assets acquired individually or with a group of otherassets (excluding those acquired in a business combination) at acquisition. In addition, it provides guidance forgoodwill and other intangible assets subsequent to acquisition. Goodwill and other intangible assets generallyinclude the following:

a. Goodwill

b. Patents

c. Trademarks

d. Customer lists

e. Company name

f. Franchise fees

g. Covenants not to compete

Balance Sheet Captions. Intangible assets (excluding goodwill) may be aggregated and presented in the balancesheet as a single line item or the components of intangible assets may be separately presented in the balancesheet. However, the aggregate balance of goodwill must be presented as a separate line item on the balance sheet.The presentation of goodwill and other intangible assets may appear as follows:

20X2 20X1

INTANGIBLE ASSETS

Goodwill 100,000 110,000

Noncompetition agreement 70,000 75,000

Trademark 50,000 60,000

220,000 245,000

Acquisition of Goodwill. Nonpublic companies acquire goodwill through a business combination. Generally, in abusiness combination, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest are


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recognized at their fair values. The excess of (a) the fair value of the consideration transferred and the fair value ofany noncontrolling interest over (b) the fair value of the identifiable net assets acquired is considered to be goodwill.

GAAP requires an acquired intangible asset to be recognized as a separate asset, apart from goodwill, if it arisesfrom legal or contractual rights. If it does not, it should be recognized separately from goodwill only if the asset isseparable (i.e., capable of being separated from the entity and sold, transferred, licensed, rented, or exchanged byitself or in combination with a related contract, asset, or liability).

Assessing the Impairment of Goodwill. FASB ASC 350 (formerly SFAS No. 142) requires that goodwill be testedfor impairment at least annually rather than being amortized. Impairment is to be assessed at the reporting unitlevel, which is defined as an operating segment or a component one level below an operating segment. Acomponent is considered a reporting unit if it is a business with discrete financial information and operating resultsthat are regularly reviewed by segment management. Two or more components should be combined into a singlereporting unit if they have similar economic characteristics. FASB ASC 280�10 (formerly SFAS No. 131, Disclosuresabout Segments of an Enterprise and Related Information) should be used to identify the reporting units of acompany.

Testing goodwill for impairment is a two�step process. The first step is to determine whether impairment exists. Thatis accomplished by comparing the fair value and the carrying value (including goodwill) of a reporting unit.Impairment exists if the carrying value exceeds the fair value of the reporting unit. Conversely, if the fair valueexceeds the carrying value, the goodwill is not considered impaired and the second step of the impairment processis not applicable.

The second step of the impairment process is the measurement of the amount of the impairment loss. The loss iscalculated by comparing the carrying value of the goodwill to its implied fair value. The loss is the amount by whichthe carrying value exceeds the implied fair value. However, the loss cannot exceed the carrying value of thegoodwill and recognized impairment losses may not be subsequently reversed. The implied fair value of goodwillcan be estimated similar to the methodology used to measure the amount of goodwill resulting from a businesscombination. The following steps are required:

� Determine the fair value of a reporting unit.

� Assign that fair value to all of the assets and liabilities of that reporting unit. Amounts should also beassigned to unrecognized intangible assets, if any.

� Compare the fair value of the reporting unit to the amounts assigned to its assets and liabilities. Any excessof fair value is considered the implied fair value of the goodwill.

� Compare the implied fair value of the goodwill to its carrying value. The impairment loss is the amount bywhich the carrying value exceeds the implied fair value.

Frequency of Testing Goodwill for Impairment. GAAP requires that goodwill be tested for impairment at leastonce a year. Impairment testing may need to be performed more frequently if events or circumstances change suchthat it is more likely than not that the fair value of a reporting unit has been reduced below its carrying value. Suchcircumstances may include the allocation of goodwill to a business to be disposed of, significant adverse changesin an entity's business or legal environment, regulatory actions or assessments, impairment testing of a significantgroup of assets within a reporting unit, or the assessment of a goodwill impairment loss in a subsidiary that is acomponent of a reporting unit. Furthermore, companies should test goodwill for impairment at the same time everyyear. However, all reporting units are not required to test for impairment at the same time as the others.

An entity is not required to make a detailed determination of the fair value of a reporting unit each year. A prior year'svaluation may be carried forward to a subsequent year if the following conditions are met in their entirety:

� The reporting unit's assets and liabilities have not changed significantly since the prior fair valuedetermination was made.

� The fair value of the reporting unit substantially exceeded the carrying amount at the time the prior fair valuedetermination was made.


439

� The entity can conclude, based on an analysis of recent events and circumstances, that the likelihood isremote that a revised fair value calculation would produce an amount lower than the current carrying valueof the reporting unit.

Amortization of Intangible Assets Other Than Goodwill. Intangible assets other than goodwill that have anindefinite useful life should not be amortized, but rather should be subject to an impairment test similar to thatperformed for goodwill. Intangible assets that have a finite useful life should be amortized over the asset'sestimated useful life. FASB ASC 350�30�35�1 through 35�5 (formerly SFAS No. 142) provides guidance for estimat�ing the useful life of an intangible asset. Amortization should be calculated using the straight�line method unlessanother method better reflects the pattern of consumption of the economic benefits of the intangible asset.

Assessing the Impairment of Intangible Assets Other Than Goodwill. Intangible assets other than goodwill thathave an indefinite useful life should be tested for impairment by comparing the fair value to the carrying amount ofthe intangible asset. If the assessment indicates that the carrying amount is not recoverable and the carryingamount exceeds the fair value of the intangible asset, the excess should be recognized as an impairment loss. If thefair value exceeds the carrying amount, impairment is deemed not to exist. Impairment should be tested at leastannually or more frequently if certain circumstances indicate that the asset may be impaired. Such circumstancesmay include a significant decline in the market value of the asset, significant adverse changes in an entity'sbusiness or legal environment, regulatory actions or assessments, or other factors that could adversely impact thevalue of the intangible asset. Once an impairment loss has been recognized, GAAP prohibits the subsequentreversal of that loss.

Covenants Not to Compete Negotiated in Connection with the Acquisition of a Business or Treasury Stock.The following summarizes accounting for the acquisition of a business or treasury stock:

� Business Combination. In a business combination, one company either acquires a controlling financialinterest in another company, generally either by acquiring equity or substantially all of the entity's assets.In an asset acquisition, some or all of the liabilities may also be assumed. Generally the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest are recognized at their fair values. Theexcess of (a) the fair value of the consideration transferred and any noncontrolling interest over (b) the fairvalue of the identifiable net assets acquired is considered to be goodwill.

� Treasury Stock Acquisition. In a treasury stock acquisition, a company acquires the stock of a stockholder.The consideration for the acquisition of treasury stock is allocated between the stock and rights, privileges,or agreements in addition to the stock. The amount allocated to stock generally is charged to stockholders'equity, but whether the other consideration is capitalized or charged to earnings depends on the specificrights, privileges, or agreements obtained.

