Overview of US GAAP

FAR_Participant_Part1 1 23 December 2017 4:01 AM

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FASB andStandard Setting

Lesson OverviewIn this lesson we will cover the primary purpose of financial accounting.

The professional organizations that are an integral part of the financial accounting environment

Primary PurposeFinancial accounting and reporting provides information to aid the decision making of the users of the financial statements—primarily the external users need this information to:

Make investment and credit decisions.Assess amount and timing of cash flows.Assess economic resources and obligations.

Conceptual Framework and Financial ReportingFinancial Accounting Standards Board (FASB)Overview of US GAAPFASB and Standard Setting

COPYRIG

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ATERIAL

Wiley CPAexcel® Exam Review Lecture Slides: Financial Accounting and Reporting


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Generally Accepted Accounting Principles (GAAP)

GAAP addresses three aspects of financial reporting:

1. Recognition—when recorded on financial statements

2. Measurement—how recorded on financial statements

3. Disclosure—anything that is not on the financial statements

Organizations The Financial Accounting Standards Board (FASB)

The Securities and Exchange Commission (SEC)

The American Institute of Certified Public Accountants (AICPA)

The Private Company Council (PCC)

FASBThe private sector body that establishes GAAP

Seven full time members—Effective

Mission to improve the usefulness of financial reporting

Address deficienciesPromote international convergence

FASB and Standard Setting


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FASBFinancial Accounting Foundation (FAF) appoints Board members and advisory councils, ensures funding, and exercises oversight

Financial Accounting Standards Advisory Council (FASAC) advises the FASB on current and possible new agenda items, policy issues, or formation of task forces

Emerging Issues Task Force (EITF) provides implementation guidance within GAAP

FASB Structure

FASBFASB

FASACProvides guidance on policy, priorities, etc

FASACProvides guidance on policy, priorities, etc

FAFProvides funding

FAFProvides funding

Standard-Setting Process

Adds Project to

Agenda

Adds Project to

Agenda

Conducts Research and

IssuesDM

Conducts Research and

IssuesDM

Public HearingPublic

Hearing

Issues EDIssues EDModifies EDModifies EDFinalizes

and Issues ASU

Finalizes and Issues

ASU



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SEC Formed by Congress in the 1933 Act

Authority to establish GAAP—but SEC relinquished that task to the private sector (FASB)

Enforcement authority

AICPA

Professional Organization for practicing CPAs

Substantial input into the standard-setting process

All past standard-setting bodies were created by the AICPA

GAAPAuthoritative GAAP

FASB Accounting Standards Codification (ASC)ASC is a compilation of pronouncements issued by FASB, APB, and CAP

Non-authoritative

FASB Concepts, AICPA Issues Papers, IFRS

SEC Guidance—considered part of authoritative GAAP for public companies

FASB and Standard Setting


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SummaryMake sure you are comfortable with the main organizations that make up the financial accounting environment.


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Accrual Accounting

Accrual Accounting

MUST know for the CPA exam!

Tested frequently andconsistently!

Types of Exam QuestionsConvert cash basis income to accrual basis income.

Convert accrual basis income to cash basis.

Given accrued expense or revenue and solve for cash paid or received (and vice versa).

Given deferred expense or revenue and solve for cash paid or received (and vice versa).

Accrual Accounting


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Accrual Basis AccountingAccrual basis accounting recognizes and reports the economic activities of an entity in the period the economic activity was incurred, regardless of when the cash activity takes place.

The Heart of Financial

Accounting and Reporting

Accrual Accounts

• Good or service received from vendor

Event

• Good or service provided to a customer

Event

• Accounts Payable(liability)

Accrual Account

• Cash ReceivedCash

• Accounts Receivable

(asset)

Accrual Account

• Cash PaidCash

Deferral Accounts

• Cash ReceivedCash

• Unearned Revenue (liability)

Deferral Account

• Good or service used

Event• Cash PaidCash• Prepaid

Expense (asset)

Deferral Account

• Good or service delivered

Event



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Theme of Accruals and DeferralsThe common theme for accruals and deferrals:

When the economic event occurs first you create an accrual account (you are accruing the cash to be received or to be paid as an asset or liability).

When the cash activity occurs first you create a deferral account (you are deferring the recognition of an expense or revenue as an asset or liability).

Tools The Accounting Equation: A = L + E

Use to reconcile accrual basis net income to cash basis net incomeUse to reconcile cash basis net income to accrual basis net income

T-accountsUse to solve for accrual basis revenue or

expense Use to solve for cash received or paid

Use accounting equation to determine change in working capital accounts

1) A = L + E

2) ∆A = ∆L + ∆E

3) ∆Cash + ∆OA = ∆L + ∆E

4) ∆Cash = ∆L + ∆E – ∆OA

Accrual Net Income to Cash Net Income

Accrual Accounting


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Accrual to CashJ&L Pecans maintain accounting records on an accrual basis. J&L decided to convert to cash basis accounting. During the year J&L reported $95,178 of net income. On January 1, 20X5 and December 31, 20X5 J&L had the following amounts:

January DecemberAccounts receivable 9,250 15,927Unearned revenue 2,840 4,111Accrued expenses 3,435 2,108Prepaid expenses 1,917 3,232

Conversion of Accrual Basis to Cash Basis∆Cash = ∆L + ∆E – ∆OA

Net Income on accrual basis $95,178

increase in accounts receivable ($9,250 – $15, 927) (6,677)

increase in unearned service revenue ($2,840 – $4,111) 1,271

decrease in accrued expense ($3,435 – $2,108) (1,327)

increase in prepaid expenses ($1,917 – $3,232) (1,315)

Net income on a cash basis 87,130

Use accounting equation to determine change in working capital accounts (signs are opposite!)

1) A = L + E

2) ∆A = ∆L + ∆E

3) ∆A – ∆L = ∆E

4) ∆E = ∆A – ∆L

Accrual basis net income is essentially the change in equity (retained earnings)

Cash Net Income to Accrual Net Income



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Cash to AccrualJ&L Pecans maintain accounting records on a cash basis. Assume J&L decided to convert to accrual basis accounting. During the year J&L reported $87,130 of cash basis income. On January 1 and December 31 J&L determined they had the following amounts:

January DecemberAccounts receivable 9,250 15,927

Unearned revenue 2,840 4,111Accrued expenses 3,435 2,108

Prepaid expenses 1,917 3,232

Conversion of Cash Basis to Accrual Basis∆E = ∆A – ∆L

Net income on a cash basis $87,130

increase in accounts receivable ($9,250 – $15, 927) 6,677

increase in unearned service revenue ($2,840 – $4,111) (1,271)

decrease in accrued expense ($3,435 – $2,108) 1,327

increase in prepaid expenses ($1,917 – $3,232) 1,315

Net income on an accrual basis 95,178

Cash Received or Revenue RecognizedUse T-accounts

Accounts receivableBeginning balanceRevenue (sales) Cash collectionsEnding balance

Unearned RevenueBeginning balance

Revenue (sales) Cash collectionsEnding balance

Accrual Accounting


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Solving for Cash CollectedA company has the following activity with respect to unearned consulting fees during the year.

Unearned consulting fees, Dec 31 2,000

Unearned consulting fees, Jan 1 3,500

Consulting fee revenue 25,000

How much cash was collected for consulting fees?

Solving for Cash CollectedInformation given on unearned revenue:

Unearned Revenue

Beginning balance 3,500

Revenue 25,000 Cash collections 23,500

Ending balance 2,000

Solving for Cash CollectedWhat if the information was accounts receivable?

Accounts Receivable


Revenue 25,000 Cash collections 26,500




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Cash Paid or Expense RecognizedUse T-accounts

Prepaid ExpenseBeginning balanceCash paid ExpensesEnding balance

Accounts PayableBeginning balance

Cash paid Expenses Ending balance

Solving for Cash PaidA company has the following activity with respect to prepaid insurance expense during the year.

Prepaid expense, Dec 31 2,000

Prepaid expense, Jan 1 3,500

Insurance expense 25,000

How much cash was paid during the year?

Solving for Cash Paid Information given on prepaid expense:

Prepaid Expense


Cash paid 23,500 Expense 25,000


Accrual Accounting


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Solving for Cash Paid What if the information was on accounts payable?

Accounts Payable


Cash paid 26,500 Expense 25,000


SummaryConvert cash basis income to accrual basis income or accrual basis income to cash basis.

Given accrued expense or revenue and solve for cash paid or received (vice versa).

Tools:

The Accounting Equation: A = L + E

T-accounts


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Financial Statements


Income Statement Reports accrual-based performance over a

period of time. It is dated as fiscal year ended (FYE). For example, December 31

Captures all revenues, expenses, gains and losses that were incurred during the period

Certain items are excluded from the income statement but included in comprehensive income.

Statement of Comprehensive IncomeReports non-owner changes to equity over a period of time. It is dated as FYE. For example, December 31 includes:

Unrealized gains/losses on investments in AFS securitiesCertain pension adjustmentsForeign currency translation adjustmentsCertain hedge accounting adjustments



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Balance SheetReports economic resources and obligations as of a specific date. It is dated as of December 31:

Assets presented in order of liquidity

Liabilities presented in order of maturity

Current/long-term designation

Various measurement attributes

Exam Question HintThe CPA exam tends to emphasize sections of the balance sheet, such as PPE or Equity.

As we cover the balance sheet items, make sure to understand not only the accounting, but also the reporting of these items.

Statement of Stockholders’ EquityReports the changes related to owners’ equity over a period of time. It is dated as FYE, for example, December 31.Owners’ Equity is presented in order of permanence:

1. Contributed capital is shown first, because it will not be returned to shareholders.

2. RE is shown last because it is less permanent because dividends are paid from RE.



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Statement of Cash FlowsReports changes in cash over a period of time. It is dated as FYE, for example, December 31.

Operating—cash flows related to income statement transactions

Investing—cash flows related to long-term assets and investments

Financing—cash flows related to liabilities and owners’ equity

Footnotes and OpinionFootnote disclosures and supplementary schedules:

Footnotes are an integral part of the financial statements.Footnotes present information not captured on the statements.

Auditor’s opinion:Opinion on the statements in conformance with GAAP


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Financial Accounting Standards Codification

Financial AccountingStandards Codification

What is the Codification?

The Codification is a compilation and organization of all GAAP sources.

Accounting Standards Codification (ASC) is the official name of the Codification.

Accounting Standards Updates (ASU) are how updates to GAAP are communicated. ASUs are not GAAP.

Example: Accounting Standard Update

Source: FASB .org



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Goals of CodificationThe FASB Codification Research System is a online, real-time, searchable data base in order to:

Simplify structure and accessibility of GAAP.

Place all authoritative literature in one place.

Reduce time and effort to research an issue.

Facilitate updating GAAP.

Assist with IFRS convergence.

Codification Structure

AreasAreas

TopicsTopics

SubtopicsSubtopics

SectionsSections

Paragraphs

Subsections

Areas and Topics

Area 100: General Topic 105: GAAPGeneral

Area 200: Presentation Topic 210: Balance SheetPresentation

Area 300: Assets Topic 305: CashArea 400: Liabilities Topic 405: LiabilitiesArea 500: Equity Topic 505: Equity

Balance Sheet



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Areas and Topics

Area 800: Broad Transactions Topic 805: Business CombBroad Transactions

Area 900: Industry Topic 905: AgricultureIndustry

Area 600: Revenue Topic 605: Recognition Area 700: Expenses Topic 705: Cost of SalesIncome Statement

Illustration of the Hierarchy

Topic Accounts Receivable

Subtopic Overall Nonrefundable Fees and Other Costs

Securities with Deteriorated Credit

Quality

Section Recognition Initial Measurement Recognition Initial

Measurement Recognition Initial Measurement

Subsection General: Factoring

General: Notes for Cash

General: Origination

Fees

General: Origination

Fees

General: Collateral

Ownership

General: Valuation

Allowances

Structure of the Classification SystemXXX = Topic, YY = Subtopic, ZZ = Section, PP = Paragraph (XXX-YY-ZZ-PP) For example, the classification codes for Receivable are as follows (Assets are 300):310 = Receivables (Topic)310-10 = Overall (Subtopic)

310-10-25 = Recognition (Section)310-10-30 = Initial Measurement (Section)

310-20 = Nonrefundable Fees and Other Costs (Subtopic)310-20-25 = Recognition (Section)310-20-30 = Initial Measurement (Section)

310-30 = Loans and Debt Securities Acquired with Deteriorated Credit Quality (Subtopic)310-30-25 = Recognition (Section)310-30-30 = Initial Measurement (Section) Source: FASB Accounting Standards Codification



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Assets: Accounts Receivable

Source: FASB Codification

Accounts Receivable: 310-10

Topic


Subtopic

Section


References that begin with an “S” are SEC requirements

Accounts Receivable: 310-10-30



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Subsection


Accounts Receivable: 310-10-30

Accounts Receivable: 310-10-30-2

Paragraph


Sections Are Uniform


Sections are organized the same



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Practice!

Practice using the software provided by NASBA.

You get a free six-month access when you have “Notice to Schedule” (NTS) from NASBA.

Practice using the research questions in the AICPA practice test.

Practice using the software in Wiley CPAexcel.

Access to Professional Literature

Source: NASBA .org/proflit


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Conceptual Framework of Financial Reporting by Business EnterprisesObjectives and Qualitative Characteristics

Objectives, Qualitative Characteristics

OverviewThe Conceptual Framework guides the standard-setting process so that the resulting GAAP is cohesive and internally consistent.

Purpose of ConceptsThe Conceptual Framework is based on the overriding objective of financial reporting—decision usefulness.

The Conceptual Framework describes two primary qualitative characteristics of the information that will be decision useful.

There are four enhancing qualitative characteristics.



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Decision Usefulness

Primary Characteristics

Faithful Representation

Completeness Neutrality Free from error

Relevance

Predictive Value

Confirmatory Value Materiality



+Relevance

=

FaRR

Faithful RepresentationCan I Depend on it?

Complete

Are all facts embedded in the information?

Neutral

The information is free from bias; no one interest group is favored; focus is on objectivity and balance.

Free from error

Would a sufficiently knowledgeable third party derive the same result?

Objectives and Qualitative Characteristics


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RelevanceDoes it Relate to my decision?

Helps me Predict

Helps form a prediction about future events; prediction is best formed from elements in the financial statements expected to persist into the future

Helps me Confirm

Provides information about earlier expectations or predictions; either as a confirmation or disconfirmation; helps understand how past actions have affected current financial position

RelevanceDoes it Relate to my decision?

The information is Material

This is information that could influence my decision.

FaRRDecision—useful information

Relevance• Relates to my decision,

helps me predict and confirm predictions. Is material to my decision

Faithful Representation• I can depend on the

information; it is complete, neutral, and free from error.



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Enhancing Characteristics• Between companies• Non uniformityComparability

• Independent observers would reach similar conclusionVerifiability

• Recent enough to make a differenceTimeliness

• Comprehensible by a user with reasonable understanding of business

Understandability

Example QuestionWhat are the Accounting Concepts intended to establish?A. Generally accepted accounting principles in financial

reporting by business enterprisesB. The meaning of "Presented fairly in accordance with

generally accepted accounting principles”C. The objectives and concepts for use in developing

standards of financial accounting and reportingD. The hierarchy of sources of generally accepted accounting

principles

AnswerAnswer: C

Here is where careful reading will pay off!

The concepts assist the development of the standards, but they are not GAAP!

Don't fall for the GAAP answers in A, B, or D.

Objectives and Qualitative Characteristics


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Example QuestionAccording to the FASB's Conceptual Framework, predictive value is an ingredient of:

FaithfulRepresentation Relevance

A. Yes YesB. Yes NoC. No NoD. No Yes

AnswerAnswer: D

Faithful representation answers the question “Can I depend on it?” Faithful representation is completeness, neutral, and free from material error.

Relevance answers the question “Does it relate to my decision?” Predictive value relates to the relevance of information. Relevant information contains predictive value and feedback value.

ConclusionNow you are ready to complete some questions on your own in study mode. Once you feel comfortable, continue on to the next lesson on the Conceptual Framework.

Study hint: If you had trouble with the terminology in this section, try the flash cards to help you learn the definitions. We strongly recommend that you understand the definitions—it will serve you well and take you farther than just memorization.

You can do it—once you put your mind to it!


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Assumptions and Accounting Principles

Assumptions, AccountingPrinciples

Acronym for AssumptionsAssumptions come “Entirely from your GUT”

The four assumptions are: 1. Entity2. Going Concern3. Unit of measurement4. Time period

Entity AssumptionThe entity is separate and distinct from its owners.

