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PFST08

SELFSTUDY CONTINUING PROFESSIONAL EDUCATION

Companion to PPC's Guide to

Preparing Financial Statements

Fort Worth, Texas (800) 3238724 trainingcpe.thomson.com

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Copyright 2008 Thomson Reuters/PPC All Rights Reserved

This material, or parts thereof, may not be reproduced in another document or manuscript in any form without the permission of the publisher.

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations. The following are registered trademarks filed with the United States Patent and Trademark Office: PPC's eToolsr PPC's ePractice Aidsr PPC's eWorkpaperst PPC's Engagement Letter Generatort PPC's Interactive Disclosure Librariest PPC's SMART ePractice Aidst Practitioners Publishing Company is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be addressed to the National Registry of CPE Sponsors, 150 Fourth Avenue North, Suite 700, Nashville, TN 372192417. Website: www.nasba.org. Practitioners Publishing Company is registered with the National Association of State Boards of Accountancy (NASBA) as a Quality Assurance Service (QAS) sponsor of continuing professional education. State boards of accountancy have final authority on acceptance of individual courses for CPE credit. Complaints regarding QAS program sponsors may be addressed to NASBA, 150 Fourth Avenue North, Suite 700, Nashville, TN 372192417. Website: www.nasba.org. Registration Numbers New Jersey 20CE00206800 (CE 2068) New York 001076 NASBA Registry 103166 NASBA QAS 006

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Interactive Selfstudy CPE Companion to PPC's Guide to PREPARING FINANCIAL STATEMENTS


TABLE OF CONTENTS Page COURSE 1: THE STATEMENT OF CASH FLOWS Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lesson 1: Lesson 2: Lesson 3: General Considerations for the Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . Basic Elements of the Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noncash Activities and Preparing a Cash Flow Statement . . . . . . . . . . . . . . . . . . . . . . . . 1 3 17 53 77 85 87

Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COURSE 2: COMMON PROBLEMS IN PREPARING NOTES TO FINANCIAL STATEMENTS Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lesson 1: Lesson 2: Lesson 3: General Considerations for Financial Statement Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . Common Problems Associated with Preparing Disclosures . . . . . . . . . . . . . . . . . . . . . . Risks and Uncertainties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 91 104 158 187 196 199

Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Page COURSE 3: THE STATEMENT OF INCOME Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lesson 1: Lesson 2: Lesson 3: General Considerations Related to the Statement of Income . . . . . . . . . . . . . . . . . . . . . The Accounting and Presentation of Certain Expenses Related to the Statement of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income Tax Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 203 232 261 293 300 303

Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COURSE 4: PREPARING FINANCIAL STATEMENTS: ASSETS Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lesson 1: Lesson 2: Lesson 3: Lesson 4: Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Longterm Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible Assets, Other Deferred Costs and Longlived Assets . . . . . . . . . . . . . . . . . . 305 307 339 356 378 399 409 411

Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ANSWER SHEETS AND EVALUATIONS Course 1: Examination for CPE Credit Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 1: Selfstudy Course Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 2: Examination for CPE Credit Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 2: Selfstudy Course Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 3: Examination for CPE Credit Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 3: Selfstudy Course Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 4: Examination for CPE Credit Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 4: Selfstudy Course Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413 414 415 416 417 418 419 420

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INTRODUCTION
Companion to PPC's Guide to Preparing Financial Statements consists of four interactive selfstudy CPE courses. These are companion courses to PPC's Guide to Preparing Financial Statements designed by our editors to enhance your understanding of the latest issues in the field. To obtain credit, you must complete the learning process by submitting your Examination for CPE Credit Answer Sheet by logging on to our Online Grading System or by mailing your completed answer sheet for print grading by December 31, 2009. Complete instructions are included below and in the Test Instructions preceding the Examination for CPE Credit. Taking the Courses Each course is divided into lessons. Each lesson addresses an aspect of financial statement preparation. You are asked to read the material and, during the course, to test your comprehension of each of the learning objectives by answering selfstudy quiz questions. After completing each quiz, you can evaluate your progress by comparing your answers to both the correct and incorrect answers and the reason for each. References are also cited so you can go back to the text where the topic is discussed in detail. Qualifying Credit HoursQAS or Registry PPC is registered with the National Association of State Boards of Accountancy as a sponsor of continuing professional education on the National Registry of CPE Sponsors (Registry) and as a Quality Assurance Service (QAS) sponsor. Part of the requirements for both Registry and QAS membership include conforming to the Statement on Standards of Continuing Professional Education (CPE) Programs (the standards). The standards were developed jointly by NASBA and the AICPA. As of this date, not all boards of public accountancy have adopted the standards. Each course is designed to comply with the standards. For states adopting the standards, recognizing QAS hours or Registry hours, credit hours are measured in 50minute contact hours. Some states, however, require 100minute contact hours for self study. Your state licensing board has final authority on accepting Registry hours, QAS hours, or hours under the standards. Check with the state board of accountancy in the state in which you are licensed to determine if they participate in the QAS program or have adopted the standards and allow QAS CPE credit hours. Alternatively, you may visit the NASBA website at www.nasba.org for a listing of states that accept QAS hours or have adopted the standards. Credit hours for CPE courses vary in length. Credit hours for each course are listed on the Overview" page before each course. CPE requirements are established by each state. You should check with your state board of accountancy to determine the acceptability of this course. We have been informed by the North Carolina State Board of Certified Public Accountant Examiners and the Mississippi State Board of Public Accountancy that they will not allow credit for courses included in books or periodicals. Obtaining CPE Credit Online Grading. Log onto our Online Grading Center at OnlineGrading.Thomson.com to receive CPE credit. Click the purchase link and a list of exams will appear. You may search for the exam using wildcards. Payment for the exam is accepted over a secure site using your credit card. For further instructions regarding the Online Grading Center, please refer to the Test Instructions located at the beginning of the examination. A certificate documenting the CPE credits will be issued for each examination score of 70% or higher. Please take a few minutes to complete the Course Evaluation so that we can provide you with the best possible CPE. Print Grading. You can receive CPE credit by mailing your completed Examination for CPE Credit Answer Sheet to the Tax & Accounting business of Thomson Reuters for grading. Answer sheets are bound into the printed course materials. For the CDROM products, answer sheets may be printed. The answer sheet is identified with the course acronym. Please ensure you use the correct answer sheet for each course. Payment of $75 (by check or credit card) must accompany each answer sheet submitted. We cannot process answer sheets that do not include payment. If more than one person wants to complete this selfstudy course, each person should complete a separate Examination for CPE Credit Answer Sheet. Payment of $75 must accompany each answer sheet submitted. We would also appreciate a separate Course Evaluation from each person who completes an examination. v

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Express Grading. An express grading service is available for an additional $24.95 per examination. Course results will be faxed to you by 5 p.m. CST of the business day following receipt of your Examination for CPE Credit Answer Sheet. Expedited grading requests will be accepted by fax only if accompanied with credit card information. Retaining CPE Records For all scores of 70% or higher, you will receive a Certificate of Completion. You should retain it and a copy of these materials for at least five years. PPC InHouse Training A number of inhouse training classes are available that provide up to eight hours of CPE credit. Please call our Sales Department at (800) 3238724 for more information.

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Companion to PPC's Guide to Preparing Financial Statements

COMPANION TO PPC'S GUIDE TO PREPARING FINANCIAL STATEMENTS

COURSE 1 THE STATEMENT OF CASH FLOWS (PFSTG081)


OVERVIEW COURSE DESCRIPTION: This interactive selfstudy course examines the statement of cash flows in detail. Users will learn the basic format and presentation of the statement of cash flows, as well as examining cash flows from operating activities, cash flows from investing activities, cash flows from financing activities, noncash activities, and issues related to each. October 2008 Users of PPC's Guide to Preparing Financial Statements Basic knowledge of financial statements. 5 QAS Hours, 5 Registry Hours Check with the state board of accountancy in the state in which you are licensed to determine if they participate in the QAS program and allow QAS CPE credit hours. This course is based on one CPE credit for each 50 minutes of study time in accordance with standards issued by NASBA. Note that some states require 100minute contact hours for self study. You may also visit the NASBA website at www.nasba.org for a listing of states that accept QAS hours. FIELD OF STUDY: EXPIRATION DATE: KNOWLEDGE LEVEL: LEARNING OBJECTIVES: Lesson 1General Considerations for the Statement of Cash Flows Completion of this lesson will enable you to:  Identify basic considerations related to a statement of cash flows, including when the statement should be presented, the definition of cash, and the types of cash flows.  Use correct form and style for the statement of cash flows. Lesson 2Basic Elements of the Statement of Cash Flows Completion of this lesson will enable you to:  Identify and report cash flows from operating activities.  List and calculate cash flows from investing activities.  Identify and compute cash flows from financing activities.  Compare and contrast the three different types of cash flows. Lesson 3Noncash Activities and Preparing a Cash Flow Statement Completion of this lesson will enable you to:  Distinguish and report noncash investing and financing activities.  Assess the direct and indirect methods for preparing cash flow statements. Accounting Postmark by December 31, 2009 Basic

PUBLICATION/REVISION DATE: RECOMMENDED FOR: PREREQUISITE/ADVANCE PREPARATION: CPE CREDIT:

Companion to PPC's Guide to Preparing Financial Statements

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TO COMPLETE THIS LEARNING PROCESS: Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to: Thomson Reuters Tax & AccountingR&G PFSTG081 Selfstudy CPE P .O. Box 966 Fort Worth, TX 76101 See the test instructions included with the course materials for more information. ADMINISTRATIVE POLICIES: For information regarding refunds and complaint resolutions, dial (800) 3238724 for Customer Service and your questions or concerns will be promptly addressed.

PFST08

Companion to PPC's Guide to Preparing Financial Statements

Lesson 1:General Considerations for the Statement of Cash Flows


Introduction
Statement of Financial Accounting Standards No. 95, Statement of Cash Flows (FASB ASC 23010153), requires a cash flow statement to be presented as part of a full set of financial statements. This course discusses these requirements, including the presentation of specific types of transactions in cash flow statements and the disclo sure of noncash transactions. The course also illustrates alternative formats for presenting cash flow statements that are permitted. Learning Objectives: Completion of this lesson will enable you to:  Identify basic considerations related to a statement of cash flows, including when the statement should be presented, the definition of cash, and the types of cash flows.  Use correct form and style for the statement of cash flows.

BASIC INFORMATION RELATED TO THE STATEMENT OF CASH FLOWS


When to Present the Statement SFAS No. 95 (FASB ASC 23010153) requires a statement that shows a company's cash receipts and payments during a period, classified by principal sources and uses, to be presented as a basic financial statement when each of the following conditions is met: a. The Company Is a Profitoriented Business Enterprise or Nonprofit Organization. Cash flow statement requirements do not apply to financial statements of individuals. b. The Financial Statements Are Prepared in Accordance with Generally Accepted Accounting Principles. A statement of cash flows is not required if the financial statements are prepared on a basis of accounting other than GAAP , e.g., cash basis or income tax basis. c. Both a Balance Sheet and an Income Statement Are Presented. If a balance sheet or an income statement is presented separately, a statement of cash flows is not required. All companies meeting the preceding criteria [except certain employee benefit plans and investment enterprises as provided in SFAS No. 102 (FASB ASC 23010154)] are required to present a statement of cash flows regardless of their legal form, e.g., proprietorships, partnerships, S corporations, or regular corporations, or whether they normally classify their assets and liabilities as current and noncurrent. The requirement applies to both interim and annual financial statements. How Cash Is Defined A statement of cash flows shows the change in cash and cash equivalents during the period. Cash and cash equivalents are defined in SFAS No. 95 as shown in Exhibit 11.

Companion to PPC's Guide to Preparing Financial Statements

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Exhibit 11 SFAS No. 95 Definitions of Cash and Cash Equivalents CASH Definition [SFAS No. 95 (FASB ASC 2301020), footnote 1] . . . cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. . . . ExamplesCertificates of deposit,a money market accounts, and repurchase agreements that have the characteristics described above. CASH EQUIVALENTS Definition [SFAS No. 95 (FASB ASC 2301020), Paragraph 8] . . . shortterm, highly liquid investments that (a) are readily convertible to known amounts of cash and (b) are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates.

Examples Treasury bills, commercial paper, money market accounts that are not classified as cash, and other shortterm investments whose original maturity is three months or less.b (Note that equity securities never meet the definition of cash equivalents.)

Notes:
a

If penalties associated with certificates of deposit or money market accounts are material or if stated terms effectively restrict withdrawal of funds, the funds should be classified as cash equivalents or investments, depending on their maturities. Only those investments that mature three months or less from the date they were purchased qualify as cash equivalents. For example, a threemonth Treasury bill and a threeyear Treasury note purchased three months from maturity both qualify as cash equivalents. A Treasury note purchased three years ago does not become a cash equivalent when its remaining maturity is three months, however.