When the seller could be a significant competitive threat, the buyer typically requires the seller to agree not tocompete for a prescribed period. That is a common situation when the acquisition involves a small to medium�sizedbusiness when one or more of the sellers has been critical to the success of the business. A single price may bespecified for the acquisition, including the covenant, or consideration for the covenant may be separate, eitherpayable at closing or in installments. The best practices indicate accounting for the covenant depends on whetherit has economic substance, and that generally depends on whether the seller could be a significant competitivethreat:

� If the covenant has no economic substance, payments should be accounted for as additional considerationfor the treasury stock acquired or the net assets acquired in a business combination.

� If the covenant has economic substance, a value should be recorded only if there is a prepayment, eitherby an upfront payment or by including the covenant in the total consideration for the treasury stock orbusiness combination.

Accounting for a Prepayment. The best practices indicate that a buyer will pay in advance for a covenant only ifhe does not believe the seller is a competitive threat, because collecting a refund of the payment if the seller doescompete may be difficult. The seller may provide financing when a single price is specified in a treasury stockacquisition or a business combination. However, the underlying note generally specifies interest and a single


440

principal amount. Typically, payments under the note are fixed and are unaffected by whether the seller violates thecovenant. Similarly, a payment due at closing and designated as consideration for a covenant usually does notprovide for a refund in the event the seller violates the covenant. Accordingly, best practices indicate that aprepayment should normally be accounted for as follows:

� Single Price for Treasury Stock. If treasury stock is being purchased and the price includes a covenant notto compete, all of the consideration should be accounted for as the cost of acquiring the treasury stock.

� Single Price for a Business Combination. If stock or assets are acquired in a business combination and theprice includes a covenant not to compete, all of the identifiable assets and liabilities should be recognizedat their fair values.

� Upfront Payment. Generally, an upfront payment only is required in a business combination. The paymentshould be recognized at its fair value in accounting for the business combination.

Accounting for Installment Payments under a Covenant. The following provides a best conclusion on theaccounting for covenants that require installment payments:

� The Covenant Has Economic Substance. If the covenant has economic substance, the payments are forfuture performance, and, best practices indicate that the contractual obligation for those payments isincurred based on the passage of time. Accordingly, no liability should be recorded for the future payments,and the payments should be charged to future operations as they become due.

� The Covenant Does Not Have Economic Substance. If the covenant does not have economic substance,best practices indicate that payments under the agreement are in substance additional payments for thetreasury stock or assets acquired in a business combination. Accordingly, the transaction obligating thebuyer for the additional payments (that is, the purchase of the stock or assets) has occurred, and theconditions for recording a liability are met.

Other Assets

Organization Costs. These represent costs incurred in establishing a legal entity. They normally consist of legalfees incurred for drafting the formation documents, such as bylaws and articles of incorporation. FASB ASC720�15�25�1 (formerly SOP 98�5, Reporting on the Costs of Start�Up Activities) requires organization costs to beexpensed as incurred. For income tax purposes, organization costs may be capitalized or amortized over afive�year period. If organization costs are capitalized for tax purposes but expensed for financial reporting, deferredtaxes should be provided.

Costs of Acquiring or Terminating a Lease. Buying and selling operating leases occurs in practice in situationssuch as the following:

� Sale of a Lease. ABC sold its office building to DEF. Since ABC already has a lease with CAS that providesa steady stream of income, DEF may be willing to pay a lump sum amount to acquire the rights to the leasewith CAS rather than finding and negotiating a new lease. Essentially, the lump sum payment representsthe cost of acquiring the right to an income stream. Accordingly, the new lessor (DEF) incurs costs inacquiring the rental property and also acquiring an existing income stream.

� Purchase of a Business. In a purchase of a business with favorable leases either as a lessor or a lessee,a portion of the purchase price may be allocated to the leases following the preceding reasoning.

Federal Tax Deposit to Retain Fiscal Year. For income tax reporting, there is a presumption that the reporting yearfor a partnership or S corporation should be the same as for its owners (generally the calendar year). A partnershipor S corporation can report on a fiscal year basis only if it can show that the fiscal year is its natural business yearor if it pays a deposit. (Note: Due to the difficulty in receiving IRS approval for a fiscal year that conforms to anentity's natural business year, many partnerships and S corporations wanting to adopt a year end other thanDecember 31 make a Section�444 election to use a fiscal year and make required deposits under Section 7519. Ifthe Section 444 election is made, there are restrictions on the fiscal year that can be used, however. Partnerships


441

or S corporations making the Section 444 election are limited to year ends of September 30, October 31, orNovember 30.) That applies to new entities as well as entities that previously reported on another basis (forexample, a C corporation that reported on a fiscal year basis and elects to file as an S corporation). (A personalservice corporation is subject to the same requirements except that a deposit is not required.)

The deposit generally represents the tax the owners would have paid for the deferral period. To illustrate, assumea C corporation that filed on a fiscal year basis elects S status effective October 1, 20X0. If the corporation changesto a calendar year, the S corporation will be required to file a tax return for the three months ending December 31,20X0, with the taxable income included in the stockholders' taxable income for 20X0. But if it retains its fiscal year,the stockholders will recognize no taxable income from the S�corporation in 20X0, and instead will include taxableincome for the year ending September 30, 20X1, in their 20X1 return. Retaining the fiscal year effectively deferstaxable income of three months, and the deposit reflects the tax benefit to the owners of that deferral. Generally, thedeposit is calculated as the product of the highest individual tax rate plus 1%, the percentage of the deferral periodto a total year, and the entity's taxable income for the prior year. Adjustments are made if the return for that periodwas for less than a year.

Although the balance of the deposit may fluctuate depending on taxable income and other factors (for example,payments to stockholders), a balance is generally required until the entity either liquidates, changes to the requiredreporting year (generally the calendar year), or terminates its S election. The deposit is generally viewed as aninterest�free loan of the tax benefits of adopting a fiscal year. Accordingly, best practices indicate that it should bereported as a noncurrent asset using a caption such as �Federal tax deposit to retain fiscal year."

The deposit is adjusted annually on May 15 of the calendar year following the calendar year in which the fiscal yearbegins. For example, an additional deposit or refund for the fiscal year ended June 30, 20X1, would be settled onMay 15, 20X1, since the fiscal year begins in calendar year 20X0. Likewise, an adjustment for the fiscal year endedMarch 31, 20X1, would be settled on May 15, 20X1. As a result, for fiscal years ending January through April, thedeposit adjustment each year will not be made until the following fiscal year. Best practices indicate, however, thatthe adjustment should be reflected in the financial statements of the fiscal year to which it relates. To illustrate,assume that an additional deposit is required for the year ended April 30, 20X1 (due May 15, 20X1). The adjustmentshould be reflected in the April 30, 20X1, financial statements through a charge to the deposit account and a creditto accrued liabilities. Similarly, if a refund is due, it should be recorded as a current asset.