Example: The owners of the corporation are separate from the corporation itself. The assets of the corporation do not belong to the owners, but to the corporation.



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Going Concern AssumptionA business has an indefinite life that extends beyond the life of the owners.

Absent evidence to the contrary (such as imminent bankruptcy), a business will continue on.

Assets would not be recorded unless we assumed that the business will be there in the next period to use these assets.

Unit of Measurement AssumptionEverything is measured in terms of a stable monetary unit of measure.

Values are not adjusted for inflation

1. Example: Land purchased in 1960 is added to land purchased in 2015 even though the value of the dollar in 1960 is different than the value in 2015.

2. We do not adjust the 1960 dollars to the 2015 equivalent.

Time Period AssumptionIndefinite life is broken into timeframes, such as a year, a quarter, a month, etc.



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PrinciplesThere are four Accounting Principles:

1. Revenue Recognition

2. Expense Recognition (matching)

3. Measurement

4. Full Disclosure

Revenue Recognition PrincipleRevenue is recognized when realized and earned.

Recognized = Recorded on the financial statementsRealized = Cash or near cash (AR) receivedEarned = Goods or service has been delivered

Much more on revenue recognition in separate lesson

Expense Recognition PrincipleOften referred to as the matching principle

Addresses when to recognize expenses

Recognizes expenses when they produce revenues



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MeasurementAssets and liabilities are recorded at the value at the time of origin.Historical cost: LandAmortized cost: Plant and EquipmentNet realizable value: Accounts ReceivableReplacement cost: InventoryNet present value: BondsFair value: Investments

Full Disclosure PrincipleNot all information can be recognized on the financial statements.

Example: Operating lease obligationsDisclosures are needed to help the financial statement user assess financial obligations of the business.

Example: The future minimum lease payments are disclosed in the footnotes.


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Constraints and Present Value

Constraint and Present Value

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ConstraintCost-benefit

Cost of providing the information should not outweigh the benefit.

Using Cash Flow and PVThis concept refers to measurement when the present value of cash flows are used to estimate fair value.

Governs measurement not recognition

When using cash flows to determine present value, there are two ways to incorporate the risk associated with the cash flows:

1. Discounted cash flows: single cash flow value is discounted using the risk adjusted rate

2. Expected cash flows: probability weighted cash flows is discounted using the risk-free rate

Constraints and Present Value


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ExampleA cash flow of $200,000 may be received in one year, two years, or three years, with probabilities of 20%, 50%, and 30%, respectively. The rate of interest on default risk-free investments is 5%. The PV factors are:

PV of 1, at 5%, for 1 year is 0.95238PV of 1, at 5%, for 2 years is 0.90703PV of 1, at 5%, for 3 years is 0.86384

Solution$200,000 × 0.2 = $ 40,000 × 0.95238 = $38,095

$200,000 × 0.5 = $100,000 × 0.90703 = $90,703

$200,000 × 0.3 = $ 60,000 × 0.86384 = $51,830

Total $180,628

Example QuestionWhich of the following is not addressed in the concept statement on cash flows and fair value accounting measurements?

A. Measurement methods at initial recognitionB. Interest method of amortizationC. Expected cash flow approachD. Determining when fresh-start measurements are

appropriate



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AnswerAnswer: D

The concept statement governs how to measure not when to measure items at present value.

Answers A, B, and C were all how to measure.

ConclusionThis concludes the third lesson on the FASB’s Conceptual Framework.

Make sure to be comfortable with the terminology and concepts presented in the Conceptual Framework lessons.

This material is integral to all other FAR topics.

Best of luck as you continue with your studies!


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Fair Value FrameworkFair Value Framework—Introduction and Definitions

Fair Value Framework—Introduction and Definitions

Introduction

Use of fair value is pervasive in financial accounting and reporting.

In an information economy, today’s value is more useful than yesterday’s value.

1960 – Industrial Economy 2016 – Information Economy

adempercem/Shutterstock

CPA Exam Coverage

Must know:

Definition of “fair value”

Fair value at initial recognition and subsequent measurement

Approaches to determining fair value

Inputs used in determining fair value and input hierarchy

Disclosure requirements any time fair value is used



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Fair Value Defined

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Dblight/iStockphoto

Entry Price ≠ Exit Price

Entry price and exit price are conceptually different:

Different markets Related party transactionDistressed saleDifferent unit of account

At initial recognition of an item, the entry price and exit price may or may not be the same value.

Adam Kazmierski/iStockphoto

Buying new car – Entry Price

Selling new car –Exit Price

Kzenon/Shutterstock Gunter Nezhoda/Shutterstock



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Exit Price

Exit price = Amount received to sell an asset or paid to transfer a liability

Eric Isselee/Shutterstock

Orderly transaction

Occurs at the measurement date.

Occurs under current market conditions.

Not a forced liquidation or distressed sale.

Orderly transaction is a hypothetical transaction because an actual transaction may not have occurred or the actual transaction is not orderly.

denis_pc/iStockphoto

Principal or Most Advantageous Market

An orderly transaction is assumed to occur in the principal market or most advantageous market to which the entity has access:

Principal market is the market available to the entity with greatest volume and level of activity for the item.

Most advantageous market is the market available to the entity that maximizes selling price or minimizes transfer price.

Determination of the most advantageous market would include the costs to transact in that market.



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Determination of Fair Value

Once the principal or most advantageous market is identified, the fair value from that market:

Should not be adjusted for transaction cost—incremental direct cost to execute sale or transfer—which do not measure a characteristic of the asset, liability, or equity item

Should be adjusted for cost of transporting item to market (the location characteristic)

Market Participants

“Market participants” are buyers/sellers that are:

Independent of the reporting entity

Acting in their economic best interest

Knowledgeable of the item or transaction

Able and willing to enter a transaction, but not compelled to do so

Fair Value Is a Market-Based Measurement

Fair value not based on buyer’s unique perspective and is applied to:

A single item (e.g., a bond)

A group of related items (e.g., a business)

Should consider attributes of the specific item being measured:

Condition, location, restrictions on use



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Fair Value Is a Market-Based Measurement

Assumes the highest and best use by market participants, even if it will be used in some other way by the reporting entity.

Highest and best use considers what is:

Physically possible

Legally permissible

Financially feasible

Application of Fair Value Definition

Assume you own a share of Smith Company. Smith trades on two different exchanges and neither is your principal market. Which market is your most advantageous market?

Answer: The NYSE is the most advantageous because the net price (after transaction cost) is $105.

Market Share Price Transaction CostNY Stock Exchange $112 $7London Stock Exchange $115 $11

Application of Fair Value Definition

What is the fair value you should use to report your investment in Smith Company?

Market Share Price Transaction CostNY Stock Exchange $112 $7London Stock Exchange $115 $11

Answer: The fair value of Smith Company is $112 per share - the fair value does not include transaction cost.



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Net Asset Value (NAV) as Practical Expedient

Practical expedient is allowed when there is no readily determinable fair value and the investee reports net assets value at fair value.

NAV as Practical Expedient

NAV = $1,500,000(Assets less liabilities)

InvestorsReal Estate Fund

Investor owns 10% of Real Estate Fund.

FV of Investment = 10% $1,500,000 =

$150,000

FV = $2,000,000Real Estate

Canadastock/Shutterstock

Showshill/Getty Images

dan_prat/Getty Images

Tsuji/Getty Images


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Recognition and Measurement


Recognition and Measurement of Fair Value

This lesson will provide an overview of the techniques used to measure fair value and the fair value option.

The CPA exam will ask about the various techniques and you will frequently see reference to the fair value option.

Recognition and Measurement of Fair Value

“Recognition” refers to what is recorded on the financial statements.

“Measurement” refers to what amount is recorded on the financial statements.



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Fair Value Defined

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Dblight/iStockphoto

Approaches to Determine Fair Value

Market Approach: Use prices generated by real market transactions for identical or similar items

Income Approach: Discount future amounts to a current present value

Cost Approach: Use the value required to replace the asset

Approaches to Determine Fair Value

Sometimes a single approach to determining fair value may be appropriate and adequate.

Quoted market prices in active markets

Sometimes multiple approaches are used to determine fair value.

Valuing an entire business

Professional judgment required if assessing multiple outcomes



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Quiz

Huskie Co. holds an investment in a bond of Shephard Co. that is not publicly traded. To determine the fair value of the bond, Huskie uses the fair value of a similar bond that is traded on an exchange and adjusts that price for characteristics in Shephard’s bond. What type of valuation approach is Huskie using?

A. Market approach

B. Income approach

C. Cost approach

D. Residual value approach

Fair Value Option

Entities can elect to measure the following at fair value:

Recognized financial assets and financial liabilities (with few exceptions)

Firm commitments not otherwise recognized and that involve only financial instruments

Written loan commitments

Rights/obligations under warranties and insurance contracts that can be settled by paying a third party

Items Not Available for Fair Value Option

Entities may not elect to measure the following at fair value:

Investments in entities to be consolidated

Obligations or assets related to pension or other employee-oriented plans

Lease-related financial assets or liabilities

Demand deposits of financial institutions

Instruments that are components of shareholders’ equity



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Fair Value Option Election Dates

Fair value option can be elected only:

When the item is first recognized

When an eligible firm commitment occurs

When the accounting treatment of an investment in another entity changes

Fair Value Option Application

Fair value option may be applied on an instrument-by-instrument basis.

Does not have to be applied to all instruments issued or acquired in a single transaction.

Must be applied to an entire instrument, not just to specific elements of an instrument.

Fair value option is irrevocable, except when a new election date for a specific item occurs.

Accounting at Eligible Election Date

Determine carrying value (CV).

Determine fair value (FV).

Determine difference between CV and FV.

Recognize difference:

Write item up or down.

Recognize increase (gain) or decrease (loss) in current income.



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Illustration—FV Option

Assume the eligible date for electing the FV option is January 2, 20X1, and the CV of the asset is $100,000 and the FV is $110,000.

FV > CV (Difference) = $ 10,000

Entry on January 1, 20X1:

DR: Investment in Equity Investee $ 10,000

CR: Unrealized Gain—FV Option $ 10,000

Accounting After Election

At each subsequent reporting date adjust the item to new fair value.

Recognize difference as:

Write item up or down.

Recognize increase or decrease in current earnings.


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Inputs and Hierarchy



This lesson will provide an overview of the inputs used to measure fair value and the hierarchy of those inputs.

The CPA exam will ask about inputs and frequently asks you to classify the inputs into the hierarchy.

Side note: If NAV is used as a practical expedient, it is NOT classified into the fair value hierarchy, but disclosures about the use of NAV are required.

Fair Value Inputs

Inputs are assumptions and data used in valuation techniques:

Observable Inputs: Derived from market data from sources independent of the reporting entity

Unobservable Inputs: Entity’s assumptions based on best information available in circumstances

Use of observable inputs should be MAXIMIZED.

Use of unobservable inputs should be minimized.Robyn Mackenzie/Shutterstock

pavlen/iStockphoto



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Hierarchy

Fair Value Hierarchy Level 1

Observable quoted prices at measurement date in active markets for identical items.

Highest level with most desirable inputs Most reliable evidence of fair valueUse whenever availableSometimes adjustments are proposed

Liquidity discount—permittedControl premium—not permittedBlockage discount—not permitted


Directly or indirectly observable but do not meet all conditions for Level 1

Quoted prices in active markets for similar items

Quoted prices in inactive markets for similar (or identical)

Observable inputs other than market prices that are relevant to an item being valued

Inputs derived from or corroborated by observable market data using correlation or other means



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Unobservable inputs for the item being valued:

Lowest level with least desirable inputs

May use reporting firm’s internal data

Based on assumptions or inferences that market participants would make

Example: Determining fair value of closely-held stock

Quiz

Huskie Co. holds an investment in a bond of Shephard Co. that is not publicly traded. To determine the fair value of the bond, Huskie uses the fair value of a similar bond that is traded on an exchange and adjusts that price for characteristics in Shephard’s bond. What level in the fair value hierarchy should Huskie classify this valuation?

A. Level 1

B. Level 2

C. Level 3

D. Puppy level


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Disclosure Requirements



Disclosure requirements depend on whether fair value is used:

On a recurring basis—Fair value is determined and applied to an item period after period.

On a nonrecurring basis—Fair value is determined and applied only when certain conditions or situations occur.

For both, the fair value at reporting date, valuation techniques, and inputs used in those techniques must be disclosed.

Coca-Cola, Inc.—Footnote Excerpt

Coca-Cola Company, 2015 10k



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Disclosures when Fair Value Is on Recurring Basis

Table showing items at each level of the fair value hierarchy.

Transfers into and out of each level of the hierarchy

For measurements in Level 3:

A reconciliation of beginning and ending balances

Description of the valuation process and significant assumptions



Disclosure Requirements when Fair Value Is on Nonrecurring Basis

In interim and annual statements, for each major category of asset or liability measured at fair value:

Reasons for the fair value measurement

Level of the fair value hierarchy within which measurements fall

For measurements in Levels 2 and 3, a description of any changes in techniques



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Disclosure Requirements when Fair Value Is on Nonrecurring Basis

For measurements that fall in Level 3, unobservable inputs:

The effect of the measurement on earnings or OCI

Quantitative information about the unobservable inputs used

If highest and best use of nonfinancial assets differs from current use, disclose that fact and why.







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Disclosure for Fair Value Option

Identify items to which the fair value option is applied and reasons for electing the fair value option.

Information to enable users to understand how fair value is applied for each item (methods and assumptions).

The amount of gains and losses associated with the fair value changes.

Wrap-up

Must know:

Definition of “fair value”

Fair value at initial recognition and subsequent measurement

Approaches to determining fair value

Inputs used in determining fair value and input hierarchy

Disclosure requirements any time fair value is used


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International Financial Reporting Standards (IFRS)IASB Accounting Standards

IASB Accounting Standards

How IFRS are Tested

Typically as an application of the measurement or recognition related to inventory, intangibles, fixed assets, etc.

Must have basic knowledge and understanding of U.S. GAAP and the differences under IFRS.

Expect one or two MC questions that require application of IFRS.

How to Study IASB/IFRS

Understand the differences in vocabulary or definitions.

Understand the differences related to recognition and measurement.

Be aware of presentation and disclosure differences.

Work through IFRS examples in the study text and MC questions.



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International Accounting Standards Board (IASB)

Establishes IFRS

IFRS based on framework

No enforcement power

Enforcement is the responsibility of the securities regulators in national jurisdictions

IASB 2001–present

The International Accounting Standards Committee (IASC): 1973–2001

Objectives of IASB

To develop a single set of high quality, understandable, enforceable and globally accepted financial reporting standards.

To promote the use and rigorous application of IFRS.

To consider the needs of a range of size and type of entities.

To promote and facilitate adoption of IFRS through convergence.

IFRS: Principles-Based Standards

Less detailed than U.S. GAAP

Fewer rules

Requires more professional judgment

Less literature to address exceptions

IASB Accounting Standards


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International Financial Reporting Standards (IFRS) Structure

Source: www.ifrs.org

IFRS Hierarchy

Level 1IFRSs and implementation guidance dealing with specific issue or similar situations.

Level 2Definitions, recognition criteria, and measurement concepts for A, L, income, and expenses in the framework.

Level 3Pronouncements from other standard-setting bodies using a similar framework.

Standard-Setting Process

Source: www.ifrs.org



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Accounting Standards Convergence

Norwalk agreement in 2002 formalized the FASB and IASB commitment to convergence.

Many differences have been eliminated, but many remain.

SEC eliminated the requirement to reconcile from international GAAP to U.S. GAAP in 2007—making it easier for foreign companies to list on U.S. exchanges.

Conclusion

Expect to have a question on the application of IFRS.

There are many similarities to U.S. in the structure and process related to setting accounting standards.

The convergence of the IFRS and FASB standards is ongoing.


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IASB Framework

IASB Framework

IASB FrameworkThe IASB Framework is similar to the FASB’s as it is used to develop GAAP

Under IFRS the Conceptual Framework is a point of reference for preparers in the absence of specific guidance in IFRS

In contrast—in US GAAP the Conceptual Framework is non-authoritative and is not referred to by preparers of financial reporting

Objective of IFRS is to provide financial statements that present a “true and fair” view of the entitie’s performance

IASB Framework



Completeness Neutrality Free from error

Relevance

Predictive Value

Confirmatory Value Materiality



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DifferencesThere are some differences in the identification and definitions of the elements of the financial statements—refer to the study guide for more details.