Some companies do not include cash overdrafts in the definition of cash. Instead, they consider overdrafts to be current liabilities similar to accounts payable. Thus, they present cash overdrafts as an operating activity in the statement of cash flows. This course maintains, however, that a cash overdraft should be included in the definition of cash. Although there is a financing element to a cash overdraft, the time required for the overdraft to be eliminated is insignificant. While cash overdrafts are believed to generally have such short lives that they are not analogous to accounts payable and should be treated as cash and cash equivalents in the statement of cash flows, this course recognizes that this opinion conflicts with an AICPA Technical Practice Aid at TIS 1300.15. AICPA Technical Practice Aids are not authoritative. They are issued by AICPA staff without action by a recognized standardsetting body and thus are not a source of established GAAP . Either method of presenting cash overdrafts is acceptable. Accountants should exercise professional judgment when preparing the statement of cash flows and present cash overdrafts in a manner appropriate to the entity's unique facts and circumstances. Paragraph 7 of SFAS No. 95 requires that the total amounts of cash and cash equivalents at the beginning and end of the period agree with similarly titled line items or subtotals shown in the balance sheets. If the balance sheet reports a single net negative cash balance in its liabilities, the captions in the statement of cash flows should be revised accordingly [for example, Cash (cash overdraft) at end of year]. If the balance sheet for a single year reports 4

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Companion to PPC's Guide to Preparing Financial Statements

both a positive balance in its assets and a negative balance in its liabilities, it is believed that a reconciliation should be provided. Cash restricted for special purposes should be segregated from cash available for general operations and, normally, should be excluded from current assets. Accordingly, it is believed that restricted cash should be excluded from the definition of cash and cash equivalents. The classification of changes within the balance should be consistent with the classification in the balance sheet. To illustrate, assume net cash of $1,000,000 is received from the issuance of industrial development bonds. At the end of the year, $700,000 has been disbursed for property and equipment, leaving a balance of $300,000 in the restricted cash account. The cash should be included in constructioninprogress. Therefore, the entire amount of the proceeds would be reported as a noncash financing and investing activity. Throughout this course, the term cash is used to include cash equivalents. (Distinguishing between cash equiva lents and shortterm investments is discussed in Lesson 2.) Basic Elements A statement of cash flows has five basic elements:  Cash flows from operating activities  Cash flows from investing activities  Cash flows from financing activities  Net change in cash during the period  Supplemental disclosure of noncash investing and financing activities Accordingly, all cash receipts and payments should be classified as operating, investing, or financing activities, and noncash transactions involving investing and financing activities, such as acquiring assets by assuming liabilities, should be disclosed separately rather than within the body of the statement. Types of Cash Flows. Exhibit 12 shows how a typical company's transactions would be classified into operating, investing, and financing activities according to the GAAP criteria. Cash receipts and payments should be classified according to their nature without regard to whether they stem from items intended as hedges of other items. Cash flows from derivative instruments accounted for as a fair value hedge or cash flow hedge may be classified in the same category as cash flows from the item being hedged, provided that such an accounting policy is disclosed and the instrument does not contain a financing element that is other than insignificant. If hedge accounting is discontinued for an instrument that hedges an identifiable transaction or event, any cash flows subsequent to the date of discontinuance should be classified consistent with the nature of the derivative instrument. In June 2008, the FASB issued a proposed SFAS, Accounting for Hedging Activitiesan amendment of FASB Statement No. 133. The proposed standard would eliminate (with two exceptions) the ability of an entity to designate individual risks as the hedged risk in a fair value or cash flow hedge. The exceptions are that an entity would continue to be able to designate the following individual risks as the hedged risk in a fair value or cash flow hedge: (a) interest rate risk related to its own issued debt (that is, its liability for funds borrowed), if hedged at inception, and (b) foreign currency exchange risk. The proposed standard would continue to require that hedge accounting be discontinued if a hedge becomes ineffective but an entity would no longer have the ability upon compliance with strict criteria to assume a hedging relationship is highly effective and recognize no ineffectiveness in earnings during the term of the hedge. The proposed standard would be effective for financial statements issued for fiscal years beginning after June 15, 2009, and interim periods within those fiscal years. Early application would not be permitted. A final standard is expected to be issued in the first quarter of 2009.

Exhibit 12 Types of Cash Flows STATEMENT OF CASH FLOWS OPERATING INVESTING FINANCING CASH RECEIPTS FROM: CASH RECEIPTS FROM: CASH RECEIPTS FROM:  Sale of goods and services  Sale of property and equip  Shortterm borrowings  Shortterm and longterm ment  Longterm borrowings notes receivable from cus  Sale of securities  Issuance of stock tomers arising from sales of  Collections on loans goods or services  Insurance proceeds relating  Interest and dividends to transactions classified as  Other cash receipts not aris investing ing from investing or financ ing activities, such as amounts received to settle lawsuits or refunds from suppliers CASH PAYMENTS FOR: CASH PAYMENTS FOR: CASH PAYMENTS FOR:  Inventory  Property and equipment  Dividends  Shortterm and longterm (including capitalized inter  Repayment of amounts bor notes payable to suppliers est) rowed, e.g., shortterm debt, for materials or goods  Securities longterm debt, and capital  Wages  Loans to others lease obligations  Other operating expenses  Treasury stock  General and administrative expenses  Interest (excluding amounts capitalized)  Settlement of an asset retirement obligation  Taxes  Other cash payments not related to investing or financing activities, such as cash contributions and cash refunds to customers 6 NONCASH INVESTING AND FINANCING TRANSACTIONS  Acquiring nonoperating assets, e.g., property and equipment or a subsid iary, by assuming liabilities or exchanging assets  Issuing stock in exchange for sub scriptions receivable or other noncash consideration  Converting debt to equity or one class of stock to another, e.g., common to preferred  Stock dividends or distributions of property as dividends  Converting g notes receivable to invest ments t

Companion to PPC's Guide to Preparing Financial Statements


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Companion to PPC's Guide to Preparing Financial Statements

Gross and Net Cash Flows Gross cash flows from investing and financing activities are generally required to be reported rather than net amounts. Thus, for example, cash flow statements would show the following amounts: Investing Activities  Proceeds from sales of assets and cash payments for capital expenditures rather than the net change in property and equipment  Proceeds from sales and maturities of securities and purchases of securities, rather than the net change in, those investments.  Loans made and collections on loans rather than the net change in notes and loans receivable Financing Activities  Proceeds from longterm borrowings and repayments of longterm obligations (including capital lease obligations) rather than the net change in longterm debt  Proceeds from shortterm debt and payments to settle shortterm debt rather than the net change in shortterm debt when the debt term exceeds three months While the general rule calls for reporting gross cash flows, reporting net cash flows from the following activities is permitted: a. Cash receipts and payments from purchasing and selling cash equivalents b. Cash receipts and payments related to investments (other than cash equivalents), loans receivable, and debt when the original maturity of the asset or liability is three months or less (amounts due on demand and credit card receivables of financial services operations are considered to be loans with original maturities of three months or less.) c. Cash receipts and payments from agency transactions (that is, transactions for which the company is holding or disbursing cash on behalf of its customers) d. For certain financial institutions, cash receipts and payments related to: Deposits placed with other financial institutions Customer time deposits Loans made to customers Although reporting net cash flows from the preceding activities is permitted, netting is not required. Presenting gross cash flows for those activities may be preferable in some instances. For example, it may create an unneces sary recordkeeping burden to segregate cash flows from investments with a maturity of three months or less from those of investments with longer maturities. Should cash flows from revolving lines of credit be presented on a gross or net basis? A difference of opinion exists among CPAs in practice. Some firms have taken the position that there must be a series of 90day notes for the cash flows to be presented net. If the borrower signs a single note with a term of more than three months for the maximum amount of the line of credit, they believe that gross amounts are required to be presented. Others, however, present all cash flows related to revolving lines of credit net. Either method is believed acceptable.

Companion to PPC's Guide to Preparing Financial Statements

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Companion to PPC's Guide to Preparing Financial Statements

SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 1. Which of the following is generally considered a cash equivalent? a. Treasury bills. b. Certificates of deposits. c. Money market accounts. d. Equity securities. 2. Harold is preparing a statement of cash flows for an S corporation that uses generally accepted accounting principles (GAAP). How should he treat a transaction that occurred when the corporation acquired assets by assuming liabilities? a. He should disclose the transaction in the body of the statement. b. He should disclose the transaction separately. c. He should classify the transaction as an operating activity. d. He should classify the transaction as an investing or financing activity. 3. Which of the following scenarios correctly illustrates how net and gross cash flows should be dealt with on the statement of cash flows, based on the guidance in GAAP? a. AlphaCo presents the net change in property and equipment. b. BetaCorp presents loans made and collections on loans. c. Gamma2 presents the net change in longterm debt. d. Delta Lenders presents the gross amount of customer time deposits.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 1. Which of the following is generally considered a cash equivalent? (Page 4) a. Treasury bills. [This answer is correct. A cash equivalent is a shortterm, highly liquid investment that is so near maturity that risks of changes in value due to interest rate changes are insignificant, and that is readily convertible to a known amount of cash.] b. Certificates of deposits. [This answer is incorrect. Typically, a certificate of deposit would be considered cash, not a cash equivalent, unless penalties associated with the certificate of deposit are material or stated terms restrict the withdrawal of funds.] c. Money market accounts. [This answer is incorrect. Unless stated terms restrict the withdrawal of funds or penalties associated with the account are material, a money market account would be considered cash, not a cash equivalent.] d. Equity securities. [This answer is incorrect. Equity securities never meet the definition of a cash equivalent. Only a shortterm investment with an original maturity of three months or less would meet the definition of cash equivalent fund.] 2. Harold is preparing a statement of cash flows for an S corporation that uses generally accepted accounting principles (GAAP). How should he treat a transaction that occurred when the corporation acquired assets by assuming liabilities? (Page 5) a. He should disclose the transaction in the body of the statement. [This answer is incorrect. This acquisition would be considered a noncash transaction that involves investing and financing activities. It should not be disclosed in the body of the statement.] b. He should disclose the transaction separately. [This answer is correct. Acquiring assets by assuming liabilities is a noncash transaction involving investing and financing activities. Harold must disclose it separately, not within the body of the statement of cash flows.] c. He should classify the transaction as an operating activity. [This answer is incorrect. Classifying a transaction as an operating activity is one option when Harold is dealing with cash receipts and payments. The acquisition described in the scenario above is a noncash transaction.] d. He should classify the transaction as an investing or financing activity. [This answer is incorrect. These are two of the ways Harold can classify cash receipts and payments. Because the type of acquisition described above is a noncash transaction involving investing and financing activities, Harold must deal with it differently.] 3. Which of the following scenarios correctly illustrates how net and gross cash flows should be dealt with on the statement of cash flows, based on the guidance in GAAP? (Page 7) a. AlphaCo presents the net change in property and equipment. [This answer is incorrect. In this scenario, GAAP requires AlphaCo to present proceeds from sales of assets and cash payments for capital expenditures.] b. BetaCorp presents loans made and collections on loans. [This answer is correct. Based on the guidance found in GAAP , BetaCorp has correctly presented gross cash flows for investing activities instead of net amounts.]

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c. Gamma2 presents the net change in longterm debt. [This answer is incorrect. GAAP requires Gamma2 to present proceeds from longterm borrowings and repayments of longterm obligations in this scenario.] d. Delta Lenders presents the gross amount of customer time deposits. [This answer is incorrect. GAAP allows the presentation of net cash flows for (1) customer time deposits, (2) deposits placed with other financial institutions, and (3) loans made to customers.]

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FORM AND STYLE CONSIDERATIONS FOR THE STATEMENT OF CASH FLOWS


Required Format Cash flow statements should report the total amounts of cash and cash equivalents at the beginning and end of the period, and those amounts should be the same as similarly titled line items or subtotals in the balance sheet as of those dates. In other words, the net change in cash during the period should be added to cash at the beginning of the period to obtain cash at the end of the period. While it is anticipated that most preparers will follow the ending cash format, they may revise the format of the statement to begin with cash at beginning of year." Title GAAP does not specify a title for statements of cash flows. This course recommends the title Statement of Cash Flows." Order of Presentation The order for presenting operating, investing, and financing activities in statements of cash flows is not addressed in GAAP . However, it is believed that most companies report cash flows from operations first. A good method would be to follow the format used in the illustrations included in SFAS No. 95 (FASB ASC 2301055) and, thus, to show investing activities following operations and to present financing activities last. It also is acceptable, however, to present financing activities before investing activities. Captions Because cash flow statements are classified according to cash flows from operating, investing, and financing activities, captions are used to identify each section. Some typical examples are as follows:  Cash Flows from Operating Activities, Cash Flows from Investing Activities, Cash Flows from Financing Activities  Cash Provided by (Used by) Operations, Cash Provided by (Used by) Investments, Cash Provided by (Used by) Financing  Operations, Investments (or Investment Activities), Financing (or Financing Activities) This Course's Policy. Throughout this course the captions Cash Flows from Operating Activities," Cash Flows from Investing Activities," and Cash Flows from Financing Activities" are used to identify each section because those captions are used by many companies and are used in the illustrative cash flow statements in the appendix to SFAS No. 95 (FASB ASC 2301055). In addition, for each classification of cash flows, i.e., operating, investing, and financing, a captioned subtotal shows the net cash flow provided or used by that classification. The caption Net Increase (Decrease) in Cash" is used to identify the change in cash during the period. Comparative Presentations. Captions used within the cash flow statement should be modified when comparative financial statements are presented and the net results in each period are not the same, such as net income in one period and a net loss in another or an increase in cash in one period and a decrease in cash in another. The following comparative statement illustrates captions that may be used.