442


443

SELF�STUDY QUIZ


31. Which one of the following choices indicates an impairment of goodwill exists?

a. Unit A's carrying value is $100,000 and its fair value is $300,000.

b. Unit B's carrying value is $200,000 and its fair value is $200,000.

c. Unit C's carrying value is $300,000 and its fair value is $200,000.

32. Which of the following is true regarding goodwill?

a. Goodwill generated internally can be capitalized.

b. Goodwill should be tested for impairment annually.

c. Goodwill can be aggregated and presented in the balance sheet with other intangible assets.

d. Goodwill should be tested for impairment at the same time for all reporting units.

33. A company filed for a patent for its new invention. The costs to file the patent were $20,000. The term of thepatent is 20 years, but the company believes that other companies will have similar products on the market in5 years. What amount, if any, is the company's first year of amortization on the patent? (Hint: Assumestraight�line method).

a. $0it is not amortized.

b. $1,000.

c. $4,000.

d. $8,000.

34. How is a covenant not to compete with no economic substance treated in a treasury stock acquisition?

a. As additional net assets acquired.

b. As an intangible asset.

c. As an expense.

d. As additional consideration for the treasury stock.

35. A C corporation with a fiscal year of May 31 elects S status and retains the fiscal year. On May 31, 20X1 itsbalance in the �Federal tax deposit to retain fiscal year" account is $4,500. On May 15, 20X2, the S corporationcalculated that the deposit should decrease by $500. Which of the following is the correct journal entry to recordthis federal tax deposit adjustment?

a. DebitCash; CreditFederal tax deposit to retain fiscal year.

b. DebitFederal tax deposit to retain fiscal year; CreditAccrued liabilities.

c. DebitFederal tax receivable; CreditFederal tax deposit to retain fiscal year.

d. DebitIncome tax expense; CreditFederal tax deposit to retain fiscal year.


444



31. Which one of the following choices indicates an impairment of goodwill exists? (Page�438)

a. Unit A's carrying value is $100,000 and its fair value is $300,000. [This answer is incorrect. When the fairvalue of the unit exceeds the carrying value, the goodwill is not considered impaired and the second stepof the impairment process is not applicable.]

b. Unit B's carrying value is $200,000 and its fair value is $200,000. [This answer is incorrect. Since thecarrying value and the fair value of the unit is the same amount, goodwill is not impaired.]

c. Unit C's carrying value is $300,000 and its fair value is $200,000. [This answer is correct. Impairmentof goodwill exists if the carrying value exceeds the fair value of the reporting unit. This is the firststep in testing goodwill for impairment. The second step is measuring the amount of impairmentloss.]

32. Which of the following is true regarding goodwill? (Page 438)

a. Goodwill generated internally can be capitalized. [This answer is incorrect. Internally generated goodwillis never capitalized. Goodwill acquired in a business acquisition is the only capitalized goodwill.]

b. Goodwill should be tested for impairment annually. [This answer is correct. GAAP requires thatgoodwill be tested for impairment at least once a year. Impairment testing may need to be performedmore frequently if events or circumstances change such that it is more likely than not that the fairvalue of a reporting unit has been reduced below its carrying value.]

c. Goodwill can be aggregated and presented in the balance sheet with other intangible assets. [This answeris incorrect. Intangible assets, excluding goodwill, may be aggregated and presented in the balance sheetas a single line item or the components of intangible assets may be separately presented in the balancesheet.]

d. Goodwill should be tested for impairment at the same time for all reporting units. [This answer is incorrect.Companies should test goodwill for impairment at the same time during the year, but reporting units arenot required to test for impairment at the same time as the others.]

33. A company filed for a patent for its new invention. The costs to file the patent were $20,000. The term of thepatent is 20 years, but the company believes that other companies will have similar products on the market in5 years. What amount, if any, is the company's first year of amortization on the patent? (Hint: Assumestraight�line method). (Page 439)

a. $0it is not amortized. [This answer is incorrect. The patent has a finite life, and therefore, should beamortized.]

b. $1,000. [This answer is incorrect. The patent has a legal life of 20 years, but its actual useful life is a shorterperiod.]

c. $4,000. [This answer is correct. The company should use 5 years as its useful life since it expectsothers to enter the market with similar products. Amortization should be calculated over thestraight�line method, unless another method better reflects the pattern of consumption of theeconomic benefits of the patent.]

d. $8,000. [This answer is incorrect. This would be the amount of amortization if the double declining balancemethod were used.]


445

34. How is a covenant not to compete with no economic substance treated in a treasury stock acquisition?(Page 439)

a. As additional net assets acquired. [This answer is incorrect. This would be the treatment if the covenantnot to compete was negotiated in a business combination.]

b. As an intangible asset. [This answer is incorrect. An intangible asset is only recorded if there is economicsubstance.]

c. As an expense. [This answer is incorrect. Whether the covenant not to compete is negotiated in a businesscombination or treasury stock acquisition, or whether the covenant has economic substance or not, it isnot treated as an expense.]

d. As additional consideration for the treasury stock. [This answer is correct. If the covenant has noeconomic substance, payments should be accounted for as additional consideration for thetreasury stock acquired or net assets acquired in a business combination.]

35. A C corporation with a fiscal year of May 31 elects S status and retains the fiscal year. On May 31, 20X1 itsbalance in the �Federal tax deposit to retain fiscal year" account is $4,500. On May 15, 20X2, the S corporationcalculated that the deposit should decrease by $500. Which of the following is the correct journal entry to recordthis federal tax deposit adjustment? (Page 441)

a. DebitCash; CreditFederal tax deposit to retain fiscal year. [This answer is incorrect. Cash is notincreased until actually received from the Treasury.]

b. DebitFederal tax deposit to retain fiscal year; CreditAccrued liabilities. [This answer is incorrect. Thiswould be the correct entry if the Federal tax deposit needed to be increased.]

c. DebitFederal tax receivable; CreditFederal tax deposit to retain fiscal year. [This answer iscorrect. A current asset should be recorded if a refund is due to the company. The deposit is viewedas an interest free loan of the tax benefits of adopting a fiscal year; therefore, the entries are runthrough the balance sheet, not as income statement items.]

d. DebitIncome tax expense; CreditFederal tax deposit to retain fiscal year. [This answer is incorrect. Thedeposit is viewed as an interest free loan of the tax benefits of adopting a fiscal year; therefore, the entriesare run through the balance sheet, not as an income statement item.]


446

IMPAIRMENT OR DISPOSAL OF LONG�LIVED ASSETS

Applicability

Occasionally, changes in operating conditions raise doubts about a company's ability to fully recover the carryingvalue of a particular long�lived asset. The �Impairment or Disposal of Long�Lived Assets" subsections of FASB ASC360�10 (formerly SFAS No. 144, Accounting for the Impairment or Disposal of Long�Lived Assets) provides guid�ance on the recognition and measurement of an impairment loss for long�lived assets.