The IASB Framework has only two assumptions:1. The accrual method is used.2. The entity is a going concern.

ConclusionThe convergence of the IASB and FASB Conceptual Framework is ongoing.

Refer to the study text for the most recent status in the convergence of the IASB and FASB Conceptual Framework.


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IFRS for SMEs

IFRS for SMEs

Simplified financial reporting guidance for small and medium-sized entities (SMEs)

Similar to “little GAAP” issued by the FASB via the Private Company Council (PCC)

IFRS does not have Other Comprehensive Basis of Accounting (OCBOA)

International Financial Accounting Standards (IFRS)

FrameworksFinancial Accounting Standards Board

(FASB)International Accounting Standards Board

(IASB)American Institute of

Certified Public Accountants (AICPA)

ApplicableFinancialReporting Framework

U.S. Generally Accepted Accounting Principles (GAAP): U.S. GAAP–based financial statements for nongovernmental entities

Private Company Council accounting alternative: U.S. GAAP–basedfinancial statements with modifications/simplifications

International Financial Reporting Standards: GAAP–based financialstatements for foreign private issuer

IFRS for Small- and medium-sized entities (SMEs):GAAP–based financial statements with modification/simplification of full IFRS

Special purpose frameworks (SPF): Non-GAAP financial statements prepared using a type of SPF such as FRF for SMES, cash basis, modified cash basis, tax basis, regulatory basis, contractual basis

Applicability Mandatory for public business entities

May be elected by private, for-profit entities

Required unless entity meets eligibility for accounting alternative

Small- and medium-entities without public accountability

FRF for SMEs may be usedby smaller- to medium-sized for-profit private entities when U.S. GAAP-based financial statements are not required

Authoritative Guidance

FASB Accounting Standards Codification (ASC) and Accounting Standards Updates (ASU)

ASC/ASU with modifications for simplicity

IFRS IFRS with modifications for simplicity

FRF for SMEs



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What You Need to KnowWhy IFRS for SMEs?

Who uses this guidance?

When is this guidance considered GAAP?

What are the major differences in IFRS for SMEs versus regular IFRS?

Why IFRS for SMEs?Millions of companies

Europe has roughly 28 million private sector enterprises (SMEs)

USA has about 25 millionUK: 4.7 millionBrazil: 6 million

Why IFRS for SMEs?IFRS for SMEs—230 pages of guidance2,500 pages for IFRS 25,000+ pages for US GAAPSimplified IFRSs, but built on an IFRS foundation and Conceptual Framework

IFRS for SMEs


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Who Can Report under IFRS for SMEs?Any entity that does not have public accountability...

securities not publicly tradednot a financial institution

... and is required or chooses to produce General Purpose Financial Statements

to present fairly financial position, results of operations, and cash flows

IFRS for SMEs Considered to be GAAP?Yes The AICPA recognizes the IASB as an accounting body for purposes of establishing international financial accounting and reporting principlesIFRS for SMEs is not considered OCBOA

Yes—if meet the criteria

Simplified and less complicated compared to voluminous US GAAP

Can Private US Entities Use IFRS for SMEs?



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Who CANNOT Use IFRS for SMEs?Entities that issue instruments in a public market—required to file financial statements

Entities that hold assets in a fiduciary capacity:BanksInsurance companiesMutual funds, etc.

Not-for-profits and governmental entities

Major Differences from IFRS1. Disclosures are simplified in a number of

areas including pensions, leases and financial instruments

2. Goodwill and indefinite life intangible assets are amortized over a period not exceeding ten year.

3. A simplified temporary difference approach to income tax accounting

Major Differences from IFRS4. Accounting for financial assets and

liabilities makes greater use of cost5. No disclosures for Earnings Per Share and

Segment Disclosures


63

IFRS—General-Purpose Financial Statements

IFRS—General Purpose Financial Statements

Heineken—Assets

Heineken—Liabilities and Stockholders’ Equity



64

Major Differences—Balance Sheet

US IFRS

Comparative periods are required.

Comparative periods are not required (unless

SEC registrant).

Major Differences—Statement of Shareholders’ Equity

US IFRS

Changes in owners’ equity can be

presented in the footnotes.

Changes in owners’ equity must be presented in a

separate statement.

Heineken—Income Statement



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Major Differences—Income Statement

US IFRSReporting special items prescribed

Dividends per share not required

No requirement on reporting special items

Dividends per share require disclosure

Heineken—Statement of Comprehensive Income

Major Differences—Statement of Comprehensive Income

US IFRS

No revaluation of PPE through OCI

Per share measures are prohibited.

Permits revaluation of PPE through OCI

NOTE: Reclassification of PPE revaluation must also flow

through OCI and not NI.

Per share measures are not prohibited.



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Heineken—Operating Activities

Heineken—Investing Activities

Heineken—Financing Activities



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Major Differences—Statement of Cash Flows

US IFRS

Interest paid Operating only Operating or financing

Interest received Operating only Operating or investing

Taxes paid Operating onlyOperating—In financing or

investing if specifically identified with an item

Dividends received Operating only Operating or investing

Dividends paid Financing only Operating or financingCash and cash equivalents

Bank overdrafts not allowed May include bank overdrafts


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General-Purpose Financial StatementsBalance Sheet/Statement of Financial Position

Balance Sheet/Statement of Financial Position

Balance SheetStatement of Financial Position

Measured at one point in time

Assets = Liabilities + Equity = Contra and adjunct accounts

Measurement AttributesHistorical cost—Land, prepaid insurance

Amortized historical cost—Fixed assets

Fair Market value —Marketable securities, derivatives

Net realizable value—Accounts receivable

Present value—Bonds



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Contra and Adjunct AccountsContra accounts are subtracted from the balance sheet accounts.

Adjunct accounts are added to the balance sheet account.

Current AssetsAssets expected to be realized in cash or consumed within one operating cycle or year

Examples: accounts receivable, prepaid expenses, and investments (short-term)

Current LiabilitiesLiabilities expected to be extinguished with current assets or another liability within one operating cycle or year

Examples: accounts payable, accrued expenses



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NoncurrentBy default accounts that are not current are classified as noncurrent.

Noncurrent asset examples: PPE, long term investments, and intangibles

Noncurrent liability examples: notes payable, bonds payable, and pension liabilities

Equity AccountsContributed Capital:

The amount contributed by ownersExample: Common stock, preferred stock, additional paid-in capital

Retained Earnings:

The amount of earnings retained by the entityCumulative net income less dividends paid

Coca-Cola, Inc.—Assets



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Coca-Cola, Inc.—Liabilities and Shareholders’ Equity


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Income Statement

Income Statement

DefinitionsRevenues—increases in net assets or settlement of liabilities from PRIMARY activities—providing goods or servicesDR: Cash or AR

CR: Revenue or SalesorDR: Unearned Revenue

CR: Revenue or Sales

DefinitionsExpenses—decreases in net assets or incurrence of liabilities from PRIMARY activities—providing goods or servicesDR: Expense

CR: Cash or APorDR: Expense

CR: AP or Accrued Liabilities

Income Statement


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DefinitionsGains—increases in net assets from incidental activities

Losses—decreases in net assets from incidental activities

Examples: sale of assets, interest income, and interest expense

Multi-step Income StatementABC Company

FYE December 31SalesCost of Goods SoldGross profitOperating expenses+/– Other income/expensesIncome from continuing operations before taxIncome taxesIncome from continuing operations+/– Discontinued operationsNet Income

Coca-Cola, Inc.—Income Statement


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Statement of Comprehensive Income


Need to Know for the CPA Exam

Definitions

Components

Presentation formats

Disclosures

Definition

Comprehensive Income

Other Comprehensive

Income (OCI)

NetIncome



75

Components of Other Comprehensive Income

Unrealized gains and losses on available-for-sale debt securities

Certain gains and losses from pension costs

Foreign currency translation adjustments

Unrealized gains and losses from certain derivative transactions

Presentation

Comprehensive income can be presented in one of two ways:

One-statement approach:

In combination with the income statement

Two-statement approach:

A separate statement of income and

A separate statement of comprehensive income

One-Statement ApproachStatement of Net Income and Comprehensive Income

FYE December 31Revenues $1,000Expenses (900)Net Income 100

Other comprehensive income items (net of tax):

Unrealized G/L foreign currency translation (2)Unrealized G/L AFS debt securities 14

Other comprehensive income 12

Comprehensive Income $ 112



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Two-Statement Approach

Statement of IncomeFYE December 31

Revenues $1,000

Expenses (900)

Net Income m

Statement of Comprehensive IncomeFYE December 31

Net Income $ 100Other comprehensive income items(net of tax):

Unrealized G/L foreign currencytranslation (2)

Unrealized G/L AFS debtsecurities 14

Other comprehensive income 12Comprehensive Income

$ 112

Coca-Cola, Co.—Statement of Comprehensive Income


Accumulated Other Comprehensive IncomeStatement of Shareowners’ Equity




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Accumulated Other Comprehensive IncomeStatement of Shareowners’ Equity


Accumulated Other Comprehensive IncomeEquity Section of Balance Sheet


Coca-Cola, Co.—Other Comprehensive Income Disclosure




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Accumulated Other Comprehensive IncomeFootnote Disclosure


Quiz

Choose the correct equation from the following:

A. Net income + Comprehensive income = Other comprehensive income

B. Comprehensive income = Net income + Prior-period adjustments + Accounting principle changes

C. Comprehensive income = Net income + Other comprehensive income

D. Comprehensive income = Total change in owners’ equity –Dividends declared

What did we do?

Definitions

Components

Presentation formats

Disclosures


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Statement of Changes in Equity

Statement of Changesin Equity

Changes in Owners’ EquityThis statement provides beginning balances, changes during the year and ending balances for the following items:

Stock (common and preferred)APICRetained EarningsTreasury StockAOCI

PresentationChanges in owners’ equity can be presented in the footnotes, supplemental schedules or as a separate statement.

Most large companies present changes in owners’ equity in a separate statement.



80

Coca-Cola, Inc.—Statement of Shareowners’ Equity

Coca-Cola, Inc.—Statement of Shareowners’ Equity (continued)


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Statement of Cash FlowsSources and Uses of Cash

Sources and Uses of Cash

Overview

The purpose of a Statement of Cash Flow

What is cash, cash equivalents, and restricted cash

The categories of the sources and uses of cashTsuji/Getty Images

Types of Exam Questions

What is cash?

Classification of an item as operating, investing, or financing

Calculation of cash flows from operating, investing, or financing

Should changes be added or deducted to derive cash flows from operations

Tested VERY

frequently!

JUAWA/Shutterstock



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Purpose of Statement of Cash Flows

The purpose of the SCF is to provide information so that users can:

Assess past ability to generate and control cash inflows and outflows.

Assess probable future ability to generate cash inflows sufficient to meet future obligations.

Assess the likelihood of future borrowing.

A Required Statement

The SCF is a basic statement like the income statement and statement of financial position.

SCF is required for all business enterprises that report both a statement of financial position and income statement.

The SCF complements the information presented in the other statements to help the user assess the entities operations.

What Is Cash?

Cash

Coin, currency, foreign currency

Cash equivalents

Are short-term, highly liquid investments

Are readily convertible to known amount of cash

Bear no interest rate risk

Examples: T-bills, and money market funds

Maksim Shmelijov/ShutterstockTorsakarin/Depositphotos



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What Is Cash?

Restricted Cash

Cash that is held for special purposes and is not freely available for the entities use

Designated for special projects

Compensating balance account

Collateral accounts

Information Reported

The total change in all cash is represented in the SCF

Cash flows related to operating activities

Cash flows related to investing activities

Cash flows related to financing activities

Acronym to Remember

Operating Ohhhhhhh

Investing

Financing

AND when I pass the CPA Exam , I am going to …..

IF. . .



84

wavebreakmedia/Shutterstock

Mauricio Graiki/Shutterstock

Sergey Nivens/Shutterstock



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Creativa Images/Shutterstock

Other Information Reported on SCF

Effects of foreign currency translation on cash flows

Reconciliation of cash at the beginning of the year to cash at the end of the year

If direct method is used must report a reconciliation of accrual net income to cash flow from operations

Significant non-cash transactions

Noncash Transactions

A supplement schedule must be provided to present significant non-cash transactions.

Examples:

Purchase of equipment with a note payable

Settle a liability by paying with common stock and not cash



86

Colin Anderson/Getty Images


87

Operating, Investing, and Financing Activities

Operating, Investing, andFinancing Activities

Categories

Cash flows from operating activities – direct method

Cash flows from investing activities

Cash flows from financing activities


Categorize a transaction or event into operating, investing or financing.

Complete one (or more) sections of the SCF.

Complete the reconciliation of beginning to ending cash.

What cash to include?

JUAWA/Shutterstock



88

Operating Activities—Direct Method

Cash inflows: From customers Interest income or dividend incomeSale of debt securities classified as trading

Cash outflows: To suppliers To employeesTo government For interest or other operational expensesPurchase of debt securities classified as trading

EMC Corp. —Statement of Cash Flows: Operating Activities –Direct Method

EMC Corp.—Statement of Cash Flows: Reconciliation Operating Activities



89

Investing Activities

Cash inflows:

Sale of property, plant or equipment

Sale of debt or equity securities of other entities

Collection of loan principal

Cash outflows:

Purchase of property, plant or equipment

Purchase of debt or equity securities of other entities

Coca-Cola, Inc. Statement of Cash Flows: Investing Activities

Year Ended December 31, 2015 2014 2013

Financing Activities

Cash inflows:

From sale of equity securities

From issuance of debt (bonds and notes)

Cash outflows:

To stockholders as dividends

To redeem long-term debt

To re-acquire capital stock



90

Coca-Cola, Inc. Statement of Cash Flows: Financing Activities


Coca-Cola, Inc. Statement of Cash Flows


Coca-Cola, Inc. Balance Sheet



91

Question - Classification

Which of the following items is included in the financing activities section of the SCF?

A. Cash effects of transactions involving making and collecting loans.

B. Cash effects of acquiring and disposing of investments and PPE.

C. Cash effects of transactions obtaining resources from owners and providing them with a return on their investment.

D. Cash effects of transactions that enter into the determination of net income.

Question - Analysis

In an SCF, if used equipment is sold at a loss, the amount shown as cash inflow from investing activities equals the carrying amount of the equipment

A. Less the loss and plus the amount of tax attributed to the loss

B. Less both the loss and the amount of tax attributable to the loss

C. Less the loss

D. With no additional addition or subtraction

Conclusion

The sources and uses of cash are categorized into operating, investing, and financing activities.

Complete the practice questions in this lesson—it will really help reinforce what transactions go into each category.


92

Operating Cash Flows—Indirect Method


Operating Cash Flows

Cash flow from operations can be presented in one of two ways:

1. Direct method—This method directly shows the amount of cash inflows and outflows from operations. It shows cash received from sales and cash paid in operations.

2. Indirect method—This method is a reconciliation of the accrual-based net income to derive cash flows from operations.


Calculate cash flows from operating activities.

Both quantitative and qualitative.

Need to know what should be added or deducted to derive cash flows from operations.

JUAWA/Shutterstock


FAR_Participant_Part1 93 26 December 2017 11:01 PM

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TOOLS

chictype/Getty Images

Operating Activities—Indirect Method

Most recordkeeping is done on an accrual basis.

The indirect method is a reconciliation of net income to cash flows from operations.

Net income is adjusted for changes in working capital.

Net income is adjusted for “noncash” income/expenses such as depreciation.

Ivsigns/iStockphoto

Accounting Equation as a Tool

The accounting equation can be used to determine whether to add or subtract changes in working capital accounts to reconcile accrual-based net income to CF from operations.

A = L + E

∆A = ∆L + ∆E

∆ Cash + ∆ Other assets = ∆L + ∆E

∆ Cash = ∆L + ∆E – ∆ Other assets



94

Using the Accounting Equation as a Tool

The equation is to adjust net income to CF from operations.

∆ Cash = ∆L + ∆E – ∆ Other assets

If you are asked to convert cash flows from operations to net income you must switch the signs!

∆ Cash = –∆L + ∆E + ∆ Other assets

If you are asked to convert an expense from accrual to cash you must switch the signs because expenses reduce net income.

If you are asked to convert an expense from cash to accrual you do NOT need to switch the signs.