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20X2 CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities Depreciation (Gain) loss on the sale of equipment (Increase) decrease in: Trade accounts receivable Inventories Increase (decrease) in: Trade accounts payable Accrued liabilities NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES CASH FLOWS FROM INVESTING ACTIVITIES Purchase of equipment Proceeds from sale of equipment NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES CASH FLOWS FROM FINANCING ACTIVITIES Longterm borrowings Reduction of longterm debt Dividends paid NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES NET INCREASE (DECREASE) IN CASH CASH AT BEGINNING OF YEAR CASH AT END OF YEAR $ $ (38,000 ) $ 12,100 2,000 (7,500 ) 2,000 8,000 (7,200 ) (28,600 ) (6,000 ) 16,800 10,800 7,500 (4,500 ) 3,000 (14,800 ) 39,150 24,350 $

20X1 20,000 14,100 (3,300 ) 1,500 3,400 (6,300 ) 2,650 32,050 (18,700 ) 14,000 (4,700 ) (6,900 ) (8,600 ) (15,500 ) 11,850 27,300 39,150

When comparative statements are presented, grouping immaterial items under an other" caption is recom mended, even if they were presented separately in prior years. Making the Statement Understandable The following matters also should be considered when preparing cash flow statements:  Except for requiring that the operating activities section start with net income when the indirect method is used, GAAP does not address the order in which items should appear within the operating, investing, and financing sections of the statement of cash flows. The operating activities section under the indirect method usually first adjusts net income for noncash income and expenses, then for changes in operating assets, and finally for changes in operating liabilities. While there is more variety in the presentation of cash flows from investing and financing activities, three approaches are common in practice(a) presenting the changes in the order in which the assets and liabilities appear in the statement of financial position, (b) presenting items in the order of significance, and (c) presenting payments together and receipts together. The method used should be the one that is likely to be the easiest for the primary users to understand.  Related or immaterial items should be grouped. Certain items may be shown separately when material and combined in an other" caption when not material. 13

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 Subtotals should be used to show cash flows from operating, investing, and financing activities except when a category consists of a single item.  Preferably, the entire statement should be presented on one page. If more detail is required for adequate disclosure, it may be included in the notes to the financial statements or in a separate schedule.  Disclosures made in other financial statements or in the notes need not be repeated. Similarly, disclosures made on the face of the cash flow statement, for example, depreciation for the period, need not be repeated. Reclassification and Restatements Reclassifications of amounts between current and noncurrent assets and liabilities, either because of changes in conditions or because of classification errors in prior years, may affect the statement of cash flows. The following paragraphs present recommendations for handling reclassifications. Reclassifications Resulting from Changed Conditions. Reclassifications resulting from changed conditions represent the effects of noncash activities and, thus, would not affect statements of cash flows. For example, reclassifying a longterm liability to current liabilities as a result of a violation of restrictive covenants does not affect cash and, accordingly, would not be shown in the cash flow statement. It is also believed that the reclassification need not be shown in the schedule summarizing noncash investing and financing transactions because the effects of the transaction were previously recognized when the initial liability was incurred. The reclassifications, if material, also generally would be disclosed in the notes to the financial statements. However, priorperiod financial statements (balance sheet and statement of cash flows) presented for comparative purposes should not be restated. Classification Errors in Prior Years. Priorperiod financial statements presented for comparative purposes should be restated when reclassifications are made to correct errors in prior years. For example, if a demand note previously classified as longterm were reclassified because it is callable at the option of the creditor, priorperiod statements (balance sheet and statement of cash flows) should treat the amount as a current liability. Thus, the cash flow statement as originally presented would have shown cash flows from longterm borrowings, and the restated financial statements would show the cash flows from shortterm borrowings. (The reclassification also should be disclosed in the notes to the financial statements, if material.)

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 4. Which of the following correctly illustrates a required element of style and format for a statement of cash flows as required by GAAP? a. Gold Inc. reports the total amounts of cash and cash equivalents at the beginning and the end of the period on its cash flow statement. b. Silver Inc. only reports the net change in cash during the period on its statement of cash flows. c. Bronze Inc. uses Statement of Cash Flows" as the title of its statement of cash flows. d. Platinum Inc. presents comparative financial statements, and on its statement of cash flows it presents immaterial items separately as in previous years. 5. As a result of a violation of restrictive covenants, the Butterfield Company reclassifies a longterm liability to current liabilities. How will this change affect the company's statement of cash flows? a. Butterfield must restate comparative priorperiod financial statements. b. The reclassification must be disclosed in the notes to Butterfield's financial statements. c. The reclassification is shown in Butterfield's schedule summarizing noncash investing and financing transactions. d. Cash is not affected, so Butterfield's statement of cash flows will not be affected.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 4. Which of the following correctly illustrates a required element of style and format for a statement of cash flows as required by GAAP? (Page 12) a. Gold Inc. reports the total amounts of cash and cash equivalents at the beginning and the end of the period on its cash flow statement. [This answer is correct. Reporting the total amounts of cash and cash equivalents is required. The amounts should match those of similarly titled line items or subtotals on the balance sheet as of those dates.] b. Silver Inc. only reports the net change in cash during the period on its statement of cash flows. [This answer is incorrect. Silver Inc. should take the net change in cash during the period and add it to the cash at the beginning of the period, which will give the company the total amount of cash at the end of the period.] c. Bronze Inc. uses Statement of Cash Flows" as the title of its statement of cash flows. [This answer is incorrect. While this title is recommended by the course, it is not required by SFAS No. 95.] d. Platinum Inc. presents comparative financial statements, and on its statement of cash flows it presents immaterial items separately as in previous years. [This answer is incorrect. On comparative financial statements it is recommended that Platinum Inc. group immaterial items under an other" caption, even if they were separately presented in previous years.] 5. As a result of a violation of restrictive covenants, the Butterfield Company reclassifies a longterm liability to current liabilities. How will this change affect the company's statement of cash flows? (Page 14) a. Butterfield must restate comparative priorperiod financial statements. [This answer is incorrect. If the reclassification were made to correct an error from a prior year, this would be true; however, it is not necessary for the reclassification made by Butterfield in the scenario above.] b. The reclassification must be disclosed in the notes to Butterfield's financial statements. [This answer is incorrect. This would be necessary if (1) the effects of the reclassification were material and (2) the reclassification was made to correct an error from a prior year.] c. The reclassification is shown in Butterfield's schedule summarizing noncash investing and financing transactions. [This answer is incorrect. Because the transaction's effects were recognized when the initial liability was incurred, it is believed that the reclassification would not need to be shown on the schedule summarizing noncash investing and financing transactions.] d. Cash is not affected, so Butterfield's statement of cash flows will not be affected. [This answer is correct. A reclassification such as the one in the scenario above represents the effects of noncash activities; therefore, it would not affect the statement of cash flows, as cash is not affected.]

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Lesson 2:Basic Elements of the Statement of Cash Flows


Introduction
As discussed in Lesson 1, a statement of cash flows has five basic elements (a) cash flows from operating activities, (b) cash flows from investing activities, (c) cash flows from financing activities, (d) net change in cash during the period, and (e) supplemental disclosure of noncash investing and financing activities. This lesson discusses items (a)(c) and related issues in greater detail. Learning Objectives: Completion of this lesson will enable you to:  Identify and report cash flows from operating activities.  List and calculate cash flows from investing activities.  Identify and compute cash flows from financing activities.  Compare and contrast the three different types of cash flows.

CONSIDERATIONS FOR CASH FLOWS FROM OPERATING ACTIVITIES


What Is Included? SFAS No. 95 (FASB ASC 2301020) defines cash flows from operating activities by exception; operating activities include all transactions and events that are not investing or financing activities. Generally, however, operating activities meet the following three criteria: a. The amounts represent the cash effects of transactions or events. b. The amounts result from a company's normal operations for delivering or producing goods for sale and providing services. c. The amounts are derived from activities that enter into the determination of net income. Thus, cash flows from operating activities include cash received from sales of goods or services and cash used in generating the goods or services such as for inventory, personnel, and administrative and other operating costs. Accordingly, cash receipts from both shortterm and longterm notes receivables from customers arising from sales of goods or services are required to be classified as operating activities. Similarly, principal payments on custom ers' accounts and both shortterm and longterm notes payable to suppliers for materials or goods also should be classified as operating activities. In addition, interest and dividend income, interest expense, and cash payments to settle an asset retirement obligation are considered to be operating activities even though they are not precisely consistent with the preceding criteria. (In Issue No. 026 (FASB ASC 2304517), the EITF acknowledged that cash payments to settle an asset retirement obligation have traits of more than one class of cash flows. However, the EITF concluded that these payments should be classified as an operating activity in the statement of cash flows.) According to an AICPA Technical Practice Aid at TIS 5600.17, landlord incentive allowances in an operating lease should also be presented in the operating activities section of the lessee's statement of cash flows. The cash allowances from the lessor are treated for accounting purposes as adjustments of rent. (Exhibit 12 lists some typical examples of cash flows from operating activities.)

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What Is Excluded? Cash flows from operating activities exclude (a) amounts that are not derived from cash receipts and cash payments, such as accruals, deferrals, and allocations such as depreciation, and (b) amounts that are considered to be derived from investing or financing activities rather than from operations, such as cash receipts and payments related to property and equipment and dividends paid. Basic Format Cash flows from operations may be presented in either of two basic formats: the direct method or the indirect method. Most preparers use the indirect method. The following paragraphs describe both methods and explain their advantages and disadvantages. Direct Method. The direct method begins with cash receipts and deducts cash payments for operating costs and expenses, individually listing the cash effects of each major type of revenue and expense. At a minimum, the following categories of cash receipts and cash payments are required to be presented:  Cash collected from customers, including lessees and licensees  Interest and dividends received  Other operating cash receipts, if any  Cash paid to employees and other suppliers of goods or services, including suppliers of insurance and advertising  Interest paid  Income taxes paid  Other operating cash payments, if any Because the direct method explicitly shows only cash receipts and payments, no adjustments are necessary for noncash expenses such as depreciation or deferred income taxes. An example of the direct method is as follows: CASH FLOWS FROM OPERATING ACTIVITIES Cash received from customers Interest received Cash paid to suppliers and employees Cash paid to settle lawsuit Interest paid Income taxes paid NET CASH PROVIDED BY OPERATING ACTIVITIES $ 348,000 1,950 349,950 273,000 11,700 5,600 11,000 301,300 48,650

If the direct method is used, a reconciliation of net income to cash flows from operating activities is required to be presented in a separate schedule showing all major classes of operating items, including, at a minimum, changes in receivables and payables related to operating activities and changes in inventory. Proponents of the direct method believe it is preferable because it shows the actual sources and uses of cash from operations. In addition, some accountants believe the statement of cash flows is easier to understand because there is no need to adjust for noncash items such as depreciation. The direct method may be preferable to the indirect method in the following circumstances:  Information required for the direct method is readily available or can be obtained without significant cost. 18

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 There are numerous reconciling items between net income and cash flows from operations making the indirect presentation cluttered and cumbersome to analyze.  Management or banks with which the company obtains financing find the relationship of specific cash receipts and payments to cash flows from operations useful for making decisions. The direct method is not used by many companies, however, and it is generally believed that it will take more time to prepare a statement using the direct method than using the indirect method. Additional time is necessary because a separate reconciliation of net income to operating cash flows is required, thus presenting operating cash flows both directly and indirectly. Nevertheless, some clients may find cash flow statements that use the direct method easier to understand and, in those cases, recommend its use. Indirect Method. The indirect method starts with net income and adjusts for (a) noncash items such as depreciation and deferred income taxes and (b) changes during the period in operating current assets and liabilities. (As explained previously, the reconciliation should show all major classes of operating items, including, at a minimum, changes in receivables and payables related to operating activities and changes in inventory. Although SFAS No. 95 (FASB ASC 230104529) literally requires presenting changes in receivables, payables, and inventory separately in the reconciliation, some firms believe that amounts could be combined if they would affect a single line item under the direct method, such as increase in accounts payable and accrued expenses. The FASB considered whether operating cash flows should be reconciled to comprehensive income rather than net income. However, the FASB decided that the statement of cash flows should continue to reconcile operating activities to net income.) Note that net income should only be adjusted for changes in operating current assets and liabilities. Changes in current assets and liabilities that arise from investing or financing activities (for example, shortterm loans or notes receivable or payable not related to sales of goods or services) should be shown as investing or financing activities, as appropriate. In addition, accounts payable may have aspects of financing or investing activities, for example, dividends payable or equipment purchased on account. In those cases, it would not be appropriate to include the net change in payables as an adjustment in arriving at cash flows from operations. An example of the indirect method is as follows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation Gain on the sale of equipment (Increase) decrease in: Trade accounts receivable Inventories Prepaid expenses Increase (decrease) in: Trade accounts payable Accrued liabilities Income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES $ 223,000 29,400 (6,700 ) (10,200 ) 26,450 4,100 37,250 (9,500 ) 4,300 298,100

Items that reconcile net income to net cash flows from operating activities are allowed to be presented in the statement of cash flows itself, as illustrated in the preceding paragraph, or in a separate schedule. If the reconciling items were presented in a separate schedule, the cash flow statement would show a single line item for cash flows from operations such as the following: Net Cash Flows from Operating Activities $ 298,100

In that case, a separate schedule would present a reconciliation of net income with net operating cash flows such as: 19

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RECONCILIATION OF NET INCOME TO NET CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation Gain on the sale of equipment (Increase) decrease in: Trade accounts receivable Inventories Prepaid expenses Increase (decrease) in: Trade accounts payable Accrued liabilities Income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES $ 223,000 29,400 (6,700 ) (10,200 ) 26,450 4,100 37,250 (9,500 ) 4,300 $ 298,100