Assets Specifically Excluded from the Requirements

GAAP for the impairment or disposal of long�lived assets does not apply to the following long�lived assets:

a. Goodwill

b. Intangible assets with indefinite useful lives not subject to amortization

c. Servicing assets

d. Financial instruments, including equity security investments accounted for under the cost or equity method

e. Deferred policy acquisition costs

f. Deferred tax assets

g. Unproved oil and gas properties accounted for by the successful�efforts method of accounting

h. Assets accounted for under FASB ASC 928 (formerly SFAS No. 50, Financial Reporting in the Record and

Music Industry); FASB ASC 920 (formerly SFAS No. 63, Financial Reporting by Broadcasters); FASB ASC985�20 (formerly SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, orOtherwise Marketed); and FASB ASC 980�360 (formerly SFAS No. 90, Regulated EnterprisesAccounting

for Abandonments and Disallowances of Plant Costs).

Overview of the Accounting Requirements

Accounting for long�lived assets depends on whether the assets will be (a) held and used, (b) held for sale, or (c)held for disposal other than by sale. Generally, the following is required for each classification:

� Long�lived Assets to Be Held and Used. An impairment loss should be recognized to the extent the asset'scarrying amount is not recoverable and exceeds its fair value. Accounting for long�lived assets to be heldand used is discussed later in this lesson.

� Long�lived Assets Held for Disposal, Other Than by Sale (e.g., Abandonment). An impairment loss shouldbe measured and recognized the same as for assets to be held and used. However, GAAP providesadditional requirements relative to depreciating long�lived assets held for disposal by abandonment andestimating future cash flows for long�lived assets to be distributed to owners or through an exchangemeasured using the recorded amount of the nonmonetary asset surrendered. Accounting for long�livedassets held for disposal, other than by sale, is discussed later in this lesson.

� Long�lived Assets Held for Sale. Should be reported at the lower of the carrying amount of the long�livedasset or its fair value less selling costs. An impairment loss should be recognized for any initial orsubsequent adjustment to the carrying amount of the long�lived asset to fair value less cost to sell. Along�lived asset is not subject to depreciation while held for sale. Accounting for long�lived assets to be soldis discussed later in this lesson.


447

Determining the Classification of a Long�lived Asset

GAAP provides different accounting requirements depending on whether a long�lived asset is to be held and used,held for disposal by sale, or held for disposal by a method other than sale. However, the need to classify long�livedassets into these three categories depends on the facts and circumstances as follows:

� GAAP requires disclosure of long�lived assets held for sale, regardless of whether they are impaired.Therefore, management should always identify the long�lived assets that the company intends to disposeof through a sale and value the assets accordingly.

� For long�lived assets that are not being held for sale, classifying them as held for disposal other than bysale or held and used is not necessary unless there is an indication that the assets may be impaired. Seethe following discussion of potential impairment.

When Is an Impairment Assessment Necessary?

An entity is required to consider the need to recognize a loss from the impairment of a long�lived asset held andused or held for disposal other than by sale whenever events or changes in circumstances indicate the carryingamount of the asset may not be recoverable. Therefore, entities are not required to routinely assess all of theirlong�lived assets for impairment. The following examples of events or circumstances that may indicate that anasset's carrying amount is not recoverable are provided:

a. The market value of the asset significantly decreases

b. A significant adverse change in the physical condition of the asset or an adverse change in the way theasset is being used

c. A significant adverse change in legal factors or the business climate that could affect the value of the asset(e.g., actions or assessments by regulators)

d. Incurring costs to acquire or construct an asset that are significantly higher than originally planned

e. Current period operating or cash flow losses along with a history of such losses from using the assetaccompanied by projections or forecasts that reflect continuing losses related to use of the asset

f. A current expectation that the possibility that the asset will be sold or disposed of significantly prior to theend of its estimated useful life is more likely than not

The list of examples is not all�inclusive. Other factors might raise doubts about the recoverability of an asset, and,if they do, the accountant should assess the asset for impairment. For small businesses, it is likely that operatinglosses resulting from using the assets will often be the first indicator that an asset may be impaired. Anotherrecurring indicator might be a change in the way an asset is being used. The following are examples of situationsthat may indicate an asset is impaired:

� A manufacturing company supplies parts to oil field service companies in the United States. Due to anexcess supply of oil from Middle Eastern countries, oil prices have dramatically declined, and 50% of theactive, domestic oil wells have been shut down. The manufacturing company's orders are negligible, andit is currently projecting a loss for at least the next two years.

� Buy City Electronics built a retail store on Main Street three years ago. Due to high growth in the county,the state is constructing a major thoroughfare approximately two miles north of Main Street. Once the newroad is constructed, Buy City expects to lose a significant amount of the revenues currently generated fromdrive�by customers. However, the Company does not believe it can justify relocating its store at the presenttime.

Accounting for Long�lived Assets Held and Used or Held for Disposal Other Than by Sale

An entity must be able to estimate both the expected cash flows (on an undiscounted basis) and the fair value of along�lived asset to calculate an impairment loss. GAAP provides guidance on estimating the future cash flows from


448

a long�lived asset and its fair value. Essentially, if the estimated undiscounted cash flows from a long�lived asset(whether held and used or held for disposal other than by sale) are at least equal to the asset's carrying amount, noadjustment is required and no impairment loss is recognized. Generally accepted accounting principles view anasset's carrying amount as the recorded amount less related valuation allowances. However, if the carrying amountexceeds the estimated undiscounted cash flows, the entity should recognize an impairment loss through a chargeto earnings and a reduction of the asset's carrying amount for any excess of the carrying amount over fair value.GAAP does not address whether the reduction should be accomplished through a credit to the asset account or toa valuation allowance. As a practical matter, crediting a valuation allowance may be the best approach for mostsmall and midsize entities. That will enable management to readily identify the temporary difference that arisesbecause impairment losses are not deductible in computing taxable income until they are realized.

Upon recognizing an impairment loss, the adjusted carrying amount becomes the asset's new cost basis. It shouldnot be adjusted for subsequent increases in fair value. However, it continues to be subject to the impairmentrequirements and future tests for recoverability should be based on comparisons with the new cost basis.

Additionally, the new cost basis of a long�lived asset (whether classified as held and used or held for disposal otherthan by sale) should be depreciated over the estimated remaining useful life of the asset. As a practical matter, theevents or changes in current circumstances that led to the impairment may have affected the remaining useful life.If the entity plans to abandon the asset, the method used to depreciate it should result in a carrying amount at thedate of abandonment equal to the expected salvage value, if any.

When a long�lived asset is distributed to owners in a spin�off or disposed of in an exchange measured using therecorded amount of the nonmonetary asset surrendered, an excess of the carrying amount over the fair value of theasset should be charged to earnings. However, a gain should not be recognized for any excess of fair value at thatdate.