Noncash Expenses

Any noncash expenses or losses on the income statement need to be ADDED back to net income to derive cash flows from operations

Examples: depreciation or amortization expense and losses

Any noncash gains on the income statement need to be SUBTRACTED from net income to derive cash flows from operation

Examples: Gains

Coca-Cola, Inc.—Statement of Cash Flows: Operating Activities



95

Coca-Cola, Inc.—Footnote Excerpt: Net Change in Operating Assets and Liabilities

Question—Adjusting Net Income

Kresley Co. has provided the following 20X5 current account balances for the preparation of the annual statement of cash flows:

Kresley's 20X5 net income is $75,000. What would be reported as net cash provided by operating activities in the statement of cash flows?

December 31 January 1Accounts receivable $11,500 $14,500Allowance for uncollectible 400 500Prepaid rent 6,200 4,100Accounts payable 9,700 11,200

Question - Qualitative

Dee's inventory and accounts payable balances at December 31, 20X5, increased over their December 31, 20X4, balances. Should these increases be added to or deducted from cash payments to suppliers to arrive at 20X5 cost of goods sold?

Increase in inventory Increase in accounts payable

a. Added to Deducted fromb. Added to Added toc. Deducted from Deducted fromd. Deducted from Added to



96

Bartosz Hadyniak/iStockphoto


97

Notes to Financial StatementsNotes to Financial Statements

Notes toFinancial Statements

DisclosuresFootnote disclosures are an integral part of the financial statements.

Remember disclosures are part of GAAP

Provide information about assumptions and estimates

Provide information that cannot be captured quantitatively

Basic DisclosuresSummary of Significant Accounting PoliciesRelated Party TransactionsLiability DisclosuresCapital Structure Errors and IrregularitiesIllegal Acts



98

Management’s Discussion and Analysis

Required narrative for publicly held firms

Includes a discussion about operations, liquidity and capital resources

Forward-looking information can be provided by management

Effects of Changing PricesDuring times of price instability and high levels of inflation firms were required to disclose the effect of changing prices.

There are currently no required disclosures.

Review the study text—this material has a low probability of being tested.


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Risks and Uncertainties


Areas of ConcernRequired disclosure of vulnerability to conditions and events capable of materially affecting financial statements in the near term (one year).

Sources of risk and uncertainty:

Nature of the entity's operations

Use of estimates in financial statements

Certain significant estimates

Areas of ConcernVulnerability to significant concentrations

NEW! Going-concern assessment

The FASB now requires disclosures if conditions give rise to substantial doubt about the entities ability to continue as a going concern!



100

Nature of OperationsInformation about the firm's products and services, geographical location, and principal markets

Relative importance of each type of business

Need not be quantitative

Use of EstimatesDisclose that estimates:

Are required for many financial statement itemsAre approximationsRequire assumptions about future events

Certain Significant EstimatesEstimates for which there is a reasonable chance of change such that its effect could be material.

Disclosures:Nature of the uncertaintyEstimated effect of the change in estimate



101

Certain Significant Estimates (continued)The standard provides examples of areas susceptible to estimate changes including:

Fair valuation

Inventory

Equipment obsolescence

Valuation allowances for deferred tax assets

Impairment testing

Contingencies

Vulnerability Due to Significant Concentrations

Example: A firm with 60% of revenues derived from one entity is vulnerable to the loss of that revenue stream.

Concentrations are aspects with insufficient diversification.

Vulnerability Due to Significant Concentrations

Disclosures are required only for concentrations in:1. Volume of business with a particular customer,

supplier, lender, grantor or contributor2. Revenue from specific products, services, or

fundraising sources3. Specific sources (suppliers) of services, materials,

labor, licenses or other rights used in operations4. Market or geographic area of operations



102

Vulnerability Due to Significant Concentrations (continued)

Disclosure is required for concentrations meeting the following three criteria:1. The concentration exists at the balance sheet date.2. The entity is vulnerable, because of the concentration,

to the risk of a "severe impact" that could cause significant financial disruption to the firm, in the near term.

3. It is reasonably possible (less than probable) that events causing a severe impact will occur in the near term.

Vulnerability Due to Significant Concentrations (continued)

Required disclosures for concentrations meeting the above criteria include information enabling users to assess the risk and its possible outcomes.


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Subsequent Events

Subsequent Events

Events that occur after the balance sheetdate, but before the financial statementsare issuedExamples: uncollectibility of accounts

receivable, lawsuits, issuance of debt orsecurities, major acquisitions

Embodies the Full Disclosure principle!

Subsequent Events

Subsequent EventsConditions that existed at the balance sheet date:

Require recognition in the financial statements

Conditions that did not exist at the balance sheet date:

Require disclosure in the footnotes



104

Major Differences

US

The cut-off date is when the financial

statements are issued or available to be

issued

IFRSCut-off date for

subsequent events is the date the financial

statements are considered

authorized for issuance

Major Differences

US

Requires adjustment for share splits after

the balance sheet date and before

statement are issued

IFRS

Does not require adjustment for share

splits after the balance sheet date

and before statement are issued

Major Differences

USRefinancing,

amendments and waivers are considered

in determining the classification of debt as current or noncurrent

IFRSRefinancing,

amendments and waivers are not considered in

determining the classification of debt as current or noncurrent


105

Evaluating Financial StatementsRatios—Liquidity/Solvency and Operational

Ratios—Liquidity/Solvencyand Operational

Categories of RatiosLiquidity/Solvency

Measures the ability to meet maturing obligations

OperationalMeasures the efficiency of operations

ProfitabilityMeasures operational results

EquityMeasures sources of equity



106

This Lesson Covers…Liquidity/Solvency



Purpose of Ratio AnalysisRatio analysis quantifies the relationship between various elements of the financial statements.

Ratio analysis enables comparisons between entities.

Ratio analysis strips the information of magnitude and unit of measure.

Ratios Permit ComparisonAssume you want to compare the performance of a US-based company and a Japanese-based company.

Calculating the profit margin ratio will permit this comparison:

US: NI ÷ Sales = $100 ÷ $2,500 = 4%

Japan: NI ÷ Sales = ¥4,000 ÷ ¥65,000 = 6%

Ratios—Liquidity/Solvency and Operational


107

Liquidity/Solvency RatiosWorking CapitalCurrent Assets (CA) – Current Liabilities (CL)Measures the extent to which CA exceed CLIf positive, then there are more CA than CLExample: 100 – 80 = 20If negative, then there are more CL than CA80 – 100 = (20)

Liquidity/Solvency RatiosCurrent Ratio (CR)CA ÷ CLStates working capital (WC) in a ratio formIf WC is positive, then the CR > 1Example: 100/80 = 1.25 If WC is negative, then the CR < 1Example: 80/100 = .8

Liquidity/Solvency RatiosAcid or Quick Ratio

Cash + AR + Marketable Securities Current Liabilities

Uses the most “liquid” assets to measure the ability to meet maturing obligationsWill always be less than the current ratio because the numerator excludes CA like inventory



108

Liquidity/Solvency RatiosTimes Interest Earned

NI + Interest Expense + Income Tax Exp

Interest Expense

Measures the ability of current earnings to cover interest costs for the period

Example: 1,000 + 50 + 300 = 27 times50

Current earnings can cover interest 27 times.

Operational RatiosAccounts Receivable (AR) turnover

Net credit sales ÷ Average AR

Example: 1,000 ÷ {(80 + 90) ÷ 2} = 11.76

Number of days in AR = 365 ÷ AR turnover

Example: 365 ÷ 11.76 = 31 days

Measures the average number of days required to collect receivables

Operational RatiosInventory turnover

Cost of Goods Sold ÷ Average Inventory

Example: 800 ÷ {(75 + 85) ÷ 2} = 10

Number of days in Inventory = 365 ÷ Inventory turnover

Example: 365 ÷ 10 = 36.5 days

Measures the average number of days inventory is sold or used

Ratios—Liquidity/Solvency and Operational


109

Example QuestionTod Corp. wrote off $100,000 of obsolete inventory at December 31, 20X5. The effect of this write-off was to decrease:

A. Both the current and acid-test ratios

B. Only the current ratio

C. Only the acid-test ratio

D. Neither the current nor the acid-test ratios

AnswerThe acid ratio includes only the most liquid assets, cash, AR and marketable securities.

The current ratio included inventory and prepaid assets.

Therefore writing off inventory will effect only the current ratio.

Answer: B


110

Ratios—Profitability and Equity

Ratios—Profitabilityand Equity

Categories of RatiosLiquidity/Solvency



ProfitabilityMeasures operational results

EquityMeasures sources of equity



111

This Lesson Covers…Profitability

Measures operational resultsEquity

Measures return on equity and degree of equity financing

Purpose of Ratio AnalysisRatio analysis quantifies the relationship between various elements of the financial statements.

Ratio analysis enables comparisons between entities.

Ratio analysis strips the information of magnitude and unit of measure.

Profit MarginNet Income (NI)

Sales

Measures net profitability on sales

Example: 100 ÷ 1,000 = 10%There is a 10% net profit on sales orFor every dollar of sales there is 10¢ of net profit.



112

Return on AssetsNet Income

Average Total Assets

Measures the rate of return on total assets; how effectively total assets generate NI

Example: 100 ÷ {(3,000 + 3,500) ÷ 2} = 3.08%

There is a 3.08% return on assets or

For every dollar of assets, 3¢ of NI is produced.

Return on Equity

Net Income

Average Common Stockholders’ Equity

Measures the rate of earnings on common shareholders’ investment

Example: 100 ÷ {(600 + 700) ÷ 2} = 15.38%There is a 15.38% return on CSE orFor every dollar of CSE, 15¢ of NI is produced.

Earnings Per ShareNet Income – Preferred Dividends

Weighted Avg. Common Shares Outstanding

Measures the income per share of common stock (see EPS lessons!)

Example: 100 ÷ 500 = $0.20

For each share of common stock, there was $.20 of net income.



113

Price–Earnings RatioStock price per share

Earnings per share

Measures the price of stock relative to its earnings per share; indicates how the market values the stock

Example: $2.50/$0.20 = 12.5 times

The market has priced this stock at 12.5 times earnings.

Debt–Equity or Leverage RatiosAll are measures of leverage because

A = L + E

L / E, E / A, or L / A

Example: 100 = 60 + 40

L / E = 60 / 40 = 150%: L is 1.5 times E

E / A = 40 / 100 = 40%: 40% financed by E

L / A = 60 / 100 = 60%: 60% financed by L


114

Consolidated Financial StatementsIntroduction to Consolidated Financial Statements

Introduction to ConsolidatedFinancial Statements

Consolidated Financial Statements

IntroductionConsolidating process

At acquisition Subsequent to acquisition Less than 100% ownership

Intercompany transactionsIntroductionInventory Fixed assets Bonds

IFRSCombined financial statementsVariable interest entities

zager/Getty Images

HIGHLY TESTED TOPIC

Types of CPA Exam Questions

Qualitative

Terminology, definitions, and concepts

Quantitative

What should be reported on consolidated statements?

What should be eliminated?

Task-Based Simulations

Higher-order thinking analysis of a fact pattern

Introduction to Consolidated Financial Statements


115

Consolidated Statements

Objective is to present the financial statements of entities under common control as if one economic entity.

An entity has control when:

It is the primary beneficiary of a variable interest entity.

It has greater than 50% ownership of another entity.

Consolidation

Pretty Tall Swiss Shalet

Consolidated Financial StatementsBalance SheetIncome StatementStatement of Shareholders’ EquityStatement of Cash Flows

Pretty Tall

Mlenny Photography/Getty Images

Swiss Shalet

Alexander Chaikin/Shutterstock

Mateusz Zagorski/Stockphoto

Benefits of Consolidated Financial Statements

Consolidated financial statements:

Present all economic resources and obligations of the economic entity.

Present economic substance over legal form.

Are more useful to decision makers than separate financial statements.



116

Exceptions to Consolidation

Consolidation is not required when the parent cannot exercise control.

There is no effective control when the:

Foreign subsidiary is controlled by foreign government.

Domestic subsidiary is in bankruptcy.

Circumstances that Affect Consolidation

Date the consolidation occurs

Date of business combination or a subsequent date

Percentage ownership

Parent owns 100% or less than 100% of the subsidiary

The type of accounting used by the parent

Cost, equity, or other method

Intercompany transactions between the parent and subsidiary

Hang in there with me. We will make it through the maze!

JuSun/Stockphoto


117

Consolidating ProcessConsolidation at Acquisition

Consolidation at Acquisition





IFRSCombined financial statementsVariable interest entities Vladimir Gjorgiev/Shutterstock

Types of Questions

Amounts reported on the consolidated statements at date of acquisition:

Balance Sheet (P + S + fair value increment)

Income Statement (P entire year)

Statement of Retained Earnings (P only)

Statement of Cash Flows (P entire year)

ALMAGAMI/Shutterstock

Read the question carefully!



118


TOOL S

Diagrams

T-accounts

Decomposition at acquisition

CPAexcel candidate’s toolbox


Company P

January 1

Statements at the date of acquisition

Acquisition July 1

Company S

Decomposition Tool for Acquisition

Price Paid

Goodwill

Net FV Assets and Liabilities

Unidentifiable asset

Plant assets

Intangible assets

Identifiable assets revalued to FV

(tangible and intangible)

Net BV (Assets – Liabilities)

Valu

e of

S C

ompa

ny



119

Example 1

Assume Passing (P) purchased 100% of Score (S) for $200,000 on January 1, 20X1. On that date, the book value of S was $150,000, which equals the fair value of all of S’s assets and liabilities except for equipment, which had a FV of $100,000 (the carrying value was $80,000). Any excess price is attributed to goodwill.

Also assume that P owes S $10,000 and S has a receivable from P of $10,000.

Potential question:

Calculate the value of specific (or total) assets, liabilities (or total), or equity (or total) reported on the consolidated balance sheet on the date of acquisition.

Example 1: Decomposition Tool

Price Paid 200,000

Goodwill

Net FV

30,000

170,000


Equipment 20,000 Identifiable assets revalued to FV

Net BV 150,000

Example 1: Consolidated Balance Sheet Date of Acquisition

Passing Score Elimin Consolidated

Debit Credit Debit Credit Debit CreditCurrent assets 80,000 30,000 100,0001

Inventory 150,000 350,000 500,000Equipment (net) 430,000 80,000 530,0002

Investment in S 200,000 0Goodwill - - 30,000Current liabilities 150,000 110,000 250,0003

Long-term debt 460,000 200,000 660,000Common stock 200,000 140,000 200,0004

Retained earnings 50,000 10,000 50,0004

Totals 860,000 860,000 460,000 460,000 1,160,000 1,160,000



120

Example 1: Calculations

1 P’s current assets 80,000S’s current assets 30,000Less interco accounts rec (10,000)

Consolidated current assets 100,000

2 P’s equipment 430,000S’s equipment 80,000Plus FV adjustment 20,000

Consolidated equipment 530,000

Example 1: Calculations

4 All equity accounts are only P’s.

3 P’s current liabilities 150,000S’s current liabilities 110,000Less interco accounts pay (10,000)

Consolidated current liabilities 250,000

Example 2

Passing Score

Current assets 70,000 20,000

Noncurrent assets 190,000 140,000

Total assets 260,000 160,000

Current liabilities 30,000 10,000

Long-term debt 50,000 -

Stockholders’ equity 180,000 150,000

Totals 260,000 160,000

On January 2, 20X8, Passing (P) borrowed $200,000 and used the proceeds to purchase 100% of the outstanding common shares of Score (S). The principal plus interest is payable in 10 annual installments, beginning December 30, 20X8. The excess cost of the investment over S’s book value of acquired net assets was allocated 60% to inventory and 40% to goodwill.

At the end of business on January 1, 20X8, P and S had condensed balance sheets as follows:

Note: The balance sheet is as of January 1 (preacquisition) and the consolidated balance sheet is January 2 (postacquisition).



121

Example 2: Potential Questions

Calculate the value reported on the consolidated balance sheet on the date of acquisition:

Assets (components or totals) or

Liabilities (components or totals) or

Equity (components or totals).

Example 2: Decomposition Tool

Price Paid 200,000

Goodwill

Net FV

20,000

180,000

Unidentifiable asset(50,000 × .4)

Inventory 30,000 Identifiable assets revalued to FV

(50,000 × .6)

Net BV 150,000 From the balance sheet

Example 2: Consolidated Balance Sheet January 2, 20X8

Passing Score Consolidated

Current assets 70,000 20,000 120,0001

Noncurrent assets 190,000 140,000 350,0002

Total assets 260,000 160,000 470,000

Current liabilities 30,000 10,000 60,0003

Long-term debt 50,000 - 230,0004

Stockholders’ equity 180,000 150,000 180,0005

Totals 260,000 160,000 470,000



122

Example 2: Calculations1 P’s current assets 70,000

S’s current assets 20,000Inventory revaluation 30,000

Consolidated current assets 120,000

2 P’s noncurrent assets 190,000S’s noncurrent assets 140,000Plus goodwill 20,000

Consolidated noncurrent assets 350,000

Note: The “Investment in S” is not in P’s noncurrent assets because the balance sheet is pre-acquisition.