Regardless of whether the direct or indirect method is used, interest and income taxes paid are required to be disclosed. Recommendations for those disclosures include the following: a. Interest payments generally can be derived by adjusting interest charged to operations by the change in accrued interest expense. b. SFAS No. 95 (FASB ASC 23010502) requires interest paid, net of amounts capitalized, to be disclosed. Since interest paid is classified as an operating activity, the objective of the disclosure is to allow financial statement users to consider interest paid as a financing cash outflow if that better suits their purposes. Thus, the amount to be disclosed is the amount of interest reflected in operating cash outflows. If interest is capitalized as part of the cost of property and equipment, the amount capitalized should be subtracted in calculating the interest payments to disclose. The resulting amount is the interest payments that are classified as an operating cash disbursement. However, interest paid and capitalized as part of an inventory type item is considered an operating cash outflow, and, accordingly, total payments need not be reduced for amounts capitalized. The following examples illustrate how to calculate the amount of interest to disclose: Assume that a homebuilder pays interest of $130,000, the amount of interest capitalized as cost of homes under construction increases by $20,000, accrued interest expense decreases by $30,000, and interest charged to operations is $80,000. Interest payments of $130,000 are reflected in cash outflows from operations ($80,000 charged to operations plus the total of $20,000 increase in capitalized interest and $30,000 decrease in accrued interest), and $130,000 should be disclosed as interest paid. It is not necessary to reduce that amount by the amount of interest capitalized since it is an inventory type item. If interest payments total $75,000 and interest of $30,000 is capitalized as a cost of constructing a building, cash flows from operations reflect interest payments of $45,000. Thus, $45,000 should be disclosed as interest paid. (Normally, the amount of interest capitalized is calculated using interest costs determined on the accrual basis; it is not based on payments, and accrued interest is not allocated between capitalized amounts and amounts charged to earnings. Therefore, it is believed appropriate to determine the amount to disclose by subtracting the amount of interest capitalized from total interest payments. Disclosing the amount of interest payments capitalized is not required.) c. The disclosure of income taxes paid should include all taxes that are included in the company's income tax provision. Since financial statements for partnerships and, generally, S corporations do not include income tax provisions, no disclosure is usually required for those entities. Accordingly, tax deposits paid 20

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by partnerships or S corporations to retain a fiscal year under IRC Section 444 should not be disclosed as income taxes paid. d. GAAP does not address how income tax refunds affect disclosure of income taxes paid. It is believed that the amount disclosed should be net of receipts of income tax refunds. (In some years, that might result in disclosing net receipts.) It is believed unnecessary to disclose either (1) the gross amount of receipts and payments or (2) that a net amount is presented. The disclosures may be made on the face of the statement or in the notes. Illustrations of disclosures presented in the notes are as follows: a. Interest paid during 20X2 and 20X1 (net of capitalized interest of $2,800 in 20X1) amounted to $15,300 and $13,100, respectively. Income taxes paid amounted to $25,900 and $24,100 during 20X2 and 20X1, respectively. b. Cash flows from operating activities reflect interest payments of $75,300 in 20X1 and $69,400 in 20X0, income tax payments of $26,300 in 20X1, and receipts of $14,200 in 20X0 from income tax refunds. The disclosures could be added to the existing longterm debt and income tax notes or disclosed in a separate note of supplemental cash flow disclosures. It is generally believed easier and faster to prepare a cash flow statement using the indirect method. Thus, that method is recommended. Agency Transactions. Changes in certain current assets and liabilities do not flow through net income and, therefore, theoretically do not affect cash provided from operations. For example, some companies collect funds such as sales tax from third parties and remit them to a separate entity or otherwise hold or disburse cash on behalf of a customer. It is believed, however, that changes in sales tax liability and changes in other agency accounts could be reported as operating activities if the changes are not material. In addition, SFAS No. 95 (FASB ASC 23010458) states that it is generally acceptable to report only the net changes in those assets and liabilities because knowledge of gross amounts generally is not essential to understanding the company's operating, investing, and financing activities. Extraordinary Items, Cumulative Accounting Adjustments, and Discontinued Operations GAAP does not require extraordinary items, cumulative accounting adjustments, or discontinued operations to be separately disclosed in cash flow statements. Thus, the criteria for classifying transactions and events as operating, investing, or financing also would apply to extraordinary items, cumulative accounting adjustments, and discontin ued operations. Specific recommendations are presented in the following paragraphs. Noncash Extraordinary Items. Extraordinary items generally consist of gains or losses or writeoffs of assets and, thus, are noncash items. Because GAAP does not require extraordinary items to be separately identified in the statement of cash flows, it is recommended that they be treated in the same manner as other noncash items. Under the direct method of reporting cash flows from operations, the approach is simple; since cash flows from operations consist only of cash receipts and payments, noncash extraordinary items would be excluded. Under the indirect method, however, net income should be adjusted to arrive at the cash effects of operating activities by adding the noncash elements of extraordinary losses to net income and subtracting the noncash elements of extraordinary gains from net income. To illustrate, assume that a company's income statement included the following amounts:

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INCOME BEFORE INCOME TAXES AND EXTRAORDINARY ITEM INCOME TAXES INCOME BEFORE EXTRAORDINARY ITEM EXTRAORDINARY ITEMSettlement of class action customer suit, net of estimated insurance proceeds (less applicable income tax benefit of $30,600) NET INCOME To simplify the illustration, assume the following additional facts: a. Payment to the customers occurred after the balance sheet date. $

305,000 91,500 213,500

71,400 142,100

b. The class action suit was covered by the company's general liability insurance. Thus, the recorded extraordinary item is net of projected insurance proceeds of $102,000 ($71,400 + $30,600). c. Income before income taxes and extraordinary items in the amount of $305,000 has been received in cash. Cash flows from operations would be presented as follows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Settlement of class action customer suit net of estimated insurance proceeds Increase in income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES $ 142,100

102,000 60,900 305,000

Note that the increase in income taxes payable consists of total income taxes shown in the income statement ($91,500 * $30,600 benefit). If an extraordinary item affects both operating current assets and noncurrent assets, the noncash effects related to operating current assets are required to be shown separately from the change in current assets resulting from operating cash receipts and payments. Thus, the noncash effects of the extraordinary item generally would be shown as a single amount. To illustrate, assume that an extraordinary loss resulting from a hurricane included a $62,000 loss of inventory and a $40,000 writeoff of undepreciated cost of a warehouse that was destroyed. Cash flows from operating activities should be presented by using a single caption such as Inventory and undepreciated cost of building and equipment destroyed by hurricane." In other words, the decrease in inventory in the amount of $62,000 would be included in the noncash adjustment for the loss and generally would not be included with the change in inventory resulting from purchases and sales. If the noncash effects attributable to operating current assets are material, the combining of the noncash effects with the change attributable to operating cash receipts and payments is not permitted by GAAP , and a presentation such as the following would not be acceptable:

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CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Undepreciated cost of warehouse destroyed by hurricane Decrease in inventory Increase in income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES

142,100 40,000 62,000 60,900 305,000

If a company experiences both an extraordinary loss and an ordinary loss, it is believed that the noncash effects of the losses could be shown as a single amount in the cash flow statement. For example, an extraordinary loss of property and equipment and a loss of property and equipment that was not extraordinary could be reported as a single line item with a caption such as Undepreciated cost of property and equipment destroyed." Extraordinary ItemsCash. Although extraordinary items are not required to be separately disclosed in cash flow statements, cash flows related to extraordinary items are required to be appropriately classified as operating, investing, or financing activities. Thus, for example, cash payments to settle a lawsuit probably would be classified as an operating activity, while cash paid to extinguish debt probably would be classified as a financing activity. To illustrate, assume that a company's creditors agreed to accept $100,000 in settlement of debt in the amount of $130,000 and the debt extinguishment met the APB Opinion No. 30 (FASB ASC 22520452), criteria for classifica tion as an extraordinary item. The company reported the transaction in its income statement as follows: INCOME BEFORE INCOME TAXES AND EXTRAORDINARY ITEM INCOME TAXES INCOME BEFORE EXTRAORDINARY ITEM EXTRAORDINARY ITEMgain on extinguishment of debt (less applicable income taxes of $9,000) NET INCOME $ 200,000 60,000 140,000 21,000 161,000

Assuming that income before income taxes and extraordinary item in the amount of $200,000 had been received in cash and that there were no other transactions, the company's cash flow statement under the indirect method would be presented as follows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Gain on extinguishment of debt Increase in income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOWS FROM FINANCING ACTIVITIES Cash paid to extinguish debt NET INCREASE IN CASH CASH AT BEGINNING OF YEAR CASH AT END OF YEAR 23 $ $ 161,000 (30,000 ) 69,000 200,000 (100,000 ) 100,000 100,000

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Under the direct method, only the cash actually received or paid would be reflected in the cash flow statement. In the preceding example, the $100,000 paid to extinguish the debt would be included, and the gain on extinguish ment of debt and the increase in income taxes payable would be excluded. Note that cash outflows for income taxes are required to be classified as an operating activity. Thus, the income tax effects related to an extraordinary item should not be allocated to investing or financing activities even though the extraordinary item may appropri ately be classified as an investing or financing activity. Cumulative Accounting Adjustments. Like most extraordinary items, cumulative accounting adjustments are noncash items. SFAS No. 154, Accounting Changes and Error Corrections (FASB ASC 25010455), requires changes in accounting principle to be recognized by retrospective application to prior periods' financial statements with a few exceptions, such as when an accounting pronouncement includes specific transition provisions. It is believed that there will still be those few instances where cumulative accounting adjustments will be necessary because they are required by a new accounting standard. Accordingly, under the direct method of reporting cash flows from operations, which only presents cash receipts and payments, cumulative accounting adjustments would be excluded. When the indirect method is used, however, net income should be adjusted to arrive at cash flows from operations by adding the noncash elements of expense amounts to net income and subtracting the noncash elements of income amounts from net income. Similar to extraordinary items, GAAP does not require cumulative accounting adjustments to be presented separately in the statement of cash flows. It is recommended that the adjustment be classified according to the nature of the change. Cumulative effect adjustments that affect operating current assets and liabilities are rare and normally relate to a change from the FIFO method of valuing inventories to another method or arise through special transition provi sions of new accounting pronouncements. If it were not practical to restate priorperiod financial statements, however, including the cumulative effect of the change in net income was permitted. In that type of situation, it is believed that GAAP requires the noncash effects of the cumulative adjustment to be shown separately from the change in the operating current asset or liability attributable to operating cash receipts and payments. Discontinued Operations. Cash inflows and outflows are required to be reported according to whether they relate to operating, investing, or financing activities. Footnote 10 of SFAS No. 95 (FASB ASC 230104524) states that separate disclosure of cash flows from discontinued operations is not required. Companies may decide, however, to report operating cash flows of discontinued operations separately. A company that chooses to report separately operating cash flows of discontinued operations should do so consistently for all periods affected, which may include periods long after sale or liquidation of the operation. Some of the disclosure variations that an accountant may choose include:  Combining the cash flows from discontinued operations with the cash flows from continuing operations within each of the three categories.  Separately identifying the cash flows related to discontinued operations within each of the three categories.  Displaying the cash flows related to discontinued operations separately for each of the three categories near the bottom of the statement, just before net increase or decrease in cash and cash equivalents." In a December 2005 speech at the AICPA Annual Conference on SEC and PCAOB Current Developments, an SEC representative stated that the SEC staff did not support aggregating operating, investing, and financing cash flows from discontinued operations into a single line item. (Because discontinued operations of a component of an entity are segregated in the income statement and assets and liabilities of the component at the balance sheet date are disclosed, information to present cash flows from both continuing and discontinued operations generally is readily available.) An example of cash flows from operating activities classified by continuing and discontinued operations is as follows:

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CASH FLOWS FROM OPERATING ACTIVITIES Continuing operations Income before income taxes Adjustments to reconcile income to net cash provided by continuing operations Depreciation Loss on sale of property and equipment Deferred taxes (Increase) decrease in: Trade accounts receivable Inventories Prepaid expenses Increase (decrease) in: Trade accounts payable Accrued liabilities CASH PROVIDED BY CONTINUING OPERATIONS BEFORE INCOME TAXES Discontinued operations Loss before income tax benefits Adjustments to reconcile loss to net cash used by discontinued operations Depreciation Gain on disposal of property and equipment Provision for loss on disposal of other noncurrent assets (Increase) decrease in: Trade accounts receivable Inventories Increase (decrease) in: Trade accounts payable Accrued liabilities CASH USED BY DISCONTINUED OPERATIONS BEFORE INCOME TAX BENEFITS Decrease in income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES

84,000 23,000 12,000 9,000 11,200 (17,700 ) 2,650 10,700 17,250 152,100 (40,000 ) 16,000 (3,000 ) 22,000 (30,050 ) 16,450 (15,200 ) 13,800 (20,000 ) (5,600 ) 126,500

Although also not required, cash flows from investing and financing activities may be allocated to continuing and discontinued operations if that information were relevant. The information may be presented (a) in a separate schedule, (b) on the face of the cash flow statement under captions such as Continuing Operations" and Discontinued Operations," or (c) on the face of the cash flow statement identified by a caption such as Proceeds from disposal of property and equipmentdiscontinued operations." Other Adjustments to Arrive at Net Cash Flows from Operating Activities The following paragraphs discuss other adjustments to arrive at net cash flows from operating activities when the indirect method is used to present cash flows from operations. The objective of the adjustments is to present net cash flows generated by operating activities by adding noncash expenses to and subtracting noncash revenues from net income. The adjustments should be reflected either in the statement itself or in a separate schedule. With few exceptions, when the direct method is used, the following items should be excluded from the statement of cash flows because the direct approach only reflects cash receipts and payments. (However, the items would be shown in the reconciliation of net income to net cash provided by operating activities.) Current Operating Assets and Liabilities. Noncash entries to current operating assets and liabilities generally should be presented as separate adjustments to net income in arriving at cash flows from operations. Common examples of noncash transactions affecting current operating assets and liabilities include recording a provision for 25

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bad debts and providing a reserve for inventory obsolescence. [However, the change in a LIFO reserve is not viewed by this course as a noncash entry. Instead the LIFO reserve is the mechanical means to convert inventory priced at one method (usually FIFO) to LIFO.] To illustrate, assume that a company's activities relating to trade accounts receivable are summarized as follows: Allowance for Doubtful Accounts 10,000 25,000 (20,000 ) 15,000

Accounts Receivable Balance 1/1/X1 Sales Cash collected Bad debt provision Writeoffs Balance 12/31/X1 $ 50,000 $ 300,000 (250,000 ) (20,000 ) 80,000 $