Accounting for Long�lived Assets Held for Sale

GAAP establishes a number of criteria that must be met before a long�lived asset can be classified as held for sale.All of the following conditions are required for classification as held for sale:

a. Management with the proper authority has committed to a plan to sell the asset.

b. The asset, in its present condition, is immediately available for sale (subject only to the usual and customarysales terms for similar assets).

c. The entity has initiated an active program to find a buyer and the asset is being actively marketed at areasonable price considering its current fair value.

d. Sale of the asset is probable and expected to be completed within one year (except as discussed in thenext paragraph).

e. It is unlikely that the plan of sale will significantly change or be abandoned prior to completion.

The period required to complete the sale of a long�lived asset may extend beyond the one year requirement statedin the paragraph above, due to events or circumstances beyond an entity's control. In the following situations, anexception is provided to the one�year requirement discussed in paragraph above:

a. At the date the entity commits to a plan to sell an asset, it reasonably expects that a party other than a buyerwill impose conditions on the transfer of the asset that will extend the period required to complete the saleand

(1) A firm purchase commitment must be obtained before necessary actions can be initiated to respondto those conditions

(2) It is probable that the entity will obtain a firm purchase commitment within one year


449

b. A firm purchase commitment is obtained by the entity but a buyer or other party unexpectedly imposesconditions on transfer of the asset that will extend the period required to complete the sale and

(1) Necessary actions have been or will be timely initiated to respond to the conditions

(2) The delaying factors are expected to be favorably resolved

c. During the initial one�year period, circumstances that were previously considered unlikely arise and, as aresult, the asset is not sold by the end of that period and

(1) The entity initiated actions necessary to respond to the change in circumstances during the initialone�year period

(2) Given the change in circumstances, the asset is being actively marketed at a reasonable price

(3) All the other conditions previously discussed are met

If the criteria for classification as held for sale are met after the balance sheet date but before the financialstatements are available to be issued, the long�lived asset should be classified as held and used at the balancesheet date but disclosures should be provided. In addition, if the criteria are initially met but conditions change ina subsequent period so that one or more are no longer met, the asset should be reclassified as held and used inthat period. An adjustment of the asset's carrying amount during the period the conditions change is generallyrequired.

If a company acquires a long�lived asset and management intends to hold the asset for sale, it should be classifiedas held for sale at the acquisition date only in the following situations:

a. The one�year requirement stated previously is met, unless one of the exceptions discussed in thepreceding paragraph applies.

b. Any other criteria stated previously that are not met at acquisition are probable of being met within a shortperiod following the acquisition, usually within three months.


450


451

SELF�STUDY QUIZ


36. A manufacturing company has a piece of equipment that it uses daily in its operations. One night, themaintenance crew used the wrong cleaning solution to clean the inside of the equipment. The equipment stillworks, but it can only produce about half of what it did prior to the change in condition. The company still planson using the equipment until it can find a suitable replacement. Which of the following is true regarding theimpairment of the asset, assuming the company can estimate both the expected cash flows and the fair valueof the equipment?

a. The asset should no longer be depreciated.

b. The adjusted carrying amount is the asset's new cost basis.

c. The loss is included in other comprehensive income.

d. It does not qualify for treatment under FASB ASC 360�10 (formerly SFAS No. 144).

37. Company X wants to classify a long�lived piece of equipment as held for sale. Which of the following meets theconditions required for classification as held for sale?

a. X advertises the equipment as for sale on its website, priced as �$1,000,000 no exceptions." The fair valueof the equipment is $500,000.

b. X expects that the equipment will be sold in 2�3 years.

c. The asset will need several modifications to be ready for the next owner.

d. It is unlikely that the plan of sale will significantly change prior to completion.


452



36. A manufacturing company has a piece of equipment that it uses daily in its operations. One night, themaintenance crew used the wrong cleaning solution to clean the inside of the equipment. The equipment stillworks, but it can only produce about half of what it did prior to the change in condition. The company still planson using the equipment until it can find a suitable replacement. Which of the following is true regarding theimpairment of the asset, assuming the company can estimate both the expected cash flows and the fair valueof the equipment? (Page 447)

a. The asset should no longer be depreciated. [This answer is incorrect. The new cost basis of a long�livedasset should be depreciated over the estimated remaining useful life of the asset.]

b. The adjusted carrying amount is the asset's new cost basis. [This answer is correct. Uponrecognizing an impairment loss, the adjusted carrying amount becomes the asset's new cost basis.It should not be adjusted for subsequent increases in fair value. However, it continues to be subjectto the requirements of GAAP.]

c. The loss is included in other comprehensive income. [This answer is incorrect. When an impairment lossis recognized, the loss is charged to current year earnings.]

d. It does not qualify for treatment under FASB ASC 360�10 (formerly SFAS No. 144). [This answer is incorrect.GAAP applies to assets (a) held and used, (b) held for sale, and (c) held for disposal other than by sale,except for certain assets specifically excluded from the provision.]

37. Company X wants to classify a long�lived piece of equipment as held for sale. Which of the following meets theconditions required for classification as held for sale? (Page 448)

a. X advertises the equipment as for sale on its website, priced as �$1,000,000 no exceptions." The fair valueof the equipment is $500,000. [This answer is incorrect. One of the conditions that must be met is that theentity has initiated a program to find a buyer and the asset is being actively marketed at a reasonable priceconsidering its current fair value.]

b. X expects that the equipment will be sold in 2�3 years. [This answer is incorrect. One of the conditions thatmust be met is that the sale of the asset is probable and expected to be completed within one year.]

c. The asset will need several modifications to be ready for the next owner. [This answer is incorrect. One ofthe conditions that must be met is that the asset, in its present condition, is immediately available for sale.]

d. It is unlikely that the plan of sale will significantly change prior to completion. [This answer is correct.GAAP requires 5 criteria that must be met before a long�lived asset can be classified as held for sale.One of the conditions is that it is unlikely that the plan of sale will significantly change or beabandoned prior to completion.]


453

Assessing an Asset Held for Sale for Impairment

As discussed previously, the carrying amount of a long�lived asset held for sale should not exceed its fair value lessthe estimated direct costs to sell the asset. In addition to estimating the asset's fair value, the entity should estimatethe incremental direct costs to transact a sale. That estimate should include only the costs that would result directlyfrom and are essential to a sale transaction and that would not be incurred if the entity did not sell the asset.Examples are broker commissions, legal and title transfer fees, and closing costs. For this purpose, selling costsexclude expected future losses associated with the operation of the asset while it is classified as held for sale.Furthermore, selling costs should be discounted if the sale is expected to occur beyond one year. An impairmentloss should be recognized to the extent the carrying amount exceeds the estimated fair value of the long�lived assetless selling costs. An entity may recognize a gain for subsequent increases in the fair value less selling costs of along�lived asset, but only to the extent of the cumulative impairment loss previously recognized. As discussedpreviously, GAAP does not address whether a reduction in carrying amount should be accomplished through acredit to the asset account or to a valuation allowance. As a practical matter, best practices indicate that creditinga valuation allowance may be the best approach for most small and midsize entities. Once an asset has beenclassified as held for sale, the entity should cease depreciating the asset.