Example 2: Calculations3 P’s current liabilities 30,000

S’s current liabilities 10,000New debt–current portion 20,000

Consolidated current liabilities 60,000

4 P’s noncurrent liabilities 50,000S’s noncurrent liabilities 0New debt–noncurrent portion 180,000

Consolidated noncurrent liabilities 230,000

5 Only P’s equity.

Total debt 200,000Current portion (20,000)Noncurrent debt 180,000

Consolidating Entries

Eliminate the equity investment in S and the equity reported by S.

Record the incremental revaluation to FV (including goodwill).

Eliminate intercompany payables and receivables.

Eliminate intercompany sales and expenses.

Eliminate intercompany profits.



123


Investment eliminating entry

Basic to all consolidating processes

Eliminates: Investment in S account on Parent’s booksShareholders’ equity of SubsidiaryRecognizes noncontrolling interest in Subsidiary’s net assets

Avoids multiple counting of same “value”Investment Subsidiary's equity Subsidiary’s assets less liabilities


One version of the entry to eliminating the investment:

The most important thing to know is the balances reported!

DR: Common Stock—Subsidiary DR: Additional Paid-in Capital—Subsidiary DR: Retained Earnings—Subsidiary DR: Differential (if any)

CR: Investment in SubsidiaryCR: Noncontrolling interest (if any)

Hang in there with me. The maze is easier when you have a path!

JuSun/Stockphoto


124

Consolidation Subsequent to Acquisition

Consolidation Subsequentto Acquisition






Douglas Allen/iStockphoto

Types of Questions

Amounts reported on the consolidated statements

Balance Sheet (P + S + fair value increment – intercompany balances)

Income Statement (P entire year + S since acquisition – depreciation fair value increment)

Equity accounts (common stock of P only)

Retained earnings of P only, if P used full equity method


Watch for midyear acquisitions!



125

Midyear Acquisition

Company P

January 1 December 31

S Corporation

July 1July 1

Illustration: Midyear Acquisition

Assume P Company acquired S Corporation on July 1. S Corp earned $400,000 evenly throughout the year and paid dividends on December 31 of $300,000.

What is included in consolidated retained earnings as of December 31?

December 31July 1

,$200,000

$200,000

January 1

Dividends

Net Income

$300,000

Example

Passing (P) purchased 100% of Score (S) for $200,000 on January 1, 20X8. S’s book value of $150,000 equaled the fair value (FV) of all of S’s assets and liabilities except for equipment, which had a FV of $100,000 (the carrying value is $80,000). Any excess price is attributed to goodwill. The equipment has a remaining life of four years.

Calculate the amounts reported on the Consolidated Statements.Balance Sheet (P + S + fair value increment – intercompany balances)Income Statement (P entire year + S since acquisition – depreciation fair value increment)Equity accounts (common stock of P only)

Retained earnings of P only, if P used full equity method



126

Example: Decomposition Tool

Price Paid 200,000

Goodwill

Net FV

30,000

170,000


Equipment 20,000 Identifiable assets revalued to FV

Net BV 150,000

Example: Consolidated Trial Balance December 31, 20X8Passing Score Elim Consolidated

Debit Credit Debit Credit Debit CreditCurrent assets 80,000 30,000 110,000Inventory 150,000 350,000 500,000Equipment (net) 430,000 80,000 525,0001

Investment in S 245,000 0Goodwill - - 30,000Current liabilities 150,000 110,000 260,000Long-term debt 255,000 150,000 405,000Common stock 200,000 140,000 200,0003


Sales 500,000 75,000 575,000Income from S 45,000 0Expenses 295,000 25,000 325,0002

Totals 1,200,000 1,200,000 485,000 485,000 1,490,000 1,490,000

Example: Calculations

1 P’s equipment 430,000S’s equipment 80,000FV adjustmentAccum depr of FV adjust

20,000(5,000)


2 P’s expenses 295,000S’s expenses 25,000Depreciation of FV adjustment 5,000

Consolidated expenses 325,0003Only P’s Equity

($20,000 / 4 years)



127

Qualitative Question

On January 1, 20X1, Prim, Inc. acquired all the outstanding common shares of Scarp, Inc. for cash equal to the book value of the stock. The carrying amount of Scarp's assets and liabilities approximated their fair values, except that the carrying amount of its building was more than fair value. In preparing Prim's 20X1 consolidated financial statements, which of the following adjustments would be made?

A. Depreciation expense would be decreased, and goodwill would be recognized.B. Depreciation expense would be increased, and goodwill would be recognized.C. Depreciation expense would be decreased, and no goodwill would be

recognized.D. Depreciation expense would be increased, and no goodwill would be

recognized.Copyright © 2007 by the American Institute of Certified Public Accountants, Inc., is reprinted and/or adapted with permission.

Qualitative Answer: A

Use simple numbers to answer abstract questions.

Price Paid 100

Goodwill

Net FV (Assets – Liabilities)

?

90

Building (10)

Net BV (Assets – Liabilities) 100Copyright © 2007 by the American Institute of Certified Public Accountants, Inc., is reprinted and/or adapted with permission.

Quantitative Quiz

On January 1, 20X9, Prairie Corp. purchased all of Shade Co.'s common stock for $1,200,000. On that date, the fair values of Shade's assets and liabilities equaled their carrying amounts of $1,420,000 and $220,000, respectively. During 20X9, Shade paid cash dividends of $20,000.

Prairie Shade

Investment in Shade 1,320,000 -

Retained Earnings 1,240,000 560,000

Total Equity 2,620,000 1,320,000

Operating Income 420,000 200,000

Equity Earnings of Shade

140,000 -

Net Income 400,000 140,000

What should be reported as retained earnings on the consolidated balance sheet?



128

Quantitative Answer

Prairie uses fully adjusted equity method because the equity investment and equity earnings equals what is reported by Shade.

Therefore, consolidated retained earnings will equal $1,240,000.

Investment in ShadePurchase 1/1/X9 1,200,000Net Income 140,000 20,000 DividendsBalance 12/23/X9 1,320,000

Shade’s Equity1,200,000 Bal 1/1/X9

Dividends 20,000 140,000 Net Income1,320,000 Bal 12/23/X9

Quantitative Quiz TwistPrairie Shade

Investment in Shade 1,200,000 -

Retained earnings 1,120,000 560,000

Total Equity 2,620,000 1,320,000

Operating Income 420,000 200,000

Dividend Income 20,000 -

Net Income 280,000 140,000

If Prairie used cost method, then the balance in the equity investment would be $1,200,000 and only dividends would have been recorded by Prairie as income.

ANSWER:P’s Retained Earnings 1,120,000S’s Net Income 140,000S’s Dividends (20,000)Consolidated RE 1,240,000

P S1,200,000 ≠ 1,320,000

20,000 ≠ 140,000

Tips and Hints

Read what the question is asking first.

Watch out for midyear acquisitions.

If full equity method is used, consolidated RE equals P’s!

Don’t let irrelevant information throw you off.




129

Hang in there. You are gaining the tools to success!

JuSun/Stockphoto

Creativeye99/Getty Images

Use Your Toolbox!


Diagrams

T-accounts

Decomposition at acquisition

CPAexcel candidate's toolbox


130

Consolidation Less than 100% Ownership

Consolidation Less Than100% Ownership






Snvv/Shutterstock

Noncontrolling Interest

When P owns > 50% of S, P controls S, and consolidation is required.

When P owns > 50% but < 100% of S, 100% of S is still consolidated; the portion not acquired by P is owned by the noncontrolling interest.

Sashkin/Shutterstock

Noncontrolling interest of S

P’s ownership of S is controlling interest



131

The Coca-Cola Company Noncontrolling Interest: Income Statement

The Coca-Cola Company, 2016 10K

The Coca-Cola Company Noncontrolling Interest: Balance Sheet

The Coca-Cola Company, 2016 10K

ExampleP (Passing) purchased 80% of S (Score) for $200,000 on January 1, 20X8. On that date, the net book value of S was $150,000, which equaled the fair value (FV) of all of S's assets and liabilities except for equipment. Equipment had a FV of $100,000 and carrying value of $80,000. Any excess price was attributed to goodwill. The remaining life of the equipment was four years. The fair value of the noncontrolling interest was $50,000.

Calculate the amounts reported on the Consolidated StatementsBalance Sheet (P + S + fair value increment – intercompany balances)Income Statement (P entire year + S since acquisition – depreciation FV increment)Equity accounts (P only)Net income to noncontrolling interestNoncontrolling interest equity



132

Example: Decomposition

100% 80% 20%Price Paid 250,000 200,000 50,000

Goodwill 80,000 64,000 16,000

Net FV 170,000 136,000 34,000

Equipment 20,000 16,000 4,000

Net Book Value 150,000 120,000 30,000

Example: Consolidated Trial Balance December 31, 20X8Passing Score Elim Consolidated

Debit Credit Debit Credit Debit CreditCurrent assets 80,000 30,000 110,000Inventory 150,000 350,000 500,000Equipment (net) 430,000 80,000 525,0001

Investment in S 236,000 0Goodwill 0 0 80,0002

Current liabilities 150,000 110,000 260,000Long-term debt 260,000 150,000 410,000Common stock 200,000 140,000 200,0003


NCI Equity 0 0 59,0005

Sales 500,000 75,000 575,000Income from S 36,000 0Expenses 300,000 25,000 330,0004

Income to NCI 0 0 9,0006

Totals 1,196,000 1,196,000 485,000 485,000 1,554,000 1,554,000

Example: Equity Method Accounting

Equity Investment in S Equity Income from SCost 200,000 0 Dividends

Depr of equip 4,000(80% × 5,000)

40,000 P’s share of S’s NI (80% × 50,000)

P’s % S’s NI 40,000 (80% × 50,000)

4,000 Depr of equip(80% × 5,000)

Ending Bal 236,000 36,000 Ending Bal



133

Example: Calculations

1 P’s equipment 430,000S’s equipment 80,000FV adjustmentAccum depreciation of FV

20,000(5,000)


2 Goodwill 80,000Impairment 0

Consolidated goodwill 80,000

3 Only P’s equity

4 P’s expenses 300,000S’s expenses 25,000Depreciation of FV adjustment 5,000

Consolidated expenses 330,000

Example: NCI Calculations5 S’s Net book value *200,000

+ FV adjustment 80,000― Depreciation FV adjustment― Goodwill impairment

(5,000)0

S’s adjusted Net book value 295,000× NCI percentage .20

NCI Equity 59,000

S’s Beginning NBV 150,000 S’s NI 50,000

S’ Ending NBV *200,000

6 S’s Net Income 50,000― Depreciation of FV adjustment (5,000)― Goodwill impairment 0

S’s adjusted Net Income 45,000NCI percentage .20

Income to NCI 9,000

Calculation of Noncontrolling Interest Equity

S’s net book value (at end of the year)

Plus: 100% of the FV increment

Less: accumulated depr/amort of FV increment

Less: goodwill impairment loss

S’s adjusted NBV

NCI % ownership of S

NCI Equity



134

S’s Net Income

Less: depreciation / amortization of differential

Less: goodwill impairment loss

S’s adjusted net income

NCI % ownership of S

Income to NCI

Calculation of Income to Noncontrolling Interest

Example Quantitative QuestionOn January 1, 20X6, Ritt Corp. purchased 80% of Shaw Corp.'s $10 par common stock for $940,000. On this date, the carrying amount of Shaw's net assets was $1,000,000.

The fair values of Shaw's identifiable assets and liabilities were the same as their carrying amounts except for plant assets (net), which were $100,000 in excess of the carrying amount. Those plant assets had a 10-year remaining life, depreciated on a straight-line basis.

The fair value of the 20% noncontrolling interest in Shaw was properly determined to be $235,000 at that time. For the year ended December 31, 20X6, Shaw had net income of $190,000 and paid cash dividends totaling $125,000.

1. What would be reported as noncontrolling interest in a consolidated balance sheet prepared December 31, 20X6?

2. What is the income to the noncontrolling interest that would be reported on the consolidated income statement for the year ended December 31, 20X6?

Copyright © 2007 by the American Institute of Certified Public Accountants, Inc., is reprinted and/or adapted with permission.

Example: Decomposition

100% 80% 20%Price Paid 1,175,000 940,000 235,000

Goodwill 75,000 60,000 15,000

Net FV 1,100,000 880,000 220,000

Equipment 100,000 80,000 20,000

Net Book Value 1,000,000 800,000 200,000

Note: 10-year life



135

S’s Net book value (at end of the year)* 1,065,000

Plus: 100% of FV increment 175,000

Less: accumulated depr/amort FV incr (10,000)

S’s adjusted NBV 1,230,000

NCI % ownership of S .20

NCI Equity 246,000

Calculation of Noncontrolling Interest Equity

S’s Beg NBV 1,000,000

S’s NI 190,000

S’s Dividends (125,000)

S’s End NBV *1,065,000

S’s Net Income 190,000Less: depr/amort FV increment (10,000)

S’s adjusted net income 180,000NCI % ownership of S .20

Income to NCI 36,000

Calculation of Income to Noncontrolling Interest

Hang in there. The path is becoming clearer!

JuSun/Stockphoto

Courtney Keating/Getty Images


136

Intercompany (I/C) Transactions and BalancesIntercompany I/C Transactions and Balances—Introduction

Intercompany (I/C)Transactions and

Balances—Introduction






Liliya Kandrashevich/Shutterstock

Intercompany (I/C) Transactions and Balances

All intercompany transactions and balances must be removed (eliminated) as if they never occurred.

You cannot have a transaction with yourself!

The Parent and Subsidiary are one economic entity.

Transactions reported by the consolidated entity are only those with outside third parties.

Intercompany I/C Transactions and Balances—Introduction


137

Exam Pointers

Carefully read the problem to make sure you answer the question asked.

The question will ask either:

What should be on the consolidated statement? or

What amount needs to be eliminated?


TOOL S

Diagrams

Journal entries

Should be-is-difference table


Downstream

Outsidethird party

Upstream

Outsidethird party

Tools: Diagrams

P S

Economic Entity



138

Tools: Journal Entries AR / AP

PDownstream

S

Assume P sells consulting services to S for $10,000 and S owes P $3,000 for the services.

DR: Cash 7,000

DR: Accounts Rec 3,000

CR: Other income 10,000

DR: Expense 10,000

CR: Cash 7,000

CR: Accts Payable 3,000


DR: Other Income 10,000

CR: Expense 10,000

DR: Accts Payable 3,000

CR: Accts Receivable 3,000

PUpstream

S

Tools: Journal Entries AR / APAssume S sells consulting services to P for $10,000 and P owes S $3,000 for the services.

DR: Expense 10,000CR: Cash 7,000CR: Accts Payable 3,000

DR: Cash 7,000

DR: Accts Receivable 3,000

CR: Other Income 10,000


DR: Other Income 10,000

CR: Expense 10,000

DR: Accts Payable 3,000

CR: Accts Receivable 3,000


Which one of the following is not a characteristic associated with intercompany transactions?

A. Intercompany transactions must be eliminated in the consolidating process.

B. Intercompany gains and losses must be eliminated in the consolidating process.

C. Transactions that originate with a subsidiary must be eliminated in the consolidating process.

D. Transactions between two subsidiaries to be consolidated with the same parent do not need to be eliminated.


Intercompany I/C Transactions and Balances—Introduction


139

Qualitative Answer

When a question is stated in the null form, “which of the following is not”—read through each response to determine if it is true or false.

Answer D is a false statement.

Quantitative Quiz

In order to carry out its operations, each subsidiary of Plumber Corp. has a specialization. The following intercompany balances are on Plumber’s trial balance for the fiscal year ended June 30.

On the June 30 consolidated balance sheet, what amount should Plumber report as intercompany receivables?

Debit CreditAccounts receivable from Sewer Co. 105,000Notes receivable from Sewer Co. 6,150Cash advance to Construction, Inc. 452,600Cash advance from Jetting Co. 157,000Accounts payable to Jetting Co. 411,230

Quantitative Answer

Zero intercompany receivables would be reported. All intercompany accounts will be eliminated.

If any of these subsidiaries were not controlled or if control was temporary, then they would not be consolidated and the payable or receivable would not be eliminated.



140

Making our way!