The operations section of the cash flow statement would be presented as follows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Provision for losses on accounts receivable Increase in accounts receivable NET CASH PROVIDED BY OPERATING ACTIVITIES $ 50,000 25,000 (50,000 ) 25,000

If noncash entries are not material, however, it is believed appropriate to present only the net change in current assets and liabilities. Amortization of Intangible Assets and Deferred Charges. Intangible assets and deferred charges (expenditures expected to yield benefits for several accounting periods) are classified as noncurrent assets and may be periodi cally charged to expense over some period of time. Some examples of intangible assets are goodwill, copyrights, franchises, licenses, trademarks, formulas, mailing lists, and film rights. The amortization or impairment of intangi ble assets and deferred charges do not use cash, and any amortization expense or impairment loss recognized should be added back to income to arrive at cash flows provided by operations. Cash Value of Life Insurance. Cash value of life insurance is reported in the balance sheet as a noncurrent asset, and increases in cash value that are allowed to accumulate are included in net income as a reduction of insurance expense. Since the increases do not provide cash, however, they should be subtracted from net income to arrive at cash flows from operations. Life insurance that accumulates value has both operating and investing characteristics. However, the primary reason for life insurance is to reduce the risk of operating losses resulting from the death of a key employee. Consistent with the requirement of Paragraph 24 of SFAS No. 95 (FASB ASC 230104522) to classify a transaction based on the nature of the activity that is likely to be predominate, it is believed that all life insurance transactions should be classified as an operating activity. An example of the operations section of the cash flows statement in those circumstances follows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Increase in cash value of life insurance NET CASH PROVIDED BY OPERATING ACTIVITIES 26 $ 38,000 (2,000 ) 36,000

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Increases in cash value that are used to reduce payments of insurance premiums (instead of accumulating) reduce a liability (for premium obligations) rather than increase a noncurrent asset (cash value of life insurance). In that case, the guidance in the Current Operating Assets and Liabilities" paragraph applies. In most circumstances, the noncash aspects of the change in trade payables attributable to the increase in cash value are believed not to be material. Accordingly, the adjustment to net income would be included in the net change in trade payables, and the increase in cash value would not be disclosed as a separate item. Deferred Income Taxes. Deferred income taxes (both current and noncurrent) are noncash expenses. Thus, increases in deferred tax liabilities and decreases in deferred tax assets should be added back to net income to arrive at net cash flows from operations, and increases in deferred tax assets and decreases in deferred tax liabilities should be subtracted from net income. Only the changes in deferred tax assets and liabilities that were included in net income should be added back to or subtracted from net income, however. Changes allocated to components of other comprehensive income (e.g., the deferred taxes on unrealized gains/losses on availablefor sale marketable securities) should not be added to or subtracted from net income since they were not included in net income. Deferred Revenue. Deferred revenue represents revenue that has been received or is receivable before it is earned, i.e., before the related goods are delivered or services are performed. In most companies, deferred revenue is not material. In those instances, deferred revenue and the related receivable, if any, should be presented in a manner similar to other operating assets and liabilities on the cash flow statement. The deferred revenue balance should be added to net income and the receivable balance, if any, should be deducted from net income in arriving at cash flows from operations. If cash flow statements are prepared using the direct method, deferred revenue received would be reported as cash collected from customers. If deferred revenue is material and the related receivable has not been collected at year end, the amounts would not be reflected in the cash flow statement since they represent noncash items. No disclosure of the transaction would be required since only supplemental disclosure of noncash investing and financing transactions is required. Depletion. Depletion is the allocation of the cost of natural resources to expense as units are removed. Because depletion does not affect cash, it should be added back to net income to arrive at cash flows from operations. Depreciation. Productive assets that are economically useful for longer than one year are capitalized and charged to operations as depreciation over their estimated useful lives. Since depreciation is a noncash expense, it should be added back to net income in arriving at cash flows provided from operations. Disposal, Sale, and Retirement of Property and Other Noncurrent Assets. When noncurrent assets are sold or retired, the cash effects of the transaction are equal to the proceeds received. Thus, any gain or loss associated with the disposal of noncurrent assets should be subtracted from or added back to net income in arriving at net cash flows from operations, and proceeds from the sale should be shown as cash inflows from investing activities. Any expenses incident to the sale also should be added back to net income and shown as an investing activity. That approach should be followed regardless of whether there is a gain or loss on the disposal or whether assets are sold or retired, i.e., no proceeds are received. Purchase (Sale) of a Business. When a company is purchased or sold, the cash paid to acquire the company (or cash proceeds from sale of the company) should be shown as cash used (or provided) by investing activities. Usually a purchase (or sale) of a business willinclude the exchange of operating items, such as receivables and payables. The cash activity for the purchase of those operating items is included in investing activities. As a result, it is necessary to show thechanges in operating assets and liabilities net of the effects of the purchase (or sale) when using the purchase method of accounting. To illustrate, assume that XYZ Company purchased ABC Company in 20X4. The following are assets obtained and liabilities assumed in the purchase:

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Accounts receivable Equipment and leasehold improvements Accounts payable Longterm debt assumed Cash paid to acquire ABC Company

17,000 120,000 (10,000 ) (90,000 ) 37,000

In addition, XYZ's accounts receivable and accounts payable increased by $23,000 and $12,000, respectively, for the year ended December 31, 20X4 (including the results of the acquisition). Net income was $155,000 and depreciation was $22,000. Cash flows from the transactions would be presented as follows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Changes in assets and liabilities, net of effects of acquisition of ABC Company: Accounts receivable($23,000*$17,000) Accounts payable($12,000*$10,000) NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOWS FROM INVESTING ACTIVITIES Acquisition of ABC Company $ 155,000 22,000 (6,000 ) 2,000 $ 173,000 (37,000 )

The changes in operating assets and liabilities resulting from the purchase transaction are not considered in determining net cash provided from operating activities; instead, they are shown as cash outflows from investing activities. In this example, the majority of the changes in accounts receivable and payable resulted from the acquisition of ABC Company, not from operating activities, and the acquisitionrelated changes are reflected as cash flows from the acquisition of ABC Company. If the acquisitionrelated changes were presented simply as changes in operating assets and liabilities, net cash provided by operating activities would be misstated. Installment Sales. When sales of goods or services are made on an installment basis, a receivable is created that is reduced as principal payments are collected. In addition to principal payments, cash receipts representing interest income generally would be collected, and the installment transaction also might be accompanied by a cash down payment. Cash flows from a transaction that relates to operating activities should be classified as operating cash flows regardless of the time at which the cash flows occur. (Note that it is only acceptable to disregard the timing of payments when a transaction relates to operating activities. The timing should be considered in classify ing amounts when a transaction has both investing and financing aspects.) Thus, if goods or services are sold in exchange for a down payment and a note receivable, the down payment and subsequent principal and interest payments all would be considered as cash receipts from operating activities. The longterm receivable is a noncash amount included in net income in the year of sale and, thus, should be subtracted from income in arriving at cash flows from operations. To illustrate, assume that merchandise with a cost of $28,000 was sold on December 31, 20X1, for a cash down payment of $20,000 and a $50,000 note to be paid in 60 monthly installments of $1,112, including interest at the rate of 12%. Relevant balances at the end of the first two years would be as follows: 20X2 Current portion of receivable Noncurrent portion of receivable Principal collected Interest collected Total cash collected 28 $ 8,749 33,486 7,765 5,579 13,344 $ 20X1 7,765 42,235 20,000 20,000

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The $42,000 gross profit recognized in the 20X1 income statement represents the $70,000 sales price less the $28,000 cost of the merchandise sold. The effect of income taxes has been ignored to simplify the illustration. Cash flows from the transaction would be presented as follows: 20X2 CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustment to reconcile net income to net cash provided by operating activities (Increase) decrease in installment receivable Net decrease in inventory NET CASH PROVIDED BY OPERATING ACTIVITIES $ 5,579 7,765 13,344 $ 20X1 42,000 (50,000 ) 28,000 20,000

Note that in 20X1 the installment receivable is subtracted from net income in arriving at cash flows from operations because it represents a noncash item that is included in net income, and the net decrease in inventory in the amount of $28,000 is added to net income. The resulting net increase in cash of $20,000 results from receipt of the cash down payment. In 20X2, interest and principal collected account for the cash inflow from operating activities. Longterm Investments in Common Stock. Under the equity method of accounting for investments in common stock, investment earnings are recognized in income when they accrue rather than when they are distributed as dividends. Thus, the investor's share of undistributed earnings or loss of an investee, i.e., equity pick up less dividends, should be subtracted from or added back to net income to arrive at cash flows from operations. Assuming a company's share of earnings in 20X2 was $40,000, its share of net loss in 20X1 was $15,000, and dividends of $5,000 were received in both years, cash flows from operations would be presented as follows: 20X2 CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustment to reconcile net income to net cash provided by operating activities (Equity in earnings) share of loss of joint venture, net of dividends received of $5,000 in 20X2 and 20X1 NET CASH PROVIDED BY OPERATING ACTIVITIES $ 63,000 $ 20X1 42,000

(35,000 ) 28,000

20,000 62,000

If investments are accounted for by the cost method, dividends received are generally recorded as investment earnings and are, therefore, considered to be cash inflows from operating activities. Accordingly, no adjustment to net income is required to arrive at cash flows from operating activities. Noncontrolling (Minority) Interests (Prior to the adoption of SFAS No. 160). Noncontrolling (minority) interests in the earnings of consolidated subsidiaries are noncash items, which generally are reported as an expense in the consolidated income statement. In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statementsan amendment of ARB No. 51 (FASB ASC 81010501A). The statement requires that the face of the consolidated income statement separately present the amounts of consolidated net income and the net income attributable to the parent and the noncontrolling (minority) interest. This guidance is effective for fiscal years, and interim periods with those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. Thus, minority interests should be added back to consolidated net income to arrive at cash flows from operations. The following is an example:

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20X2 CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) Adjustment to reconcile net income to net cash provided by operating activities Minority interests in net income (loss) of consoli dated subsidiaries NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES $ 41,500 $

20X1 (29,700 )

8,300 49,800

(5,940 ) (35,640 )

Noncontrolling Interests (Based on SFAS No. 160). Subsequent to the adoption of SFAS No. 160, Noncontrol ling Interests in Consolidated Financial Statementsan amendment of ARB No. 51 (FASB ASC 81010501A), the consolidated income statement will present the consolidated net income followed by separate amounts of net income attributable to the parent and the noncontrolling interest. Because the noncontrolling interest is not reported as an expense in the consolidated financial statements, no adjustment to reconcile net income to net cash provided by operating activities will be needed for the net income attributable to noncontrolling interest. Rather, the cash flow statement begins with the consolidated net income. The following example uses the prior presentation and modifies it as needed: 20X2 CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) Adjustment to reconcile net income to net cash provided by operating activities NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES $ 49,800 $ 20X1 (35,640 )

49,800

(35,640 )

Unrealized Gains and Losses on Marketable Equity Securities. Unrealized gains and losses on trading securi ties, as well as nontemporary unrealized losses on heldtomaturity debt securities and availableforsale securities, are required to be recognized in income in the period in which they occur. Because unrealized gains and losses are noncash items, net income should be adjusted for their effect by adding back unrealized losses and subtracting unrealized gains to arrive at cash flows from operations. Premium Amortization and Discount Accretion. Depending on market conditions, bonds and notes may be purchased at par, above par (at a premium), or below par (at a discount). Bonds and notes classified as heldto maturity should be recorded at cost with any discount or premium amortized to income over the life of the securities. Since the amortization of premiums and discounts are noncash items, net income should be adjusted for their effect to arrive at cash flows from operations. The amortization of a premium results in recording interest income at an amount less than the amount of cash received. Accordingly, premium amortization should be added back to net income. Conversely, the amortization of a discount results in recording interest income at an amount greater than the amount of cash received. Thus, discount amortization should be reflected as a decrease to net income.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 6. Which of the following is a criteria that must be met for cash flows to be considered from operating activities? a. Amounts represent both cash and noncash effects of transactions and events. b. Amounts result from normal operations for providing services and delivering/producing goods for sale. c. Amounts are derived from investing or financing activities. d. Cash used for inventory, personnel, and administrative expenses must be excluded. 7. When preparing information about cash flows for operating activities, Helen begins with cash receipts and deducts cash payments for operating costs and expenses. She individually lists the cash effects of each major type of revenue and expense. She presents seven types of cash receipts and cash payments, including cash collected from customers (including lessees and licensees), interest and dividends received, and income taxes paid. What method is Helen using to prepare the information? a. The direct method. b. The indirect method. c. A hybrid of the direct and indirect methods. 8. Under which of the circumstances below would use of the direct method of preparing cash flows from operating expenses be preferable than use of the indirect method? a. Required information will require significant time and cost to obtain. b. Few reconciling items between net income and cash flows from operations exist. c. The relationship of cash receipts/payments to cash flows from operations is used for decisionmaking. 9. Carlsbad Construction Contractors (CCC) pays interest of $100,000. The amount of interest capitalized as cost of homes under construction increases by $30,000. The accrued interest expense decreases by $50,000. CCC charges $20,000 of interest to operations. When disclosing interest as part of the cash flows from operations, how much interest is reflected in CCC's cash outflows from operations? a. $20,000. b. $50,000. c. $100,000. d. $150,000. 10. JohnsonHillman makes a $100,000 cash payment to settle a lawsuit, which would be considered an extraordinary item. How should this payment be reflected on the company's statement of cash flows if JohnsonHillman uses the direct method? a. The extraordinary item should be included and classified as an operating activity. b. The extraordinary item should be included and classified as a financing activity. c. The extraordinary item should be excluded because the company uses the direct method. d. The extraordinary item should be separately disclosed in the financial statements. 31