FASB ASC 310�40�40�10 [formerly FASB Staff Position (FSP) No. FAS 144�1, �Determination of Cost Basis forForeclosed Assets under FASB Statement No. 15 and the Measurement of Cumulative Losses Previously Recog�nized under Paragraph 37 of FASB Statement No. 144"] clarifies that any valuation allowance for a loan collatera�lized by a long�lived asset should not be carried over as a separate element of the cost basis for purposes ofaccounting for the long�lived asset subsequent to foreclosure. In other words, the lender is not allowed to look back

to lending impairments measured and recognized under FASB ASC 450 (formerly SFAS No. 5), FASB ASC 310;470 (formerly SFAS No. 15), or FASB ASC 310 (formerly SFAS No. 114) for purposes of measuring the cumulativeloss previously recognized. Therefore, if an impairment loss is recognized and the fair value of the long�lived assetless selling costs subsequently increases, the amount of the gain that may be recognized is limited to thecumulative losses previously recognized and measured under GAAP. Loan impairment losses are not included inthe calculation of cumulative losses.

Decision to Sell Subsequently Withdrawn

If, subsequent to classification as held for sale, an entity decides not to sell the long�lived asset, the entity shouldreclassify the asset as held and used. During the reporting period in which the decision not to sell was made, theentity should adjust, through a charge to earnings, the carrying amount of the asset to the lower of

a. The asset's carrying amount before it was classified as held for sale, adjusted for any depreciation thatwould have been recognized had the asset been continuously classified as held and used.

b. Fair value at the date of the decision not to sell.


454


455

SELF�STUDY QUIZ


38. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $110,000. The sale of the asset looks promising, and T estimates that the selling costs will be$5,000. What amount of gain can T recognize on the subsequent increase in fair value?

a. $0.

b. $5,000.

c. $20,000.

d. $25,000.

39. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $90,000. The sale of the asset looks promising, and T estimates that the selling costs will be $5,000.What amount of gain can T recognize on the subsequent increase in fair value?

a. $0.

b. $5,000.

c. $10,000.

d. $20,000.

40. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $110,000 and T decides to put the asset back into operations. During the time the asset wasclassified as held for sale, T would have recognized $10,000 of depreciation had the asset been continuouslyclassified as held and used. What amount does T now record as the asset's carrying amount when it isreclassified as held and used?

a. $80,000.

b. $90,000.

c. $100,000.

d. $110,000.


456



38. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $110,000. The sale of the asset looks promising, and T estimates that the selling costs will be$5,000. What amount of gain can T recognize on the subsequent increase in fair value? (Page 453)

a. $0. [This answer is incorrect. An entity may recognize a gain for subsequent increases in the fair value lessselling costs of a long�lived asset held for sale.]

b. $5,000. [This answer is incorrect. This is the amount of gain that will be realized if the asset sells for$110,000, incurs $5,000 of selling costs, with a basis of $100,000.]

c. $20,000. [This answer is correct. An entity may recognize a gain for subsequent increases in the fairvalue less selling costs of a long�lived asset held for sale, but only to the extent of the cumulativeimpairment loss previously recognized.]

d. $25,000. [This answer is incorrect. Selling costs must be included when calculating the gain.]

39. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $90,000. The sale of the asset looks promising, and T estimates that the selling costs will be $5,000.What amount of gain can T recognize on the subsequent increase in fair value? (Page 453)

a. $0. [This answer is incorrect. The fair value does not have to be greater than the carrying amount of theasset before it was classified as held for sale in order to recognize a gain. The only requirement is that animpairment loss was previously recognized on the asset before a gain can recognized.]

b. $5,000. [This answer is correct. The gain recognized if the difference in fair value of the asset($90,000) is reduced by the selling costs ($5,000) less the new carrying amount of $80,000 ($100,000� $20,000). Since a $20,000 loss has previously been recognized, the company can recognize a$5,000 gain.]

c. $10,000. [This answer is incorrect. The selling costs are included when calculating the gain.]

d. $20,000. [This answer is incorrect. If the company recognized a $20,000 gain, the asset would be recordedin an amount greater than its fair value. The company is limited to recognizing $20,000 of gain since it hasrecognized only $20,000 of loss previously, but the actual gain is less than this amount.]

40. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $110,000 and T decides to put the asset back into operations. During the time the asset wasclassified as held for sale, T would have recognized $10,000 of depreciation had the asset been continuouslyclassified as held and used. What amount does T now record as the asset's carrying amount when it isreclassified as held and used? (Page 453)

a. $80,000. [This answer is incorrect. This is the fair value of the asset when it was classified as held for sale.]

b. $90,000. [This answer is correct. During the reporting period in which the decision not to sell wasmade, the entity should adjust, through a charge to earnings, the carrying amount of the asset tothe lower of (a) the asset's carrying amount before it was classified as held for sale, adjusted for anydepreciation that would have been recognized had the asset been continuously classified as heldand used, or (b) the fair value at the date of the decision not to sell.]


457

c. $100,000. [This answer is incorrect. The carrying amount of the asset is not the same as the carrying valuebefore it was classified as held for sale.]

d. $110,000. [This answer is incorrect. The fair value of the asset at the time it is returned to operations is not propercarrying amount.]


458


Lesson 4 (PFSTG104)


31. Which of the following group of intangible assets may be aggregated and presented in the balance sheet asa single line item?

a. Goodwill, patents, covenants not to compete.

b. Goodwill, trademarks, and customer lists.

c. Trademarks, customer lists, and covenants not to compete.

d. Goodwill, patents, and trademarks.

32. A company purchased a trademark for $30,000 on January 1, 20X1. Before the issuance of FASB ASC350�30�35�1 (formerly SFAS No. 142), the company amortized intangible assets, such as trademarks, over 10years. For tax purposes, the trademark will be amortized over a 15�year period. What is the company's 20X1amortization relating to the trademark for GAAP purposes?

a. $0it is not amortized.

b. $2,000.

c. $3,000.

d. $6,000.

33. A company purchased a covenant not to compete in a purchase method business combination. The covenantrequires installment payments, and is thought to have economic substance. Which of the following statementsregarding this transaction is most accurate?

a. Payments are recorded as an intangible asset as they become due.

b. Future payments are recorded as additional treasury stock.

c. Payments are recorded as additional net assets acquired.

d. No liability is recorded for future payments.

34. A new company incurred $15,000 of organization costs. What is the net amount of organization costscapitalized on the company's balance sheet at the end of the first year?

a. $0.

b. $8,000.

c. $12,000.

d. $15,000.


459

35. An S corporation with a fiscal year of April 30 has a balance of $5,000 in its �Federal tax deposit" account. Thecorporation has determined that it owes an additional deposit of $1,000 for the year ended April 30, 20X1, dueMay 15, 20X1. What is the balance of the federal tax deposit account on the balance sheet?

a. $0.

b. $4,000.

c. $5,000.

d. $6,000.