VLADGRIN/Getty Images


141

Intercompany (I/C) Inventory Transactions

Intercompany (I/C) InventoryTransactions




Intercompany transactionsIntroductionInventoryFixed assets Bonds


George Dolgikh/Shutterstock

Types of Questions

Questions usually ask either:

What should be on the consolidated statement? or

What amount needs to be eliminated?

Carefully read the problem to make sure you answer the question asked!.

rSnapshopPhotos/Shutterstock



142


TOOL S

Diagrams

Journal entries



Tools: Diagram

Downstream

Upstream

P SOutsidethird party

Outsidethird party

Cost

CostSelling Price

Selling Price

NOTE: The arrows depict the flow of goods, not cash.

Tools: Table

Should be(If interco

transaction had not occurred)

What is (on the general ledger of P and S)

P S

Difference(Eliminating

entry)

Sales

CGS

Inventory



143

16,000 20,000 0P S

Outsidethird party

Outsidethird party

P purchased inventory for $16,000 and sold it to S for $20,000. S held the inventory at year-end.

20,000

Example: Downstream 100% of Inventory Held

Example: Downstream100% of Inventory Held

Should be What is P S

Difference

Sales 0 20,000 0 20,000 dr

CGS 0 16,000 0 16,000 cr

Inventory 16,000 0 20,000 4,000 cr

16,000 20,000 0P S

Outsidethird party

Outsidethird party20,000

Example: Downstream 30% of Inventory Held

16,000 20,000 14,000

P SOutside

third partyOutside

third party

P purchased inventory for $16,000 and sold it to S for $20,000. S held 30% of the inventory at year-end.

6,000



144

Example: Downstream30% of Inventory Held


Difference

Sales ? 20,000 ? 20,000 dr

CGS 11,200(16,000 × .7)

(16,000 + 14,000) 18,800 cr

Inventory 4,800(16,000 × .3)

0 6,000 1,200 cr

16,000 20,000 14,000P S

Outsidethird party

Outsidethird party

6,000

Example: Upstream 100% of Inventory Held

0 38,00020,000

P S

Outsidethird party

Outsidethird party

S purchased inventory for $20,000 and sold to P for $38,000. P held the inventory at year-end.

38,000

Example: Upstream100% of Inventory Held


Difference

Sales 0 0 38,000 38,000 dr

CGS 0 0 20,000 20,000 cr

Inventory 20,000 38,000 0 18,000 cr

0 38,000 20,000P S

Outsidethird party

Outsidethird party

38,000



145

Example: Upstream 30% of Inventory Held

26,600 38,000 20,000P S

Outsidethird party

Outsidethird party

S purchased inventory for $20,000 and sold to P for $38,000. P held 30% of the inventory at year-end.

11,400

Example: Upstream30% of Inventory Held


Difference

Sales ? ? 38,000 38,000 dr

CGS 14,000(20,000 × .7)

(26,600 + 20,000) 32,600 cr

Inventory 6,000(20,000 × .3)

11,400 0 5,400 cr

26,600 38,000 20,000P S

Outsidethird party

Outsidethird party

11,400

Example Question

During the year, Papa Company sold inventory, which cost $18,000, to its subsidiary Sonny for $30,000. At the end of the year, Sonny held $10,000 of the intercompany goods. The balance had been resold to unaffiliated customers for $24,000. What should be reported as:

inventory on the consolidated financial statements?sales on the consolidated financial statements ?cost of sales on the consolidated financial statements?intercompany profit to be eliminated?




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Example Question Diagram

18,000 30,00024,000 selling price

20,000 CGSP S

Outsidethird party 10,000

Outsidethird party

Example Question: Table


Difference

Sales 24,000 (30,000 + 24,000) 30,000 dr

CGS 12,000(18,000 × 2/3)

(18,000 + 20,000) 26,000 cr

Inventory 6,000(18,000 × 1/3)

0 10,000 4,000 cr

18,000 30,000 24,000 SPP S

Outsidethird party


Practice!

Don’t let information overwhelm you.

Practice using tools.

Read strategically.

Don’t let distractors get to you.



147

On our way out of the maze!

VLADGRIN/Getty Images


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Intercompany (I/C) Fixed Asset Transactions

Intercompany (I/C) FixedAsset Transactions





IFRSCombined financial statementsVariable interest entities 5PH/Shutterstock


A gain or loss cannot be recognized on the intercompany sale/purchase.The asset’s carrying value, depreciation expense, and accumulated depreciation must be adjusted to the original cost from an outside third party.

Questions usually ask either:

What should be reported on the consolidated financial statements? or

What should be eliminated?



149


TOOL S

Diagrams

Journal entries



Example: Sale of Land

On December 31, P sold land to S for $150,000. The land originally cost P $130,000. S still holds the land.

130,000P S

Outsidethird party

150,000


Example: Sale of Land

To understand the transaction, it helps to first evaluate the journal entries each company made at the date of the sale. Here are the entries that P and S would have made on December 31.

On P’s Books On S’s BooksDR: Cash 150,000 DR: Land 150,000

CR: Land 130,000 CR: Cash 150,000CR: Gain on sale 20,000



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Example: Land

To help keep straight what the consolidated amount should be, prepare a table that compares the original asset basis to the intercompany asset basis.

Should be What is Difference

Land 130,000 150,000 20,000 cr

Gain on sale 0 20,000 20,000 dr

Example: Depreciable Asset Diagram

Now suppose on December 31, P sold equipment to S for $7,000. The equipment originally cost $9,000. The equipment had an original life of 10 years, and P held the equipment for 3 years before the sale to S.

9,000P S

7,000

9,000 / 10 yrs = 900 depr 7,000 / 7 yrs =

1,000 depr

Example: Depreciable Asset Calculate Gain or Loss

9,000P S

7,000

9,000 / 10 yrs= 900 depr 7,000 / 7 yrs

= 1,000 depr

Gain on date of saleCost 9,000Accumulated depr 2,700Net book value 6,300Selling price 7,000Gain 700

Tip: The gain or loss divided by remaining life equals the difference in depreciation! 700 / 7 years = 100!



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Example: Depreciable Asset Transaction Entries

The journal entries each company made at the date of the sale:

On P’s Books On S’s BooksDR: Depreciation expense 900

CR: Accum depreciation 900

DR: Cash 7,000 DR: Equipment 7,000DR: Accum deprecation 2,700 CR: Cash 7,000

CR: Equipment 9,000CR: Gain on sale 700

Example: Depreciable Asset—Year 1


Equipment 9,000 7,000 2,000 dr

Accumulated depreciation 2,700 0 2,700 cr

Depreciation expense 900 900 0

Gain on sale 0 700 700 dr

Example: Depreciable Asset—Year 2


Equipment 9,000 7,000 2,000 dr

Accumulated depreciation 3,600 1,000 2,600 cr

Depreciation expense 900 1,000 100 cr

Retained earnings (plug) - - 700 dr



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Quantitative Quiz

Pug Corp. (P) owns 80% of Sheltie Co.'s (S) common stock. On January 2, Year 1, P sold to S for $245,000, machinery with a carrying amount of $210,000. S is depreciating the acquired machinery over the remaining 7-Year life by the straight-line method. The net adjustments to compute Year 1 and Year 2 consolidated income before income tax would be an increase (decrease) of:

Year 1 Year 2A. ($30,000) $5,000B. ($30,000) $4,000C. ($35,000) $5,000D. ($35,000) $4,000

Quantitative SolutionAnswer: A

35,000 gain / 7 years = 5,000 difference in depreciation

Year 1: The sale occurred at the beginning of the year, so the impact on net income is a debit to remove the 35,000 gain, less the credit for the 5,000 depreciation adjustment (net 30,000). The percentage ownership (80%) is not relevant 100% is eliminated.

Year 2: The only impact on consolidated net income is the 5,000 depreciation adjustment.

Book value 210,000Selling price 245,000Gain 35,000


An intercompany depreciable fixed asset transaction resulted in an intercompany gain. Which one of the following is least likely to be reflected in the consolidated financial statements prepared at the end of the period in which the intercompany transaction occurred?

A. Consolidated income will be less than the sum of the incomes of the separate companies being combined.

B. Consolidated assets will be less than the sum of the assets of the separate companies being combined.

C. Consolidated depreciation expense will be more than the sum depreciation expense of the separate companies being combined.

D. Consolidated accumulated depreciation will be more than the sum of accumulated depreciation of the separate companies being combined.




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Qualitative Answer: C

SB Is Diff

Equipment 10,000 8,000 2,000 dr

Accum depr 4,000 0 4,000 cr

Depr exp ? ?

Gain on sale 0 2,000 2,000 dr

The question is in null form; find the false statement. Use simple numbers to answer the question.

Consolidated assets

Consolidated income

Almost there!

photosindia/Getty Images


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Intercompany (I/C) Bond Transactions

Intercompany (I/C) BondTransactions






Branislav Senic/Alamy Stock Photo


When an entity purchases the bonds issued by an affiliate that is consolidated, the purchase is a constructive retirement of the bonds.

Investment in Bonds/Bonds Payable is overstated by face amount of the bonds.

Premium/Discount on Investment in Bonds/Bonds Payable is overstated. Interest Income/Interest Expense is overstated by amounts related to I/C bonds.Interest Receivable/Interest Payable is overstated by amounts related to I/C bonds.



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Illustration: Intercompany Bond Elimination

P’s Books S’s Books EliminationBonds Payable 100,000 cr 100,000 drPremium on Bonds Payable 3,000 cr 3,000 drInvestment in Bonds 100,000 dr 100,000 crPremium on Investment in Bonds 6,000 dr 6,000 cr

Gain or Loss on Retirement of Bonds 3,000 dr

Assume S purchased $100,000 of P’s bonds on the market for a premium of $6,000. P originally issued the bonds for a premium, and $3,000 is unamortized on the date of S’s purchase.

Eliminations in Subsequent Periods

Interest Revenue/Interest Expense on I/C Bonds:

Interest Payable/Interest Receivable on I/C Bonds:

DR: Interest RevenueCR: Interest Expense

DR: Interest PayableCR: Interest Receivable

You can always do more than you think you can.

Tischenko Irina/Shutterstock


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IFRS—Consolidations







Viktor1/Shutterstock

U.S. GAAP IFRS Differences

U.S. IFRS

Control defined as > 50% ownership. Control can be obtained with < 50% ownership in certain circumstances (i.e., potential rights or decision-making rights).

Defines variable interest entities. Does not define variable interest entities but has similar concept with special-purpose entities.

Accounting policies of P and S do not have to align.

Accounting policies of P and S have to align.



157

U.S. GAAP IFRS Differences

U.S. IFRS

Accounting periods can be up to three months apart.

Accounting periods should have the same end date; if not, adjust for transactions during gap period.

Noncontrolling interest is assigned its percentage of goodwill at date of acquisition.

Parent has a choice at acquisition date whether or not to assign goodwill to noncontrolling interest (NCI).

Noncontrolling Interest U.S. GAAP and IFRS

Goodwill is assigned to the noncontrolling interest.

100% Parent share 80%

NCI share 20%

Total FV 200 160 40

Goodwill 25 20 5

FV net assets 175 140 35

FV increment 75 60 15NBV 100 80 20

100% Parent share 80%

NCI share 20%

Total FV 195 160 35

Goodwill 20 20 0

FV net assets 175 140 35

FV increment 75 60 15NBV 100 80 20

Noncontrolling Interest Option under IFRS

Goodwill is not assigned to the noncontrolling interest.


158

Combined Financial Statements

Combined FinancialStatements






pick/Shutterstock

Combined vs. Consolidated Financial Statements

Combined statements appropriate when:

Common control—one individual owns two or more entities

Common management—two or more entities under common

management

Unconsolidated subsidiaries—combine results of two or more

unconsolidated subsidiaries


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Office buildings Retail buildings Restaurant buildings

Super CPA

Colin Anderson/Getty Images

Office buildings

Retail buildings

Restaurant buildings

Super CPA Management

Rawpixel.com/Shutterstock


The process of combining financial statements includes:Eliminating intercompany transactions/balances

Intercompany receivables/payablesIntercompany revenues/expensesIntercompany gains/lossesIntercompany ownership/equity, if any

There is no goodwill or bargain purchase.



160

Mr. Allen owns all of the common stock of Astro Company and 80% of the common stock of Bio Company. Astro owns the remaining 20% interest in Bio's common stock, for which it paid $8,000, and which it carries at cost, because there is no ready market for Bio's stock. The condensed balance sheets for Astro and Bio as of December 31 were:

What would be reported as equity on the combined financial statements of Astro and Bio?

Astro BioAssets 300,000 120,000Liabilities 100,000 60,000Common Stock 50,000 40,000Retained Earnings 150,000 20,000


Example Question


Answer

Astro's investment in Bio would be eliminated.

Astro's equity 200,000

Bio's equity 60,000

less Astro's investment in Bio (8,000)

252,000


161

Variable Interest Entities (VIEs)

Variable Interest Entities(VIEs)






Monkey Business Images/Shutterstock

Voting and VIE Model for Consolidation

Is the entity a variable interest entity (VIE)?

If yes, is the investor the primary beneficiary?

Yes = Consolidate VIE.

If no, does the investor have > 50% voting ownership?

Yes = Consolidate.

No = Do not consolidate; report as investment.



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Variable Interest Entity (VIE) Defined

A VIE is a legal entity which by design:

Cannot finance its activities without additional subordinated financial support, or

Expected losses exceed its total equity investment at risk, or

Its equity holders, as a group, do not have the direct or indirect ability to make decisions about the VIE’s activities, or

Shareholders do not control the entity.

VIE Characteristics

May be a partnership, joint venture, legal trust, or corporation

Set up for a well-defined, limited purpose

Sponsor or sponsors provide most of its resources

Activities are governed largely by contract or agreement and rest with sponsors, not shareholders.

Risks and rewards are largely attributable to sponsors.

Value of sponsor interest increases/decreases with changes in net asset value of the VIE.

Consolidation of VIEs

The primary beneficiary of a VIE will consolidate the VIE.

Primary beneficiary must meet two conditions:

Power criterion—power to direct the activities of VIE that significantly impact the VIE’s economic performance, and

Losses/benefits (or risk/rewards) criterion—has obligation to absorb losses from or right to receive benefits of the VIE.



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Example VIE Fact Pattern

VIEco was established to construct and lease the office building that houses Pamco’s headquarters. Pamco then leases the building from VIEco. VIEcoobtains long-term financing from Bankco using the building as collateral.

Pamco and Bankco share gains and losses of VIEco 60% and 40%, respectively. Pamco enjoys the use of the building without carrying the asset or debt. VIEco carries the building as an asset and uses the lease payments collected from Pamco to pay the debt to Bankco.

Example: VIE Illustration

Example: VIE

The primary beneficiary of VIEco is Pamco.

Power criterion—Pamco has the power to direct the activities of VIEcothat impact VIEco’s economic performance, and

Losses/benefits (or risk/rewards) criterion—Pamco has obligation to absorb losses from or right to receive benefits of VIEco.



164

Pedro Nogueira/Shutterstock

CPA Exam


165

Exit or Disposal Activities and Discontinued Operations

Exit or Disposal Activities and

Discontinued Operations

Exit or DisposalA company may sell, dispose, abandon or involuntarily convert a plant assetRecord depreciation up to the date of saleCalculate a gain or loss

Asset cost– Accumulated depreciation

Asset net book value– Cash received

Gain or loss

Exit or Disposal—DisclosuresDescription of the facts and circumstances

Expected manner and timing of the disposal

Gain or loss on disposal

Where gain is reported on the income statement

If held-for-disposal present separately on the balance sheet

Segment in which the asset belongs



166

Discontinued OperationsDisposal of a component of a business is a discontinued operation only if it represents a “strategic shift” that will have a major impact on the entity’s operating results.

Examples of Strategic ShiftDisposal of

A major geographic area

A line of business

An equity method investment

Income Statement ReportingThese amounts are reported below Income from Continuing Operations, on an after-tax basis, in a separate section labeled Discontinued Operations

Earnings per share for Discontinued Operations is presented.

Discontinued Operations is the only item separated from Continuing Operations.



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Income Statement ReportingThe operating income (loss) of the discontinued component is reported as discontinued for all periods presented.

If a component is discontinued in 20X8, the income statement reports the operating income of the component for 20X6 and 20X7 in the discontinued operations section for comparative purposes.

Balance SheetThe carrying amount of major classes of assets and liabilities included as part of a discontinued operations are classified as Held-for-Sale.

The disposal group held for sale should be remeasured at the lower of its carrying value or fair value less selling costs. The resulting gain or loss is included in the income or loss from discontinued operations.