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11. Slick Sales Inc. provides company cars to members of its doortodoor sales force. In 2008, three sales people's employment was terminated, and their cars were sold at a loss. If Slick Sales uses the indirect method, how should this be reflected in the company's net income? a. The loss should be subtracted from net income. b. Proceeds are shown as cash inflows from investing activities. c. Expenses incident to the sale are added to net income and shown as a financing activity. 12. On December 31, 20X1 Infomercial Mania sold a weighttraining machine with a cost of $20,000 on an installment basis to a customer with the following terms: cash down payment of $30,000 and a $70,000 note to be paid in 60 monthly installments at the rate of 12%. Infomercial Mania should classify as cash flows from activities in the December 20X1 cash flow statement? a. $30,000; operating. b. $30,000; financing. c. $100,000; operating. d. $100,000; investing.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 6. Which of the following is a criteria that must be met for cash flows to be considered from operating activities? (Page 17) a. Amounts represent both cash and noncash effects of transactions and events. [This answer is incorrect. Only transactions and events involving cash receipts and cash payments may be classified as cash flows from operating expenses.] b. Amounts result from normal operations for providing services and delivering/producing goods for sale. [This answer is correct. This is one of the three criteria that operating activities generally meet. Another criterion is that the amounts must be derived from activities that enter into the determination of net income.] c. Amounts are derived from investing or financing activities. [This answer is incorrect. According to SFAS No. 95, cash flows from operating activities are defined by exclusionthey include anything that is not an investing or financing activity. Such excluded amounts include cash receipts and payments for property and equipment and dividends paid.] d. Cash used for inventory, personnel, and administrative expenses must be excluded. [This answer is incorrect. Cash flows from operating activities include (1) cash that is received from sales of goods or services and (2) cash used to generate the goods or services, such as amounts related to personnel, inventory, and administrative and other operating costs.] 7. When preparing information about cash flows for operating activities, Helen begins with cash receipts and deducts cash payments for operating costs and expenses. She individually lists the cash effects of each major type of revenue and expense. She presents seven types of cash receipts and cash payments, including cash collected from customers (including lessees and licensees), interest and dividends received, and income taxes paid. What method is Helen using to prepare the information? (Page 18) a. The direct method. [This answer is correct. Helen is using the direct methodone of the two basic formats permitted. Other categories of cash receipts and cash payments that Helen should present include other operating cash receipts (if any), cash paid to employees and other suppliers of goods or services (including suppliers of insurance and advertising), interest paid, and other operating cash payments (if any).] b. The indirect method. [This answer is incorrect. Helen is not using the indirect method in this scenario. The indirect method starts with net income and adjusts for both noncash items (such as depreciation and deferred income taxes) and changes during the period in operating current liabilities and assets. The reconciliation should show all major classes of operating items.] c. A hybrid of the direct and indirect methods. [This answer is incorrect. Two basic formats are permittedthe direct method and the indirect method. A hybrid of the two is not permitted. Most preparers use the indirect method.] 8. Under which of the circumstances below would use of the direct method of preparing cash flows from operating expenses be preferable than use of the indirect method? (Page 18) a. Required information will require significant time and cost to obtain. [This answer is incorrect. It is preferable for a company to use the direct method when information required to use the direct method is readily available or can be obtained by the preparer without significant additional costs.] b. Few reconciling items between net income and cash flows from operations exist. [This answer is incorrect. If there are many reconciling items between net income and cash flows from operations, which would make an indirect presentation cluttered and cumbersome to analyze, it is preferable to use the direct method.] 33

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c. The relationship of cash receipts/payments to cash flows from operations is used for decisionmak ing. [This answer is correct. If management or banks with which the company obtains financing finds this information useful for decisionmaking, then the direct method should be used.] 9. Carlsbad Construction Contractors (CCC) pays interest of $100,000. The amount of interest capitalized as a cost of homes under construction increases by $30,000. The accrued interest expense decreases by $50,000. CCC charges $20,000 of interest to operations. When disclosing interest as part of the cash flows from operations, how much interest is reflected in CCC's cash outflows from operations? (Page 20) a. $20,000. [This answer is incorrect. The $20,000 charged to operations is only part of the amount that must be reflected in the disclosure required by SFAS No. 95.] b. $50,000. [This answer is incorrect. The $50,000 decrease in accrued interest is only part of the amount that CCC should include in its disclosure. SFAS No. 95 details the required disclosure.] c. $100,000. [This answer is correct. CCC would include the $20,000 charged to operations plus the total of the $50,000 decrease in accrued interest and the $30,000 increase in capitalized interest.] d. $150,000. [This answer is incorrect. Cash outflows from operations does not equal interest paid plus the decrease in accrued interest expense.] 10. JohnsonHillman makes a $100,000 cash payment to settle a lawsuit, which would be considered an extraordinary item. How should this payment be reflected on the company's statement of cash flows if JohnsonHillman uses the direct method? (Page 23) a. The extraordinary item should be included and classified as an operating activity. [This answer is correct. In this scenario, the extraordinary item is a cash item, not a noncash item. Under the direct method, cash actually paid is reflected in the cash flow statement. Cash flows related to extraordinary items are required to be appropriately classified as operating, investing, or financing activities. A cash payment to settle a lawsuit would generally be classified as an operating activity.] b. The extraordinary item should be included and classified as a financing activity. [This answer is incorrect. Generally, a cash payment to settle a lawsuit would not be classified as a financing activity. If JohnsonHillman paid cash to extinguish debt, that payment generally would be classified as a financing activity.] c. The extraordinary item should be excluded because the company uses the direct method. [This answer is incorrect. Noncash extraordinary items would be excluded from the cash flow statement under the direct method; however, the extraordinary item in this scenario would be considered a cash extraordinary item.] d. The extraordinary item must be separately disclosed in the financial statements. [This answer is incorrect. Extraordinary items are not required to be separately disclosed, so JohnsonHillman would not be required to make that disclosure in the above scenario.] 11. Slick Sales Inc. provides company cars to members of its doortodoor sales force. In 2008, three sales people's employment was terminated, and their cars were sold at a loss. If Slick Sales uses the indirect method, how should this be reflected in the company's net income? (Page 27) a. The loss should be subtracted from net income. [This answer is incorrect. A gain on the sale would be subtracted from net income, while a loss from the sale would be added to net income.] b. Proceeds are shown as cash inflows from investing activities. [This answer is correct. When noncurrent assets are sold or retired, as in the Slick Sales scenario, the cash effects of the transaction are equal to proceeds received.] c. Expenses incident to the sale are subtracted from net income and shown as a financing activity. [This answer is incorrect. The expenses would be added back to net income, not subtracted from it. Also, expenses would be shown as an investment activity, not a financing activity.] 34

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12. On December 31, 20X1 Infomercial Mania sold a weighttraining machine with a cost of $20,000 on an installment basis to a customer with the following terms: cash down payment of $30,000 and a $70,000 note to be paid in 60 monthly installments at the rate of 12%. Infomercial Mania should classify as cash flows from activities in the December 20X1 cash flow statement? (Page 28) a. $30,000; operating. [This answer is correct. In 20X1 the installment receivable should be subtracted from net income to arrive at cash flows from operations: Net income of $80,000 (100,000 20,000) less installment receivable ($70,000) plus decrease in inventory ($20,000) = $30,000. It is only acceptable to disregard the timing of payments when a transaction relates to operating activities.] b. $30,000; financing. [This answer is incorrect. According to SFAS No. 95, cash flows from a transaction that relates to operating activities should be classified as operating cash flows regardless of the time at which the cash flows occur.] c. $100,000; operating. [This answer is incorrect. When calculating cash flows on an installment basis, a longterm receivable is a noncash amount included in net income in the year of sale, and should be subtracted from income in arriving at cash flows from operations.] d. $100,000; investing. [This answer is incorrect. According to SFAS No. 95, cash flows from a transaction that relates to operating activities should be classified as operating cash flows regardless of the time at which the cash flows occur.]

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CONSIDERATIONS FOR CASH FLOWS FROM INVESTING ACTIVITIES


According to SFAS No. 95 (FASB ASC 2301020; 230104512 and 4513), investing activities include the following:  Lending money and collecting on loans  Acquiring and selling or disposing of securities SFAS No. 159 (FASB ASC 82510453) eliminated the requirement to classify cash receipts and cash payments from transactions involving trading securities as operating activities. The cash flows from such transactions should be classified based on the nature and purpose for which the related securities were acquired. However, this guidance does not apply to securities classified as cash equivalents.  Acquiring and selling or disposing of productive assets that are expected to generate revenue over a long period of time Exhibit 12 lists some typical examples of cash flows provided by and used in investing activities. The following paragraphs discuss how to present cash flows from investing activities in statements of cash flows. Format Considerations Netting Certain Cash Flows. While the general rule is that cash receipts and payments should be reported on a gross rather than a net basis, cash flows related to loans and shortterm investments with original maturities of three months or less may be reported net rather than gross. Amounts due on demand and credit card receivables of financial services operations are considered to be loans with original maturities of three months or less. (Certain financial institutions may also report cash flows related to customer loans and deposits placed with other financial institutions on a net basis.) However, all other cash receipts and payments from investing activities should be reported on a gross basis. Noncash Investing Activities. Certain investing activities, such as acquiring assets by assuming liabilities or exchanging assets, are noncash transactions that do not involve cash receipts or payments. (Exhibit 12 lists other typical examples of noncash investing activities.) Nevertheless, investing activities that do not involve cash are required to be reported separately so that information is provided on all investing activities. Capital Expenditures Purchases. Cash outlays for acquiring longlived assets (including capitalized interest, if any) should be reported as a cash outflow from investing activities. The amount to be reported in a statement of cash flows generally should consist of (a) assets purchased for cash and (b) downpayments for assets purchased by assuming liabilities. Payments of liabilities, including capital lease obligations, and tradein allowance and other noncash aspects of the transaction should be excluded from the amounts reported as investing activities. The following example illustrates how to report a typical capital expenditure assuming the following facts:  Net income and depreciation for the year amounted to $12,000 and $3,000, respectively.  On January 1, the company purchased a new machine with a list price of $74,000.  A used machine with an undepreciated cost of $5,000 was traded in on the purchase. The tradein allowance on the used machine was $4,000. Thus, the loss was $1,000.  The company made a down payment of $10,000 and financed the balance of the purchase with an installment loan in the amount of $60,000 to be paid in six annual installments of $10,000 plus interest at the rate of 14%.

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A cash flow statement such as the following would be presented: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustment to reconcile net income to net cash provided by operating activities Depreciation Loss on disposal of equipment NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOWS FROM INVESTING ACTIVITIES Purchase of equipment CASH FLOWS FROM FINANCING ACTIVITIES Debt reduction NET DECREASE IN CASH CASH AT BEGINNING OF YEAR CASH AT END OF YEAR $ $ 12,000 3,000 1,000 16,000 (10,000 ) (10,000 ) (4,000 ) 24,000 20,000

Investing cash flows only include advance payments, the down payment, or other amounts paid at the time productive assets are purchased or shortly before or after. Thus, in the preceding example, cash flows used by investing activities consist solely of the $10,000 cash down payment. Subsequent principal payments on the installment loan are classified as financing activities. The noncash aspects of the transaction (equipment acquired by assuming liabilities, net of the tradein allowance) should be disclosed separately. Purchase and sale or disposal of longlived assets generally are classified as investing activities. SFAS No.95, however, states that sometimes it may be appropriate to classify such transactions as operating activities, e.g., when longlived assets are acquired or produced to be a direct source of a company's revenues such as assets rented to others for a short period of time and then sold. Sales. Proceeds from sales of longlived assets should be shown as cash inflows from investing activities. Accordingly, if the facts in the Purchases" paragraph were changed to assume that a used machine with an undepreciated cost of $5,000 was sold for $6,500 (rather than traded in on the new equipment), a cash flow statement such as the following would be presented: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustment to reconcile net income to net cash provided by operating activities Depreciation Gain on sale of equipment NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from sale of equipment Purchase of equipment $ 14,500 3,000 (1,500 ) 16,000 6,500 (10,000 ) (3,500 )

NET CASH USED BY INVESTING ACTIVITIES

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CASH FLOWS FROM FINANCING ACTIVITIES Debt reduction NET INCREASE IN CASH CASH AT BEGINNING OF YEAR CASH AT END OF YEAR $

(10,000 ) 2,500 24,000 26,500

Note that the difference in the net change in cash between this example and the example in the Purchases" paragraph (an increase of $2,500 compared with a decrease of $4,000) equals the cash inflow from the sale of equipment in the amount of $6,500. Installment Sales Installment sales of longlived assets are considered to be investing activities. Accordingly, cash receipts in the form of cash down payments and collections of principal should be classified as cash provided by investing activities. (Interest collected should be classified as cash flows from operating activities, however.) For example, a building with an undepreciated cost of $60,000 (cost $100,000; accumulated depreciation $40,000) that is sold for $70,000 with terms of sale requiring a cash down payment of $20,000 and payment of the balance in five annual installments of $10,000 plus interest at the rate of 16% would result in the following amounts at the end of the first two years (assuming no other transactions): 20X2 Net incomegain on sale of $10,000 in 20X1 and $8,000 interest income in 20X2 Building Accumulated depreciation Sales price Cash down payment Current portion of receivable Longterm portion of receivable Principal collected $ 8,000 10,000 30,000 10,000 $ 20X1 10,000 100,000 40,000 70,000 20,000 10,000 40,000

The following example illustrates how the transaction would be presented in cash flow statements: 20X2 CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustment to reconcile net income to net cash provided by operating activities Gain on sale of building NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOWS FROM INVESTING ACTIVITIES Collection on installment sales $ 8,000 8,000 10,000 $ 20X1 10,000 (10,000 ) 20,000