36. FASB ASC 360�10 (formerly SFAS No. 144) applies to which of the following assets?

a. Equipment held for sale.

b. Goodwill.

c. Deferred tax assets.

d. Servicing assets.

37. Which of the following statements is most accurate regarding assets that are held for sale when applyingGAAP?

a. These assets must routinely be assessed for impairment.

b. Any loss on impairment is presented on the other comprehensive income statement.

c. At least one of the five conditions must be met to classify assets as held for sale.

d. The assets should no longer be depreciated.

38. J Co. classifies an asset with a book value of $150,000 as held for sale. At the time of the classification, Jrecognized a loss of $60,000 due to declining market values. Five months later, the fair value of the assetincreases to $170,000. J estimates that the selling costs will be $10,000. What amount of gain can J recognizeon the subsequent increase in fair value?

a. $0.

b. $10,000.

c. $60,000.

d. $70,000.

39. J Co. classifies an asset with a book value of $150,000 as held for sale. At the time of the classification, Jrecognized a loss of $60,000 due to declining market values. Five months later, the fair value of the assetincreases to $110,000. J estimates that the selling costs will be $10,000. What amount of gain can J recognizeon the subsequent increase in fair value?

a. $0.

b. $10,000.

c. $20,000.

d. $60,000.


460

40. J Co. classifies an asset with a book value of $150,000 as held for sale. At the time of the classification, Jrecognized a loss of $60,000 due to declining market values. Five months later, the fair value of the assetincreases to $170,000 and J decides not to sell the asset and put it back into operations. During the time it washeld for sale, J would have recognized $10,000 of depreciation on the asset if it was continuously classified asheld and used. What amount does J now record as the asset's carrying amount when it is reclassified as heldand used?

a. $90,000.

b. $140,000.

c. $150,000.

d. $170,000.


461

GLOSSARY

Average cost method: A method used to determine the cost of a security sold or the amount reclassified out ofaccumulated other comprehensive income into earnings.

Cash value life insurance: Cash value life insurance policies (which are sometimes called permanent life insurance)have an investment element with low to moderate risk and a rate of return that is often higher than other investmentsof similar risk, primarily because its value appreciates tax�free. The two most common forms of cash valuepolicieswhole life and universal lifediffer primarily in that premiums are fixed under a whole life policy, but theymay vary for a universal life policy.

Certificate of deposit: Certificates of deposit are not marketable securities. Certificates of deposit may be includedwith cash and need not be separately disclosed.

Cost method: Certain investments in equity securities (a) do not have readily determinable fair values and (b) donot qualify for consolidation or the equity method. Such investments are accounted for using the cost method.

Depreciation: Depreciation is a method of allocating cost rather than a valuation allowance.

Equity method: Under the equity method, the investment is initially recorded at cost, is increased by the investor'sproportionate share of the investee's net income, and is reduced by dividends and the investor's proportionate shareof the investee's net loss.

First�in, first�out method: Inventory or sold is considered to be the oldest inventory available for sale; conversely,ending inventory is considered to be the latest inventory purchased.

Goodwill: If there is a difference between the cost of the investment and the investor's proportionate equity in theinvestee's net assets at acquisition, the difference should first be related to specific assets of the investee based ontheir fair market value. Any difference that cannot be related to specific assets is considered to be attributable togoodwill.

Gross profit method: The gross profit method is the most common method of estimating inventories at interim dateswhen physical inventories are not taken.

Intangible asset: Goodwill and other intangible assets generally include the following: Goodwill, Patents,Trademarks, Customer lists, Company name, Franchise fees, Covenants not to compete.

Last�in, first�out method: Inventory sold is considered to be the latest inventory purchased; conversely, endinginventory is considered to be the oldest inventory available for sale.

Long�lived asset: Accounting for long�lived assets under FASB ASC 360�10 (formerly SFAS No. 144) depends onwhether the assets will be (a) held and used, (b) held for sale, or (c) held for disposal other than by sale.

Lower of cost or market: Inventories are stated at the lower of cost or market value.

Marketable security: The balance sheet caption �marketable securities" includes equity securities and debtsecurities.

Money market accounts: Money market accounts offered by banks, savings and loan associations, and brokeragehouses are typically subject to only minimal withdrawal restrictions. Therefore, they are more in the nature ofinterest�bearing checking accounts and should be included in the cash caption.

Organization costs: These represent costs incurred in establishing a legal entity. They normally consist of legal feesincurred for drafting the formation documents, such as bylaws and articles of incorporation.

Overdraft accounts: Entities frequently have cash accounts with more than one financial institution. Generally, foreach financial institution, all cash account balances should be totaled to determine whether the entity has a netpositive or negative balance.


462

Repurchase agreements: Repurchase agreements are short�term investments typically sold by banks asalternatives to certificates of deposit. Transfers to and from the fund are made daily to cover checks clearing inoperating accounts. Accordingly, repurchase agreements should be presented in the financial statements in amanner similar to money market accounts.

Restricted cash: Cash restricted for special purposes should be segregated from cash available for generaloperations and, normally, should be excluded from current assets.

Specific identification method: If goods on hand can be identified as pertaining to specific purchases, they maybe inventoried at the actual cost of each specific item. This method requires the keeping of records by whichindividual items can be identified and their costs determined.

Trade receivables: Trade receivables include open accounts, notes, and installment contracts representing claimsfor goods and services sold in the ordinary course of business.


463

INDEX

A

ACCOUNTING CHANGE� Change in depreciation method 429, 430. . . . . . . . . . . . . . . . . . . . � Change in estimate 430. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Prospective application 430. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

AGENCY TRANSACTIONS� Escrow accounts 354. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

AMORTIZATION� Cost in excess of equity in net assets of investee

(goodwill) 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Intangible assets 439. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ASSETS� Components of current assets 351. . . . . . . . . . . . . . . . . . . . . . . . . � Offsetting against liabilities 352. . . . . . . . . . . . . . . . . . . . . . . . . . . .

B

BALANCE SHEET� Offsetting assets and liabilities 352. . . . . . . . . . . . . . . . . . . . . . . . .