All prior periods are also adjusted.

Comparative StatementsPrior year financial statements are always reported comparatively with the current year.

The component in discontinued operations must be segregated in the previous years.

Although the component was not discontinued in those years, financial results for all years presented should be on the same basis.



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DisclosuresFor disposals that meet the criteria for a discontinued operation and for individually significant disposals that do not meet the criteria:

Facts and circumstances leading to the disposal

Expected manner and timing of the disposal

Information about continuing involvement after the disposal date

Disclosures (continued)Major line items of income (revenue, cost of sales, depreciation, etc.)

The total operating and investing cash flows of the discontinued operation

The depreciation, amortization, capital expenditures, and significant noncashoperating and investing items

Two CasesReporting is affected by whether the decision to discontinue, and the discontinuation itself, take place in the same period:

1. Decision and discountinue occur in the same period

2. Discontinuation occurs in a later period. In this case, estimated disposal losses are estimated and recognized (but not gains). No estimate of operational income or losses in future periods.



169

Case 1 ExampleIncome from continuing operations is $10,000 for the current year. On December 1, the company discontinued a business component and sold the entire component for $14,000:

1. The loss from operating the component for the current year was $700 (net of tax).

2. The net book value (assets less liabilities) of the component is $13,000 on Dec 1.

3. The tax rate is 40%.

Reporting FormatIncome from continuing operations $10,000Discontinued operations:– Loss from operation of discontinued component (net of tax) (700)+ Gain on the disposal of discontinued component (net of tax) 600*

(100)Net Income $ 9,900* ($14,000 – $13,000)(1 – .40)

Comparative StatementsPrior year financial statements are always reported comparatively with the current year.

The component in discontinued operations must be segregated in the previous years.

Although the component was not discontinued in those years, financial results for all years presented should be on the same basis.



170

Case 2 Example Income from continuing operations is $10,000 for the current year. The company decided to discontinue a component.

Actual disposal is expected next year. The fair value of the component is $11,000 (after estimated cost to sell):

1. The loss for operating the component for the current year was $700 (net of tax).

2. The net book value of the component was $13,000.

Reporting FormatIncome from continuing operations $10,000Discontinued operations:– Loss from operation of discontinued component (net of tax) (700)– Estimated loss on the disposal of discontinued component (net of tax) (1,200)*

(1,900) Net Income $ 8,100* ($11,000 – $13,000)(1 – .40)

Next YearIf the actual loss is not equal to the estimated amount, the difference is reported in next year’s discontinued operations section.

In this example, if the actual loss in year 2were only $1,000, a $200 disposal gain would be reported in year 2 in the discontinued operations section of the income statement.



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Next Year (continued)If a disposal gain had been estimated in the year of the decision to dispose, the gain is not recognized.

Rather, the actual disposal gain is recognized in the year of disposal and reported in the discontinued operations section of the income statement

Proficiency QuestionThe book value of the net assets of a discontinued segment is $300,000. The fair value is $200,000 and the cost of disposal is $20,000

Ignoring income tax, the estimated disposal loss is $120,000

True or False

True

The estimate loss is (200,000 – 300,000) – 20,000

Abbott Labs, Dec 31, 2014 Annual report



172





173

Public Company Reporting Topics (SEC, EPS, Interim, and Segment)U.S. Securities and Exchange Commission (SEC)SEC—Role and Standard-Setting Process

SEC—Role andStandard-Setting Process

Creation of the SECThe SEC was created by Congress after the 1929 stock market crash.

The SEC has the legal authority to set accounting standards, but has delegated that responsibility to the private sector—currently the FASB.

Purpose of the SECThe SEC enforces compliance with US GAAP for all publicly traded companies.

Compliance with IFRS for foreign registrantsTo promote efficient allocation of capital through open, orderly and fair securities marketsAccess to information that is decision-useful (relevant) to the market participant is critical



174

Foreign Issuers Reporting to the SECIn 2008, as part of the “roadmap” to international convergence, the SEC eliminated the reconciliation to US GAAP for foreign private issuers.This is a significant step to acknowledging the IASB approved IFRSs.Elimination of the reconciliation should encourage more foreign businesses to list on US exchanges.

Foreign Private IssuerA foreign private issuer is any non-governmental foreign issuer that:

Has the majority of its securities owned outside of the US Officers and directors are not US citizens or residentsThe majority of assets are outside the USThe business is administered principally outside of the US

Securities Issued and TradedThe SEC regulates the initial issuance and subsequent trading of securities.

The SEC’s database is IDEA (Interactive Data Electronic Applications) where financial statement information is stored in XBRL (eXtensible Business Reporting Language)

XBRL tags accounting data into a taxonomy to ease the access to the data

SEC—Role and Standard-Setting Process


175

Organizational Structure Five commissioners appointed by the President of the US

Four divisions

Office of the Chief Accountant

Divisions• Oversees compliance • Filings submitted to this division

Corporate Finance

Corporate Finance

• Investigates violations• Makes recommendations for punishment

EnforcementEnforcement

• Oversees the secondary markets and exchanges, brokers, and dealers

Trading and Markets

Trading and Markets

• Oversees investment advisors and investment companies

Investment ManagementInvestment

Management

Laws Administered by the SECThe Securities Acts of 1933 and 1934The Public Utility Holding Company Act of 1935Trust Indenture Act of 1939Investment Company Act of 1940Investment Advisors Act of 1940Securities Investor Protection Act of 1970Sarbanes-Oxley Act of 2002



176

Participation in Standard SettingEven though the SEC delegates standard setting to the FASB, the SEC participates in the setting of accounting standards.

SEC pronouncements along with the FASB Accounting Standards Codification comprise authoritative US GAAP for public companies.

Private companies do not have to comply with SEC pronouncements.

Pronouncements IssuedFinancial Reporting Releases• Formal pronouncements—highest ranking

authoritative source for public companiesFRR

Staff Accounting Bulletins• SEC’s current position on technical issuesSAB

Accounting and Auditing Enforcement Releases• Reports enforcement actions

AAER


177

SEC Reporting Requirements


What is a Security?Section 2.1 of the 1933 Act defines a security as: Any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral trust certificate, reorganization certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt of, guarantee of, or warrant or right to subscribe to or to purchase any of the foregoing.

The Securities Act of 1933This act applies to the registration of the initial public offering (IPO) of securities.

Form S-1 is the basic registration form for new securities.

Part 1 is the prospectus and provides information about the company, business operations, risks, financial statements and use of proceeds.

Part 2 provides information about the cost of the issuance, information about the directors and officers, and additional financial schedules.



178

Financial Statements for IPOThe following audited financial statements must be presented:

2 years of balance sheets3 years of income statements, statements of cash flow and statements of shareholders’ equity

IPO Process

IssuerIssuer Under-writerUnder-writer DealerDealer PublicPublic

The Securities Act of 1934This act applies to reporting information about securities that are already issued.

Regulation S-X provides detailed guidance on the reporting requirements

Form 10-K is the annual filing

Form 10-Q is the quarterly filing

Form 8-K reports significant events



179

Annual Filing—Form 10-KThe financial statements in Form 10-K must be audited by an independent registered auditor.

2 years of balance sheets3 years of income statements, statements of cash flows, and statements of shareholders equity

Annual Filing—Form 10-KIn addition to the audited financial statements, there are significant disclosures:

Management Discussion and Analysis (MD&A)Reports on controlsManagement certificationsMuch, much more (see study guide)

Quarterly Filing—Form 10-QThe financial statements in Form 10-Q are not audited, but are reviewed by the auditor.

Disclosures in the 10-Q are not as extensive as the 10-K.

Update on significant matters since the last quarter such as legal proceedings, changes in securities outstanding.



180

Coca Cola, Inc.—10-Q Income Statement

Coca Cola, Inc.—10-Q Balance Sheet

Coca Cola, Inc.—10-Q Cash Flows


181

Earnings per ShareIntroduction to Earnings per Share

Introduction toEarnings Per Share

Earnings per Share Overview

Introduction

Basic Earnings per Share (BEPS)

Diluted Earnings per Share (DEPS)

Earnings per Share and IFRS

Need to Know for the CPA Exam

Terminology

How to calculate EPS

Disclosure requirements



182

Why Is EPS Important?

For public companies, reporting EPS on the income statement is required.

EPS measures profitability relative to ownership of that company.

Company A Company B

Earnings (Net Income) $1 million $2 million

Common Shares 200,000 500,000

EPS $5.00 $4.00

Two Measures of EPS

1. Basic EPS (BEPS)

Computed on common shares outstanding and net income.

2. Diluted EPS (DEPS)

Includes the assumed conversion of potential common stock (PCS). PCS includes stock options and other securities that could become common stock in the future. DEPS is an “as if” calculation.

There is a dilutive effect of PCS when DEPS is less than BEPS.

Basic EPS Formula

Only for common stock outstanding

PCS not considered when computing BEPS.

Common stock dividends have no effect on EPS.

Note: The denominator is not the ending number of CS outstanding but the weighted average.

Net income – Preferred stock dividendsWeighted average shares of common outstanding

Introduction to Earnings per Share


183

Diluted EPS Formula

Numerator and denominator impact of PCS are considered when computing DEPS.

Basic EPS PCS Impact

Net Income – PS dividends +/- Adjust to NI for assumed conversion of PCS

Wtd avg shares of CS O/S + Shares from assumed conversion of PCS

Reporting Requirements

BEPS is required.

DEPS is required if the firm has dilutive PCS (complex capital structure).

BEPS and DEPS are shown on the face of the income statement for:

Income from continuing operations (IFCO)

Net income (NI)

An entity that reports discontinued operations may present BEPS and DEPS for discontinued operations on the face of the income statement or in the footnotes to the financial statements.

BEPS Reporting Example

Other Information:Common shares outstanding all year are 13,1001,000 shares of 4%, $100 par, nonconvertible cumulative preferred stock outstanding all yearAnnual preferred dividend: 1,000($100)(.04) = $4,000

Income amounts (after tax):

Income from continuing operations $ 40,000

Discontinued operations (net) (10,000)

Net Income $ 30,000



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BEPS Reporting Example

Income from continuing operations $2.75 ($40,000 – $4,000) / 13,100

Discontinued operations (.76) $10,000 / 13,100

Net Income $1.99 ($30,000 – $4,000) / 13,100

A carefully laid plan will get you there!

lzf/iStockphoto


185

Basic Earnings per Share

Basic Earnings Per Share


Introduction




Common Computational Issues

BEPS Numerator

What amount of preferred stock dividends to subtract from net income

BEPS Denominator

Computing the weighted average shares when stock is issued or purchased during the year and impact of stock dividends and splits



186

BEPS NumeratorCumulative Preferred Stock

Deduct one full year of dividends regardless of amount declared or paid.

Noncumulative Preferred Stock

Deduct dividends declared in the current year.

BEPS Numerator TipsCumulative preferred stock dividends are subtracted in calculating BEPS for each year, whether declared or not.

Dividends in arrears on cumulative preferred stock declared in a subsequent year are NOT subtracted in the numerator of BEPS in the year declared.

No tax effect on the preferred stock dividend.


Quiz

There are 1,000 shares of 7%, $100 preferred stock outstanding. For the current year, what amount of preferred dividends is subtracted in calculating BEPS when the preferred stock is cumulative, there are two years’ dividends in arrears, and $4,000 of dividends were paid?

Answer:

The amount of dividends accrued for the current year:

1,000 shares × $100 par × 7% = $7,000



187

Quiz—Twist

There are 1,000 shares of 7%, $100 preferred stock outstanding. For the current year, what amount of preferred dividends is subtracted in calculating BEPS when the preferred stock is noncumulative, $2,000 of dividends were declared in the current year, and $3,200 of dividends were paid?

Answer:

The amount of dividends declared:

$2,000

BEPS Denominator

The denominator of BEPS is the weighted average (WA) common shares outstanding, not ending shares outstanding or ending shares issued.

If 1 million shares are purchased to hold as treasury stock on July 1, the effect is to reduce the WA by 500,000 shares (1 million for half a year).

BEPS Denominator Tips

Stock dividends and splits are retroactively applied to the beginning of the year. Any stock issuance or treasury stock purchase before the stock dividend or split is adjusted for the dividend or split.

The dividend or split is also applied to statements of earlier periods that are shown comparatively with the current statements.




188

{(1,000 × 12/12

+ 600 × 3/12)

- 120 × 1/12}

Example Weighted Average Calculation

Calculate the weighted average shares outstanding:

Jan 1: 1,000 common shares outstanding

Oct 1: Issue 600 shares

Nov 4: Split stock 2-for-1

Dec 1: Acquire 120 shares for treasury

Dec 9: Issue 40% stock dividend

2

1.4

Weighted averages shares outstanding = 3,206

Answer―Weighted Average Calculation

Below is the calculation of weighted average shares outstanding:

{ [1,000(12/12) + 600(3/12)](2) – 120(1/12)}(1.4) = 3,206

A company had 400,000 shares of common stock issued and outstanding on January 1, Year 1, and had the following equity transactions for Year 1:

What should the company use as the denominator for the calculation of basic earnings per share for year ended December 31, Year 1?

A. 1,650,000B. 1,575,000C. 1,325,000D. 1,075,000

Example Question

Transactions DateIssued 200,000 new shares for cash April 1Issued new shares as result of 3-for-1 stock split July 1Purchased 300,000 shares treasury stock for cash October 1




189

Calculate the weighted average shares outstanding:

{(400,000 × 12/12

+ 200,000 × 9/12)

- 300,000 × 3/12}

Answer―Example Question

Jan 1: 400,000 common shares outstanding

Apr 1: Issue 200,000 shares

Jul 1 : Split stock 3-for-1

Oct 1: Acquire 300,000 shares for treasury

Weighted averages shares outstanding = 1,575,000

Answer: B

Below is the calculation of weighted average shares outstanding:

({[400,000 + (200,000 9/12)] 3} – 300,000 3/12)

= 1,575,000

Comparative StatementsRetroactively apply stock dividends and splits to comparative years.

The retroactive application ensures that the base on which EPS is computed uses the same measuring unit.



190

Example Comparative Statements

During Year 2, a firm split its stock 2-for-1. The beginning common shares outstanding was 20,000 and the ending was 40,000.

There was no other change in CS outstanding for Year 2 or Year 1.

Net income in both years was $80,000. The firm has only CS, and there are no PCSs.

In the Year 2 income statement, what is reported BEPS for both years?

Example Comparative Statements

Year 2 Year 1Year 1 beforerestatement

Net Income $80,000 $80,000 $80,000

Wtd Avg Shares 40,000 40,000 20,000

BEPS $2.00 $2.00 $4.00

Adjust Year 1 shares outstanding to allow comparison between years.

Conclusion

BEPS Numerator

Subtract preferred dividends from NI. If cumulative, always subtract; if not cumulative, subtract only what was declared.

BEPS Denominator

Use weighted average shares outstanding; weight by the number of months since issue. All CS splits and dividends are applied retroactively.



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Diluted Earnings per Share

Diluted EarningsPer Share


Introduction




Diluted EPS

Diluted EPS incorporates potential common stock (PCS) securities that can become common stock in the future.

This is an “as if” calculation to see the impact on EPS if all potential conversions of stock were to occur.

Basic EPS is the benchmark and is adjusted for the effect of PCS.



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Target Corporation

Target Corporation, 2016 10k

BEPS

DEPS

Wtd Avg

Computation Process

Compute BEPS first because it is the starting point.

Use the information in BEPS:

1. To make changes in numerator and denominator for assumed conversion and exercise of PCS.

2. As the benchmark for antidilution.

Diluted EPS Formula

Include numerator and denominator impact of PCS when computing DEPS.

Basic EPS PCS ImpactNet Income – PS dividends +/- Adjust to NI for assumed conversion of PCS

Wtd avg shares of CS O/S + Shares from assumed conversion PCS



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Potentially Convertible Securities

When computing the numerator and denominator effects of PCS, different techniques are used depending on the type of PCS.1. For convertible preferred stock and convertible bonds, use the “if-

converted method.” The convertible securities are assumed to have been converted.

2. For stock options and warrants, use the “treasury stock method.” The options and warrants are assumed to have been exercised, and treasury stock is purchased.

3. When there is more than one PCS, use the dilution/antidilutionmethod—use the PCS that is the most dilutive first.

If―Converted ExampleAssume there are 100, 5%, $1,000 convertible bonds outstanding all year.

Each bond is convertible into 20 shares of common stock.

The bonds were issued at face value, and the tax rate is 30%.