Certain types of installment sales have both operating and investing aspects, for example, when inventory is sold on an installment basis. Investments Shortterm Investments vs. Cash Equivalents. If a company has amounts that do not meet the definition of cash, it must decide whether to account for such amounts as cash equivalents or as other shortterm investments. [If a 38

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company's cash balances consist solely of cash on deposit and similar demand deposits that are effectively not subject to withdrawal restrictions or material penalties, e.g., certificates of deposit or money market accounts, they should be classified as cash in conformity with footnote 1 of SFAS No. 95 (FASB ASC 2301020). It is believed that the disclosures described in this paragraph need not be made in those circumstances because the amounts are considered to be cash rather than cash equivalents. Cash equivalents are defined as shortterm, highly liquid investments that (a) are readily convertible to known amounts of cash and (b) are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates."] In distinguishing between shortterm investments that are classified as cash equivalents and those that are not, SFAS No. 95 (FASB ASC 23010456 and 501) (a) permits all companies to establish a policy concerning which shortterm, highly liquid investments with original maturities of three months or less are considered cash equivalents and which are to be reported as shortterm investments and (b) requires companies to disclose the policy in their financial statements. An illustrative disclosure would be as follows: NOTE ASUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash Equivalents and Shortterm Investments Cash equivalents consist primarily of Treasury bills, repurchase agreements, and commercial paper with original maturities of three months or less. Certificates of deposit with original maturi ties over three months are classified as shortterm investments. Cash equivalents and shortterm investments are stated at cost because that approximates market value. At December 31, 20X2 and 20X1, cash equivalents amounted to $40,900 and $31,800, respectively. Once a policy is established, it should be consistently followed. A change in the type of investments that are classified as cash equivalents is a change in accounting principle. Purchases and sales of investments that are classified as cash equivalents are required to be a part of companies' cash management rather than part of their operating, investing, and financing activities. Thus, the net change in cash equivalents should be included in the net change in cash and cash equivalents shown in the statement of cash flows, but purchases and sales of cash equivalents would not be reported separately. Investments That Are Not Cash Equivalents. Purchases and sales of investments in debt or equity securities that are not cash equivalents should be classified as operating or investing activities based on the nature and purpose for which the related securities were acquired: The following illustrates how investments that are not cash equivalents should be presented in cash flow state ments. (The illustrations assume that classifying transactions in trading securities as operating activities and classifying transactions in availableforsale securities as investing activities is appropriate based on the nature and purpose for which the related securities were acquired.) CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation (Increase) decrease in: Trade accounts receivable Trading securities Inventories Prepaid expenses Increase (decrease) in: Trade accounts payable Accrued liabilities Income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES 39 $ 39,000 6,800 20,700 18,000 (16,350 ) 4,250 (25,000 ) (12,350 ) 6,650 41,700

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CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from sales of availableforsale securities Purchases of availableforsale securities NET CASH USED BY INVESTING ACTIVITIES

17,600 (21,600 ) (4,000 )

SFAS No. 159, The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an amendment of FASB Statement No. 115, eliminated the requirement to classify cash receipts and cash payments from transactions involving trading securities as operating activities. Thus, the cash flows from such transactions should be classified based on the nature and purpose for which the related securities were acquired. Interest and Dividend Income. Receipts from interest and dividends should be classified as cash flows from operating activities rather than cash flows from investing activities. In many cases, interest and dividend income on investments held by outside custodians is automatically reinvested to principal. It is believed that such interest and dividend proceeds should be treated as constructively received" and presented as a cash activity in the statement of cash flows. The interest or dividend income should be reflected as a cash flow from operating activities, while the reinvestment should be reflected as an investing activity. Even though the proceeds are not physically transferred from the custodian and reinvested in separate transactions, the substance of the transaction is that cash proceeds have been used to increase an investment. Accordingly, presenting the transaction as a cash activity is believed more appropriate than presenting it as a noncash activity. If presented as a noncash activity, interest or dividend income would be subtracted from net income in arriving at cash flows from operations and the reinvestment would be separately reported as a noncash investing and financing activity. Making Loans Making loans (notes and loans receivable) is an investment activity. Accordingly, the principal amount of the loan should be shown as cash used for investing activities, and principal collected on the loan should be shown as cash provided by investing activities. However, as discussed perviously, cash flows relating to investments or loans receivable with original maturities of three months or less may be reported net. Interest collected on the loans should be shown as an operating activity. For example: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOWS FROM INVESTING ACTIVITIES Loans made Collections on loans $ 31,300 7,500 38,800 (27,700 ) 8,500 (19,200 )

NET CASH USED BY INVESTING ACTIVITIES

Purchase (Sale) of a Business When a company is purchased or sold, cash flow statements should report the cash paid to acquire the company (or cash proceeds from sale) as an investing activity. For example, if a company pays $90,000 to acquire another business with working capital (other than cash) of $30,000 and net noncurrent assets of $60,000, cash flows from investing activities would be presented as follows: CASH FLOWS FROM INVESTING ACTIVITIES Acquisition of ABC Company (net of cash acquired) 40 90,000

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The major categories of assets obtained and liabilities assumed would be disclosed as noncash investing and financing activities. Federal Tax Deposit to Retain Fiscal Year It is believed that a payment by an S corporation or partnership of a federal tax deposit to retain its fiscal year or the collection of a refund of a prior payment, should be reported as an investing activity. The deposit is, in substance, an interestfree loan to the IRS of the tax benefits to the owners of reporting on a fiscal year basis. Since SFAS No. 95, Paragraph 21 (FASB ASC 2301020), defines operating activities as those that are not defined as investing or financing activities, and the definition of investing activities does not include fiscal year deposits, some accountants question whether such deposits should be viewed as operating activities instead of investing activities. It is believed that it is unreasonable to assume that all investing and financing activities could be addressed in the pronouncement. Furthermore, that guidance notes that operating activities generally should report the cash effects of events that enter into the determination of net income. Tax deposits only affect cash; they never enter into the determination of net income.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 13. Natalie is preparing information on cash flows from investing activities for inclusion in Tech Town's statement of cash flows. Which of the following tasks has Natalie performed correctly? a. Natalie reports cash receipts and payments on a shortterm investment of 6 months on a net basis. b. Natalie reports Tech Town's assumption of a liability separately. c. Natalie excludes information about the acquisition of a productive asset. d. Natalie reports amounts due on demand on a gross basis as required. 14. In 2008, Harbor Time makes a capital expenditure to purchase a new boat for harbor tours. How should that be reported on Harbor Time's statement of cash flows? a. As a cash flow from operating activities. b. As a cash flow from investing activities. c. As a cash flow from financing activities. d. Information on this transaction should be excluded. 15. Mystery Barn has shortterm investments and must distinguish between those that are cash equivalents and those that are not. How will this affect the company's financial statements? a. Mystery Barn must disclose its policy in its financial statements, and changing the policy is a change in accounting principle. b. Mystery Barn must classify all shortterm investments with original maturities of three months or less as cash equivalents. c. Mystery Barn must classify purchases and sales of investments classified as cash equivalents as part of the cash flows from investing activities. 16. Which of the following is classified as an investing activity on the statement of cash flows? a. Purchases and sales of availableforsale securities. b. Receipts from interest and dividends. c. Cash dividends paid.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 13. Natalie is preparing information on cash flows from investing activities for inclusion in Tech Town's statement of cash flows. Which of the following tasks has Natalie performed correctly? (Page 36) a. Natalie reports cash receipts and payments on a shortterm investment of 6 months on a net basis. [This answer is incorrect. The general rule is that cash receipts and payments from investing activities should be reported on a gross rather than a net basis; shortterm is defined as having original maturities of three months or less.] b. Natalie reports Tech Town's assumption of a liability separately. [This answer is correct. Investing activities that do not involve cash, such as the transaction listed above, should be reported separately so that information is provided on all investing activities.] c. Natalie excludes information about the acquisition of a productive asset. [This answer is incorrect. The acquisition of a productive asset that is expected to generate revenue over a long period of time is part of the cash flows from investing activities, and therefore should be included in the information Natalie is preparing.] d. Natalie reports amounts due on demand on a gross basis as required. [This answer is incorrect. Amounts due on demand and credit card receivable of financial services operations are considered loans with original maturities of three months or less; therefore, Natalie is not required to report them on a gross basis, but is allowed to report them on a net basis.] 14. In 2008, Harbor Time makes a capital expenditure to purchase a new boat for harbor tours. How should that be reported on Harbor Time's statement of cash flows? (Page 36) a. As a cash flow from operating activities. [This answer is incorrect. However, if the longlived asset was acquired or produced to be a direct source of Harbor Time's revenues, an exception to normal procedures might be made and then it could be reported as a cash flow from operating activities.] b. As a cash flow from investing activities. [This answer is correct. Harbor Time's cash outlay for the acquisition of longlived assets (which also includes any capitalized interest) should generally be reported as a cash outflow from investing activities.] c. As a cash flow from financing activities. [This answer is incorrect. Financing activities include providing owners with a return on their investment, and borrowing and repaying money.] d. Information on this transaction should be excluded. [This answer is incorrect. However, if Harbor Time paid liabilities, any noncash aspects of the transaction (such as a tradein allowance) should be excluded from the appropriate cash flow.] 15. Mystery Barn has shortterm investments and must distinguish between those that are cash equivalents and those that are not. How will this affect the company's financial statements? (Page 38) a. Mystery Barn must disclose its policy in its financial statements, and changing the policy is a change in accounting principle. [This answer is correct. Once Mystery Barn establishes a policy, that policy should be followed consistently.] b. Mystery Barn must classify all shortterm investments with original maturities of three months or less as cash equivalents. [This answer is incorrect. Under SFAS No. 95, Mystery Barn can distinguish between shortterm, highly liquid investments with original maturities of three months or less and decide which are classified as cash equivalents and which are classified as shortterm investments.] 44

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c. Mystery Barn must classify purchases and sales of investments classified as cash equivalents as part of the cash flows from investing activities. [This answer is incorrect. The guidance indicates that such sales and purchases are part of the company's cash management, not part of operating, investing or financing activities.] 16. Which of the following may be classified as an investing activity on the statement of cash flows? (Page 39) a. Purchases and sales of availableforsale securities. [This answer is correct. The purchase and sale of securities are shown as operating or investing activities on the cash flow statement based on the nature and purpose for which the relating securities were acquired.] b. Receipts from interest and dividends. [This answer is incorrect. The receipts from interest and dividends would be classified as cash flows from operating activities.] c. Cash dividends paid. [This answer is incorrect. Cash dividends paid should be shown as a financing activity, and financing activities include providing owners with a return on their investment.]

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CONSIDERATIONS FOR CASH FLOWS FROM FINANCING ACTIVITIES


SFAS No. 95 (FASB ASC 2301020) states that financing activities include the following:  Obtaining resources from owners and providing them with a return on, and a return of, their investment  Borrowing money and repaying amounts borrowed, or otherwise settling the obligation  Obtaining and paying for other resources from creditors on longterm credit Exhibit 12 lists some typical examples of cash flows provided by financing activities. The following paragraphs discuss how to present cash flows from financing activities in statements of cash flows. Format Considerations Netting Certain Cash Flows. Cash receipts and payments are generally required to be reported on a gross rather than a net basis. However, loans with original maturities of three months or less may be reported net rather than gross. Certain financial institutions are permitted to also report cash flows related to customer deposits on a net basis.) All other financing activities should be reported gross. Noncash Financing Activities. Certain financing activities, such as issuing stock in exchange for noncash consid eration such as property and equipment, do not involve cash receipts or payments. (Exhibit 12 lists other typical examples of noncash financing activities.) Nevertheless, financing activities that do not involve cash are required to be reported separately so that information is provided on all financing activities. Cash Dividends Financing activities include providing owners with a return on their investment, and, thus, cash dividends paid should be shown as a cash outflow from financing activities, as illustrated below: CASH FLOWS FROM FINANCING ACTIVITIES Dividends paid (6,000 )

Dividends declared but not paid and stock dividends are noncash transactions. Accordingly, they should not be shown in the cash flow statement itself. Rather, they should be disclosed as noncash investing and financing activities. Stockholders often borrow funds from closely held corporations to avoid the taxation associated with dividend distributions. The corporation records the borrowings as stockholder loans receivable and may offset dividend distributions against the loan receivable. (The IRS may consider the loans" as constructive dividends" to the stockholder, thus making the distribution taxable to the stockholder.) To the extent that dividends are offset in the year the stockholder loan is made, it is believed that the statement of cash flows should reflect the amount paid to the stockholder as a financing activity, rather than an investing activity. In subsequent years, however, offsetting the stockholder loan against dividend distributions should be reported as a noncash financing activity. Issuing Stock Proceeds from issuing stock should be reported as cash inflows from financing activities. Although cash flows are generally required to be reported on a gross basis, it is believed acceptable to show proceeds from issuing stock, net of stock issue costs, as cash received from financing activities provided the amount of stock issue cost is disclosed as follows: CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuing common stock (net of stock issue costs of $3,000) 46

27,000

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The following transactions relating to issuing stock do not affect cash flows and should be disclosed as noncash investing and financing activities as discussed in Lesson 3:  Stock issued for receivables or other noncash consideration such as property and equipment  Stock issued to settle debt  Stock issue costs that have not been paid in cash during the period Shortterm and Longterm Debt Cash receipts from both shortterm and longterm borrowings should be shown as cash inflows from financing activities. The reduction of shortterm and longterm obligations should be reported as a separate cash outflow from financing activities, except for cash flows related to loans with original maturities of three months or less, which may be reported net. To illustrate, assume that a company's activities related to borrowings are summarized as follows:  Equipment is acquired in a capital lease transaction; the capital lease obligation was $84,000.  Cash borrowed consisted of $10,000 of shortterm debt payable in less than three months, $40,000 of other shortterm debt, and $125,000 of longterm debt.  Cash paid on borrowings consisted of $8,100 on the capital lease obligation, $5,000 on shortterm debt payable in less than three months, $15,000 on other shortterm debt, and $12,000 on longterm debt. Cash flows from financing activities would be presented as follows: CASH FLOWS FROM FINANCING ACTIVITIES New borrowings: Shortterm Longterm Debt reduction: Shortterm Longterm