BUSINESS COMBINATIONS� Allocation of purchase price 437. . . . . . . . . . . . . . . . . . . . . . . . . . . � Covenants not to compete 439. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Lease acquisition costs 440. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Organization costs 440. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

C

CAPTIONS� Accumulated depreciation 413, 428. . . . . . . . . . . . . . . . . . . . . . . . . � Allowance for doubtful accounts 375. . . . . . . . . . . . . . . . . . . . . . . . � Cash and cash equivalents 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash value of life insurance 401. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Intangibles and other deferred costs 437. . . . . . . . . . . . . . . . . . . . � Inventories 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Organization costs 440. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment 412, 413. . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment held for investment 404. . . . . . . . . . . . . � Receivables 375. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CASH� Balance sheet presentation 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 351, 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash and cash equivalents 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Certificates of deposit 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Compensating balances 353. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current asset 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Demand deposit 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Escrow accounts 354. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Held checks 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Money market accounts 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Operating accounts 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Overdrafts 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Repurchase agreements 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Restricted 353. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CASH VALUE OF LIFE INSURANCE� Balance sheet presentation 401. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 401. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Loans against cash value 401. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COMPREHENSIVE INCOME� Equity method investees 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COST METHOD INVESTMENTS� Impairment 403. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CUTOFF� Held checks 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

D

DEFERRED CHARGES� Lease acquisition costs 440. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Organization costs 440. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DEPRECIATION� Accumulated 413. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Capital leases 420. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 413, 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in estimated useful life 430. . . . . . . . . . . . . . . . . . . . . . . . . � Change in method

�� Planned 429. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Prospective 430. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Retroactive 430. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Change in method planned 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in salvage value 430. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Definition 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated useful life 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Methods 429. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Pattern of decline in value 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Salvage value 428, 430. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Selection of method 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DISCLOSURES� Inventories 380, 381, 383. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment 413. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Receivables 375. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

E

ENVIRONMENTAL REMEDIATION COSTS� Asbestos removal costs 412. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Capitalization of costs 412. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

EXPENSES� Organization costs 440. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Start�up costs 440. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

I

IMPAIRMENT OF ASSETS� Long�lived assets 446. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INCOME TAXES� Tax deposit to retain fiscal year 440. . . . . . . . . . . . . . . . . . . . . . . . . � Temporary differences, examples of

�� Receivables 376. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INDUSTRY PRACTICE� Inventories 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTANGIBLE ASSETS� Amortization 439. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Balance sheet presentation 437. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 437. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 437. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Covenants not to compete 439. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Goodwill

�� Acquisition 437. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Impairment 438. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Impairment 439. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTEREST� Imputing 439. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTERIM PERIODS� Inventories

�� Gross profit method 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� LIFO approximations 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� LIFO liquidations 383. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


464

�� Market declines 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Standard cost system 383. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INVENTORIES� Average cost 381. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Costs 381. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current asset 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 380, 381, 383. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � FIFO defined 381. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Gross profit method 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interim financial statements

�� Gross profit method 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� LIFO approximations 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� LIFO liquidations 383. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Market declines 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Standard cost system 383. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� LIFO�� Interim financial statements 382. . . . . . . . . . . . . . . . . . . . . . . . .

� Lower of cost or market 381, 382. . . . . . . . . . . . . . . . . . . . . . . . . . . � Net realizable value 381. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Obsolescence 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Physical counts 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Specific identification method 381. . . . . . . . . . . . . . . . . . . . . . . . . . � Standard cost 383. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INVESTMENTS� Captions 401. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash value life insurance policies 401. . . . . . . . . . . . . . . . . . . . . . . � Common stockequity method

�� Accounting treatment 391, 392. . . . . . . . . . . . . . . . . . . . . . . . . . �� Difference between cost and equity in net assets 392. . . . . . �� Intra�entity profits 393. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Negative balances 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Significant influence 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Components 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cost method investments 403. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Impairment 403. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Nonmarketable securities 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment held for investment 404. . . . . . . . . . . . .

L

LEASES� Acquisition costs 440. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Bargain purchase options 418. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Capital 417. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Criteria for classification as capital lease 417. . . . . . . . . . . . . . . . . � Depreciation 420. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated economic life 418. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Executory costs 418. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Fair value 420. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Guaranteed residual value 418, 420. . . . . . . . . . . . . . . . . . . . . . . . . � Land 417. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Minimum lease payments 418. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Modification of capital lease terms 421. . . . . . . . . . . . . . . . . . . . . . � Noncancellable lease 417. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Operating leases 417. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Sales tax 418. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term 417. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIABILITIES� Buy�out agreements 439. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash overdrafts 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Loans against cash value of life insurance 401. . . . . . . . . . . . . . . � Long�term debt� Noncompete agreements 439. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Offsetting against assets 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term debt� Transfers of receivables 376, 377. . . . . . . . . . . . . . . . . . . . . . . . . . .

M

MARKETABLE SECURITIES� Accounting for 357, 358. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Balance sheet presentation 369. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Categorizing securities 359. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 357. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current asset 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Debt securities 357. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 357. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Equity securities 357. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Impairment 363. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Preferred stock 357. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Subsequent changes in fair value 362. . . . . . . . . . . . . . . . . . . . . . . � Transfer between categories 360. . . . . . . . . . . . . . . . . . . . . . . . . . . � Treasury securities 364. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unrealized holding gains/losses 369. . . . . . . . . . . . . . . . . . . . . . . .

MATERIALITY� Escrow accounts 354. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Overdrafts 352. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Salvage value 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

N

NONMONETARY TRANSACTIONS� Authoritative literature 426, 427. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanges measured at recorded amounts involving

monetary considerations 427. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanges of assets measured at fair value 426. . . . . . . . . . . . . . � Exchanges of different types of assets 427. . . . . . . . . . . . . . . . . .

P

PARTNERSHIPS� Federal tax deposit to retain fiscal year 440. . . . . . . . . . . . . . . . . .

PREPAID EXPENSES� Current assets 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Supplies 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PROPERTY AND EQUIPMENT� Appraisal values 412. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 412, 413. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 411. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Contributed assets 426. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cost basis 412. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Decline in value 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 413. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated useful life 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanges 426. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Fully depreciated 412. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Idle facilities 411. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Long�term investment 391, 404. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Salvage value 428. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Trade�in 427. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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RECEIVABLES� Captions 375. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 375. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current assets 351. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 375. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Nontrade 376. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Related party 376. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Trade 375. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Transfers 376. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RELATED PARTY TRANSACTIONS� Receivables 376. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

S

S CORPORATION� Federal tax deposit to retain fiscal year 440. . . . . . . . . . . . . . . . . .

V

VALUATION ALLOWANCES� Impairment of long�lived assets 447, 453. . . . . . . . . . . . . . . . . . . .


465

TESTING INSTRUCTIONS FOR EXAMINATION FOR CPE CREDIT

Companion to PPC's Guide to Preparing Financial StatementsCourse 1Preparing Financial Statements: Liabilities and Stockholders' Equity (PFSTG101)

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CPE Examination Questions (Lesson 1) 72. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



Companion to PPC's Guide to Preparing Financial StatementsPFST10

467

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Companion to PPC's Guide to Preparing Financial StatementsCourse 1Preparing Financial Statements: Liabilities and Stockholders' Equity (PFSTG101)

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Companion to PPC's Guide to Preparing Financial Statements PFST10

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Companion to PPC's Guide to Preparing Financial StatementsCourse 2Accounting for Certain Tax Transactions (PFSTG102)















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Companion to PPC's Guide to Preparing Financial StatementsCourse 2Accounting for Certain Tax Transactions (PFSTG102)

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Companion to PPC's Guide to Preparing Financial StatementsCourse 3The Statement of Cash Flows and Notes to Financial Statements (PFSTG103)















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