Net income is $18,500, and weighted average common stock outstanding is 5,000 before considering PCS.

BEPS = $18,500 / 5,000 = $3.70

What is DEPS?

If―Converted Effect

The convertible bonds are dilutive because $1.75 < $3.70.

[100($1,000)(.05)(1 ‒ .30)] [100(20)]

Net effect of bond conversion = $1.75



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If―Converted BEPS and DEPSBasic EPS Diluted EPS

Numerator Denominator Numerator Denominator

Net Income $18,500 $18,500

Interest 100($1,000)(.05)(1 ‒ .30) 3,500

CS outstanding 5,000 5,000

Conversion of bonds 100(20) 2,000

Totals $18,500 5,000 $22,000 7,000

EPS $3.70 $3.14

If―Converted Twist

If the bonds were issued during the year, then both the numerator and denominator effects would be multiplied by the fraction of the year the bonds were outstanding.

Assume April 1 issuance (9/12 months or 75%)

(.75) 3,500 = 2,625= $1.75

(.75) 2,000 = 1,500

If―Converted TwistBasic EPS Diluted EPS


Net Income $18,500 $18,500

Interest [100($1,000)(.05)(1 ‒ .30)].75

2,625


Conversion of bonds [100(20)].75

1,500

Totals $18,500 5,000 $21,125 6,500

EPS $3.70 $3.25



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Treasury Stock Method Example

Assume the same net income of $18,500 and weighted average common stock outstanding of 5,000 before consideration of PCS.

In addition, assume 5,000 options to purchase the firm’s $2 par CS for $10 were outstanding all year, and the average market price of CS was $25.

Treasury Stock Method Example

Three steps for the treasury stock method for incorporating assumed exercise of stock options to DEPS:

1. Assume exercise: 5,000($10) = $50,000 proceeds from exercise and 5,000 increase in CS outstanding.

2. Use the proceeds to purchase treasury stock at $25: $50,000/$25 = 2,000 shares purchased for the treasury.

3. Incremental shares (denominator effect): 5,000 – 2,000 = 3,000 shares added to denominator of DEPS.

Treasury Stock Method ExampleBasic EPS Diluted EPS


Net Income $18,500 $18,500


Shares issued 5,000

Shares repurchased (2,000)

Totals $18,500 5,000 $18,500 8,000

EPS $3.70 $2.31



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Multiple Potential Common Stock

Apply the same logic when there is more than one PCS.

Compute the numerator and denominator effect for each PCS.

Enter the PCS with the lowest ratio, and compute an initial value for DEPS.

Keep going until you have either:

Entered all PCS, or

There is an antidilutive PCS. Stop if PCS is antidilutive; DEPS is the previous value computed.

Multiple Potential Common Stock Example

Assume net income is $50,000 and the WA common shares is 10,000. The company also has the following:

8% convertible bond, 200 bonds each convert to 40 common shares. The bond yield was 10%, and the tax rate is 40%. Bonds were issued at par, and no bonds have been converted.

4% convertible, cumulative preferred stock, $100 par, 1,000 shares issued and outstanding. Each preferred share is convertible into 2 shares of common. The preferred was issued at par.

Basic EPS is ($50,000 – 4,000) / 10,000 = $4.60

Effect of Conversion

Effect of Bond Conversion

[.08($200,000)(1 ‒ .40)]

[200 bonds × 40 CS]

= $1.20

Effect of PS Conversion

Numerator effect: $ 0

Denominator effect:(2 CS for 1 PS)

2,000

= $ 0

1st2nd



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Effect of Preferred Stock Conversion

Numerator Denominator

Net Income $50,000

Preferred Dividends 0

CS O/S 10,000

Shares issued (2 CS for 1 PS) 2,000

Totals $50,000 12,000

DEPS $4.16

Effect of Bond ConversionNumerator Denominator

Net Income $50,000

Interest [(.08 × $200,000) (1 - .4)] 9,600

CS O/S 10,000

Shares issued (200 bonds × 40 CS) 8,000

Totals $59,600 18,000

DEPS $3.31

Multiple Potential Common Stock Example

Basic EPS Diluted EPS


Net Income $50,000 $50,000

Preferred dividend (4,000) 0

CS O/S 10,000 10,000

Conversion of PS 2,000

Conversion of bonds 9,600 8,000

Totals $46,000 10,000 $59,600 20,000

EPS $4.60 $2.98



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Target Corporation

Target Corporation, 2016 10k

BEPS

DEPS

Wtd Avg

Diluted EPS Summary

Remember that DEPS builds directly on BEPS.

Always compute BEPS first, even if a problem on DEPS doesn’t ask you to do so—you always have to be careful to check for antidilution.

If the PCS was outstanding only part of the year, then the incremental shares are weighted by that fraction of the year.

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Earnings Per Shareand IFRS


Introduction




U.S. GAAP–IFRS Differences

U.S. IFRS

Dilution under treasury stock method uses year-to-date calculations.

Dilution calculated independently each period.

Per share measures not allowed on alternative measures of performance.

Per share measures allowed on alternative measures of performance.

Contingently convertible securities included in DEPS calculation unless contingency unlikely to occur.

Contingently convertible securities included only if contingency condition met at reporting date.


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Segment Reporting

Segment Reporting

Segment ReportingMany corporations operate a diverse set of businesses.

GAAP requires disclosures by major segments to allow assessment of those businesses or segments.

GAAP is disclosure only.

Segment ReportingThree focuses:

1. What is a segment (operating segments)?

2. Which segments must report this information (reportable segments)?

3. What information is reported?

Segment Reporting


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Operating SegmentIdentified by management as a significant component meeting these criteria:

1. Generates revenues and expenses

2. Chief operating decision maker reviews results

3. Provides financial information about its operations

Reportable SegmentsAn operating segment meeting at least one of three quantitative tests

Not all firm components are operating segments; not all operating segments are reportable segments

Three Quantitative Tests for Reportable Segment

The three tests separately involve revenues, net income and assets.

Each uses 10% or more

If a test is met, the operating segment is a reportable segment.



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Test 1—Operating RevenueAn operating segment’s revenue (internal plus external) that is ≥ 10% of the combined revenues (internal and external) of all operating segments.

Test 2—Operating ProfitFirst: Compute two amounts and use the larger absolute value

Combined operating profit of all operating segments reporting

positive profit

Combined operating loss of all operating segments reporting an

operating loss

Second: If the absolute value of an operating segment’s operating profit or

loss is ≥ 10% of the larger amount above, then it is a reportable segment.

Test 2—Operating Profit: ExampleAssume segments have the following profits (losses) $100, 50, (25), 75, (30), 10.

The sum of operating profit for operating segments with positive profit is 235.

The sum of losses for operating segments with operating losses is (55).

The higher absolute value is 235

An operating segment with either an operating profit or loss ≥ than $23.5 is a

reportable segment (25) and 10.

Segment Reporting


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Test 3—Identifiable AssetsAn operating segment’s identifiable assets that are ≥ 10% of the combined assets of all operating segments.

75% Revenue RuleSales to unaffiliated customers ≥ 75% of consolidated revenues

Consolidated revenues

Other operating segments (not meeting a quantitative test) are added to the reportable group until the 75% measure is met.

More than 10 reportable segments may exceed the cost-benefit constraint.

Reportable Segment DisclosuresDescription of the segmentFactors used to identify reportable segmentsTypes of products and servicesEarnings, total assets External revenue and internal revenueInterest revenue and expenseDepreciation, amortization and depletionUnusual and infrequent expensesIncome tax expense



206

Reportable Segment Disclosures (continued)Operating segment disclosures are required in interim financial reports.

Reconciliation between reportable segments = items (e.g., revenue, profit, assets) and the related consolidated items.

Restate previously reported information for changes in internal organization.

Enterprise-Wide Disclosures

Information about products or services

Information about geographic areas

Also, if one customer accounts for 10% ormore of the firm’s revenues, that fact mustbe disclosed.

Coca-Cola, Inc.Footnote Excerpt: Operating Segments

Segment Reporting


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Coca-Cola, Inc.Footnote Excerpt: Operating Segments


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Interim Financial ReportingInterim Reporting Principles

Interim Reporting Principles

Interim Reporting PrinciplesInterim financial statements are issued between annual reports.

Interim reports help provide timely information.

Securities regulators may require interim statements.

SEC in the US requires interim reporting.

Interim Reporting PrinciplesDifferences between annual and interim reports:

Interim period statements are not audited.Certain methods used for interim are not allowed for annual.

Example: Gross profit method to estimate ending inventory and cost of goods sold



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General Accounting GuidelineInterim reports are an integral part of the annual report, not stand-alone reports.

A discrete view of interim reporting would view each interim period as a discrete independent period.

Example: Revenue received in one interim period is not allocated to other interim periods.

RevenueRevenue recognition proceeds the same way as for annual reports.

Example: A customer advance received in Q1 that applies equally to the last three quarters is allocated evenly over those three quarters.

ExpensesAn expenditure relating to more than one interim period, is recognized in those periods rather than immediately.

Example: Rent prepaid at the end of Q1 for the last three quarters of the year is recognized equally as rent expense in those last three quarters.

Expenses related to revenue are recognized in the same interim period as the revenue.



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Income Tax ExpenseFirms face a graduated annual income tax rate. The average annual tax rate is not known until the end of the year.

For each interim period, the annual rate is estimated.

Cumulative Year-to-Date Income × Estimated Annual Tax Rate

= Required Tax Provision to Date

– Prior Periods' Recognized Exp.

= Current Interim Period's Tax

Income Tax ExampleLindy Company, a calendar year corporation, has the following income before income

tax provision and estimated effective annual income tax rates for the first three

quarters of 20X7:

Income before Estimated effectiveincome tax annual tax rate

Quarter provision at end of quarter First $60,000 40%Second 70,000 40%Third 40,000 45%

What is Lindy's income tax provision in its interim income statement for the third

quarter?

Income Tax SolutionCumulative income × est. tax rate = cumulative provision requiredQ 1 and 2 130,000 × .40= 52,000 Q3 170,000 × .45= 76,500

24,500Income Tax Expense 24,500

Income Tax Payable 24,500



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Exceptions to Integral ViewThe following items are not allocated to more than one interim period (discrete view):

Gains and losses on disposal of equipment Discontinued operations


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Interim Reporting—Details and IFRS


Interim ReportingRecall that interim financial statements are issued between annual reports

Provide timely information

Securities regulators may require interim statements

In the U. S. we take an integral view approach

Decline in Inventory ValueInventory is written down to net realizable value or market value when below costDeclines in inventory value are recorded in the interim period in which it occursExample: Inventory value declines below cost in Q2; the loss and write-down of inventory is recorded in Q2



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Decline in Inventory ValueLater recoveries are recorded in the interim period they occurLC-NRV or LC-M is suspended for interim reporting if the decline is expected to be recovered by year-endIf the expected recovery fails to occur by year-end, the loss is recognized in Q4

Inventory—LIFO LiquidationsIf a liquidation is expected to be replenished before year-end, the estimated replacement cost is used for cost of goods soldIf replenishment is not expected, the liquidation is recorded and cost of goods sold reflects the lower cost

Accounting Principle Changes and Error Corrections

Accounting principle changes and error corrections: the retrospective approach is applied in the interim period in which the change is made

The RE balance at the beginning of the interim period of change is adjusted

Previous interim period statements within the same annual period are adjusted as well



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Accounting Principle Changes and Error Corrections

Example: A principle change in Q3 adjusts beginning Q3 RE for the effect on all previous years and on Q1 and Q2 of the current year

Q1 and Q2 statements are retrospectively restated

U.S. IFRS

Major Differences

Based on integral view

Allocation of costs over each Q

Based on discrete view

Must meet definition of asset in order to

allocate

U.S. IFRS

Major Differences

Can defer cost variances if recovery expected

Can defer decline in inventory value if recovery

expected

Cannot defer cost variances

Cannot defer decline in inventory value


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Special Purpose FrameworksCash, Modified Cash, Income Tax

Cash, Modified Cash, Income Tax

Cash Basis Modified Cash Basis Income Tax BasisRegulatory BasisOther Basis

Sometimes called—Other Comprehensive Basis of Accounting(OCBOA)

Special Purpose Reporting Frameworks

FrameworksFinancial Accounting Standards Board

(FASB)International Accounting Standards Board

(IASB)American Institute of

Certified Public Accountants (AICPA)

ApplicableFinancialReporting Framework

U.S. Generally Accepted Accounting Principles (GAAP): U.S. GAAP–based financial statements for nongovernmental entities

Private Company Council accounting alternative: U.S. GAAP-based financial statements with modifications/simplifications

International Financial Reporting Standards: GAAP–based financialstatements for foreign private issuer

IFRS for Small- and medium-sized entities (SMEs):GAAP–based financial statements with modification/simplification of full IFRS

Special purpose frameworks (SPF): Non-GAAP financial statements prepared using a type of SPF such as FRF for SMEs, cash basis, modified cash basis, tax basis, regulatory basis, contractual basis

Applicability Mandatory for public business entities

May be elected by private, for-profit entities

Required unless entity meets eligibility for accounting alternative

Small- and medium-entities without public accountability

FRF for SMEs may be used by smaller- to medium-sized for-profit private entities when U.S. GAAP-based financial statements are not required

Authoritative Guidance

FASB Accounting Standards Codification (ASC) and Accounting Standards Updates (ASU)

ASC/ASU with modifications for simplicity

IFRS IFRS with modifications for simplicity

FRF for SMEs



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AICPA’s FRF for SMEsAICPA has a financial reporting framework (FRF) for small- and medium-sized entities (SMEs) It provides guidance on the concepts, and presentation of financial statements prepared under cash, modified cash, income tax basis.

This is NOT GAAP

Key Points to KnowBasics of each presentation formatThe reporting of certain information within an special purpose frameworkFinancial statement titles must be descriptive (and not misleading)

Why Is This Important? GAAP Accrual Accounting is not used by:

Sole Proprietors

Over 20 Million in the USPartnerships

Over 2.8 Million in the US

Cash, Modified Cash, Income Tax


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Cash Basis Financial StatementsBased solely on cash receipts and disbursements

Cash received = revenue recognitionCash paid = expense recognition

Pure cash basis balance sheetCash = equityNo other assets or liabilities

Appropriate for:Small, closely-held businesses Sole proprietors

Combination of cash basis and accrual basis

Modifications have support by GAAP

Modified Cash Basis Financial Statements

Common and acceptable modifications to cash basis is recognizing:

InventoryProperty, Plant and Equipment (PP&E)

Along with depreciation or amortizationIncome taxes and other payablesAccounts receivableInterest-bearing payables

Along with interest expense and interest payable

Modified Cash Basis Financial Statements



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Income Tax Basis Financial StatementsBased on income tax rules and regulations

Taxable amount = RevenueDeductible amount = Expense

Certain nontaxable and nondeductible items included as revenues or expenses

Muni bond interest receivedLife Insurance premiums on officersFines

Possible changes due to IRS findings should be disclosed in notes.

Other Regulatory BasisStructured to comply with regulatory requirements

State Insurance Regulatory AgencyPublic Utility Regulatory Agency

Use should be restricted to the filing entity and the regulatory agency


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Private Company Council


Private Company CouncilWhat do you need to know?

The purpose of PPCDefinition / characteristics of a public business entityWhat accounting standards are modified

Purpose of the Private Company CouncilThe Private Company Council (PCC) works with the FASB to identify where alternative accounting for private companies is needed.The PCC develops proposed modifications for FASB approval.

The trade off is relevance of the information vs cost-benefit.

Users of the financial statements of public vs private companies



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Public Business EntityAn entity required to file or furnish financial statements with the SEC or other regulatory agencies

An entity required to make US GAAP statements publicly available on a periodic basis

The consolidated subsidiary of a public entity is not considered a public entity other than the information presented with the parent company.

GoodwillGoodwill should be amortized on a straight-line basis over 10 years, or less than 10 years if it is appropriate.Assign goodwill to a reporting unitTested for impairment when a triggering event occurs.

If there is a triggering event, the entity applies the normal impairment testing, including the pre-test option.

Intangibles Acquired in Business Combination

Not required to recognize separately from goodwill certain intangibles that cannot be sold or licensed independent from the business

Customer contracts, customer relationships, and non-compete agreements

Must recognize other intangibles that are 1) separable or 2) contractual or legal such as copyrights, trademarks, and customer lists



221

Intangibles Acquired in Business Combination (continued)

If the private company elects this guidance it must also adopt the good will accounting alternative to amortize goodwill over a period not to exceed 10 years.

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