45,000 125,000 (15,000 ) (20,100 ) 134,900

NET CASH PROVIDED BY FINANCING ACTIVITIES

New borrowings of shortterm debt consist of the net cash flows from loans with original maturities of less than three months in the amount of $5,000 ($10,000 borrowed less $5,000 repaid) plus $40,000 from other shortterm debt. Because payments on debt with original maturities of three months or less are netted with new borrowings, reduction of shortterm debt consists solely of payments of other shortterm debt in the amount of $15,000. Payments on longterm debt consist of $8,100 paid on capital lease obligations and $12,000 paid on other longterm debt. Note, however, that incurring the capital lease obligation does not affect cash and, thus, would be disclosed as a noncash investing and financing activity rather than as a cash inflow from financing activities. Debt Issue Costs. It is believed that bank fees and other costs incurred in obtaining financing or refinancing should be offset against the debt and charged to interest expense over the life of the debt, generally using the interest method. All of the costs are therefore accounted for as discount on the debt. Because debt issue costs have both operating and financing characteristics, the Emerging Issues Task Force considered whether such costs should be shown as an operating activity or as a financing activity in the statement of cash flows. In Issue No. 9513, Classification of Debt Issue Costs in the Statement of Cash Flows" (FASB ASC 230104515), the EITF reached a consensus that cash payments for debt issue costs should be classified as a financing activity. Accordingly, the amounts reported as a financing activity are the proceeds (the face amount of the debt), less the bank fees and other costs incurred, and repayment of that amount (the reduction in the net liability reported in the financial statements). No adjustment is needed to reconcile net income with net cash provided by operating activities. To illustrate, assume costs of $40,000 are incurred in obtaining a loan of $1,000,000. The loan is to be repaid in 36 47

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monthly installments of $33,000 including interest at 11.55%. A rate of 14.41% discounts the payments to the net proceeds of $960,000 (calculated as principal less the issuance costs of $40,000). That is the effective rate. At the end of the first year, payments of $396,000 have been made. Based on the stated rate, those payments have been allocated approximately $295,800 to principal and $100,200 to interest, and the principal balance outstanding is $704,200. However, based on the effective rate, the payments have been allocated approximately $275,400 to principal and $120,600 to interest, and the principal balance outstanding is $684,600. Assuming those are the only transactions for the year, cash of $564,000 has been provided (that is, the proceeds of $960,000 less the payments of $396,000), and the statement of cash flows would be as follows: CASH FLOWS FROM OPERATING ACTIVITIES Net loss and net cash used in operating activities CASH FLOWS FROM FINANCING ACTIVITIES Proceeds of longterm debt Payments for debt issue costs Principal payments NET INCREASE IN CASH $ $ (120,600 ) 1,000,000 (40,000 ) (275,400 ) 684,600 564,000

Life Insurance Policies. Loans against life insurance policies should be treated as longterm borrowings if the loans will be repaid following the guidance in the Shortterm and Longterm Debt" paragraph. Generally, however, the loans are considered to be permanent and, in those cases, treating them as distributions rather than loans is recommended. For example, assume that a company acquires an insurance policy that accumulates cash value of $9,000 over two years, borrows $2,000 against the cash value as a longterm liability (which is offset against cash value in the company's financial statements), and cancels the policy. If the loan were treated as a distribution, the following amounts would be reported in the cash flow statement assuming no other transactions: 20X2 CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities (Increase) decrease in cash value of life insurance NET CASH PROVIDED BY OPERATING ACTIVITIES $ 5,000 2,000 7,000 $ 20X1 4,000 (2,000 ) 2,000

Upon the death of an insured individual, the face amount of the policy less any outstanding loans against the cash value is distributed. An example of a cash flow statement is presented below assuming a $250,000 policy on the life of a stockholder had accumulated cash value of $20,000 at the date of death and that outstanding loans against the cash value amounted to $10,000. Net income reported in the statement amounts to income from the life insurance policy of $230,000 ($250,000 face value less $20,000 cash value previously recognized in earnings). CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Decrease in cash value of life insurance NET CASH PROVIDED BY OPERATING ACTIVITIES $ 230,000 10,000 240,000

The cash provided by operating activities in the preceding example equals the net cash distribution received by the company and is composed of $250,000 face value of the policy less outstanding policy loans of $10,000.

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Treasury Stock The amount paid to acquire a company's own stock should be reported as a cash outflow from financing activities in the amount of the cash disbursed to acquire the stock. Subsequent reissuance of treasury stock for cash should be reported as a cash inflow from financing activities. The following cash flow statement would be appropriate assuming 200 shares of common stock were acquired in 20X1 for $2,500 and reissued in 20X2 for $2,700: 20X2 CASH FLOWS FROM FINANCING ACTIVITIES Purchase of treasury stock Proceeds from reissuance of treasury stock NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES $ 2,700 2,700 $ 20X1 (2,500 ) (2,500 )

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 17. Which of the following would be classified as a financing activity on the statement of cash flows? a. Proceeds from issuing stock. b. Stock issued for property and equipment. c. Stock issued to settle debt. d. Stock issue costs not paid in cash during the period. 18. First Strike Inc. acquires an insurance policy on a key employee that accumulates $25,000. The company takes out a permanent $7,000 loan on the insurance policy. Upon the insured employee's death, what is the net income First Strike must report in cash flows? a. $7,000. b. $18,000. c. $25,000. d. $32,000.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 17. Which of the following would be classified as a financing activity on the statement of cash flows? (Page 46) a. Proceeds from issuing stock. [This answer is correct. The proceeds from issuing stock are reported as cash flows from financing activities. Generally, they are reported on a gross basis.] b. Stock issued for property and equipment. [This answer is incorrect. This type of transaction does not affect cash flows and would be disclosed as a noncash investing and financing activity.] c. Stock issued to settle debt. [This answer is incorrect. This type of transaction is disclosed as a noncash investing and financing activity because it does not affect cash flows.] d. Stock issue costs not paid in cash during the period. [This answer is incorrect. Cash flows are not affected by this type of transaction; therefore, stock issue costs not paid in cash during the period are classified as a noncash investing and financing activity.] 18. First Strike Inc. acquires an insurance policy on a key employee with a value of $25,000. The company takes out a permanent $7,000 loan on the insurance policy. Upon the insured employee's death, what is the net income First Strike must report in cash flows? (Page 48) a. $7,000. [This answer is incorrect. This is the loan amount, not the amount of net income First Strike needs to report.] b. $18,000. [This answer is correct. Most loans against insurance policies are permanent, so to get the net income the loan amount must be subtracted from the cash value of the insurance policy.] c. $25,000. [This answer is incorrect. If First Strike had repaid the loan, the company would receive the full amount of the value of the policy upon the insured employee's death. However, as the loan was a permanent loan in this scenario, First Strike will not receive $25,000.] d. $32,000. [This answer is incorrect. To get the net amount in this scenario, the loan amount should not be added to the cash value of the insurance policy.]

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Lesson 3:Noncash Activities and Preparing a Cash Flow Statement


Introduction
Building on the information provided in the previous lessons, Lesson 3 continues to discuss issues related to the cash flow statement. First the lesson covers noncash investing and financing activities, and then it discusses alternative methods for preparing a cash flow statement, as permitted by GAAP . Learning Objectives: Completion of this lesson will enable you to:  Distinguish and report noncash investing and financing activities.  Assess the direct and indirect methods for preparing cash flow statements.

CONSIDERATIONS FOR NONCASH INVESTING AND FINANCING ACTIVITIES


SFAS No. 95 (FASB ASC 23010503) requires investing and financing activities that do not involve cash receipts and payments during the period to be excluded from the cash flow statement and reported separately. For example, the appendix to SFAS No. 95 (FASB ASC 230105511) includes the following illustrative schedule of noncash investing and financing activities: Supplemental schedule of noncash investing and financing activities: The Company purchased all of the capital stock of Company S for $950. In conjunction with the acquisition, liabilities were assumed as follows: Fair value of assets acquired Cash paid for the capital stock Liabilities assumed $ $ 1,580 (950 ) 630

A capital lease obligation of $850 was incurred when the Company entered into a lease for new equipment. Additional common stock was issued upon the conversion of $500 of longterm debt. Because the disclosure of noncash investing and financing transactions is not selfbalancing, it is possible to inadvertently omit a noncash transaction from the schedule. Thus, all investing and financing transactions should be carefully reviewed to ensure that all noncash transactions are included. It is recommended that accountants use a worksheet that reconciles noncash investing and financing transactions. As previously mentioned, investing and financing transactions involve the following activities: Investing Activities  Lending money and collecting on loans  Acquiring and selling or disposing of securities (other than cash equivalents)  Acquiring and selling or disposing of productive assets that are expected to generate revenue over a long period of time Financing Activities  Obtaining resources from owners and providing them with a return on, and a return of, their investment 53

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 Borrowing money and repaying amounts borrowed, or otherwise settling the obligation  Obtaining and paying for other resources from creditors on longterm credit Although the supplemental disclosure of noncash investing and financing transactions is not selfbalancing, transactions having both cash and noncash aspects, for example, purchase of equipment in exchange for a cash down payment and an equipment loan, reconcile to the cash received or disbursed as shown within the cash flow statement. Format Considerations The supplemental disclosure of noncash investing and financing transactions may be presented either in narrative form (for example, in the notes to the financial statements) or summarized in a schedule. If the supplemental disclosure is made in a schedule, presenting it at the bottom of the cash flow statement is recommended. An example is as follows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation (Increase) decrease in: Trade accounts receivable Inventories Prepaid expenses Increase (decrease) in: Trade accounts payable Accrued liabilities Income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOWS FROM INVESTING ACTIVITIES Purchase of equipment CASH FLOWS FROM FINANCING ACTIVITIES Proceeds of longterm borrowings Repayment of longterm borrowings NET CASH PROVIDED BY FINANCING ACTIVITIES NET INCREASE IN CASH CASH AT BEGINNING OF YEAR CASH AT END OF YEAR SUPPLEMENTAL DISCLOSURES Schedule of Noncash Investing and Financing Transactions Capital lease obligation incurred for use of equipment $ $ 67,100 9,200 (47,750 ) 21,850 13,950 11,200 (17,450 ) 3,300 61,400 (30,000 ) 25,000 (5,000 ) 20,000 51,400 67,800 119,200

15,600

Alternatively, companies may disclose noncash investing and financing transactions in the notes to the financial statements in a separate note. (Note also, interest and income taxes paid are required to be disclosed on the face of the statement or in the notes.) 54

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It is believed that all noncash investing and financing transactions should be disclosed either totally in a separate schedule or totally in the notes to the financial statements. In other words, they recommend against disclosing some noncash transactions in a separate schedule and other noncash transactions in the notes. Assets Acquired by Assuming Liabilities Assets acquired by assuming liabilities, including capital lease obligations, are noncash transactions that should be disclosed separately. (Noncash transactions include acquiring assets by incurring liabilities not only through seller financing, but through thirdparty financing as well.) For example, the following scenario was presented in Lesson 2:  Net income and depreciation for the year amounted to $12,000 and $3,000, respectively.  On January 1, the company purchased a new machine with a list price of $74,000.  A used machine with an undepreciated cost of $5,000 was traded in on the purchase. The tradein allowance on the used machine was $4,000.  The company made a down payment of $10,000 and financed the balance of the purchase with an installment loan in the amount of $60,000 to be paid in six annual installments of $10,000 plus interest at the rate of 14%. The noncash aspects of the preceding transaction should be disclosed separately, for example, in a schedule of noncash investing and financing transactions such as follows: Acquisition of equipment Cost of equipment, net of tradein Loss on tradein Equipment loan Cash down payment for equipment $ 69,000 1,000 (60,000 ) 10,000

As shown in Lesson 2, the $10,000 cash down payment should be shown as cash used by investing activities. The traditional form of this transaction is for the lender to send a check to the seller or for the buyer to assume debt. In some situations, the form of the transaction is such that the buyer actually receives the proceeds of the borrowing and then sends those proceeds to the seller. The following are common examples:  The lender deposits the proceeds of the loan into the company's checking account, and the company drafts a check to the vendor.  The company drafts restricted cash accounts to pay the vendor, for example, cash restricted under the terms of an industrial development bond or cash restricted under a construction draw arrangement.  The company draws against a preestablished line of credit to pay the vendor. The substance of each of those situations is the same; the company acquires an asset by incurring a liability. The company is in the same position as if the lender sent a check to the vendor. Accordingly, it is believed that each should be reported as a noncash investing and financing activity. In addition to acquiring equipment via longterm debt, companies sometimes finance the acquisition of equipment through a shortterm trade account. To illustrate, assume that:  A wholesale distributor buys three trucks from a local dealer for $110,000 in December 20X0. The distributor pays the dealer $10,000 cash at that time and agrees to pay the remaining $100,000 in sixty days upon receipt of the vendor's invoice. The distributor records the $100,000 liability in trade accounts payable. 55

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 The trade accounts payable balance increased by $300,000 during 20X0, including the $100,000 for the trucks.  The trade accounts payable balance increased $350,000 during 20X1, after payment of the $100,000 payable to the dealer. Although the $100,000 liability is included in trade accounts payable on the distributor's balance sheet as of December 31, 20X0, that amount should not be reflected as an increase in accounts payable in the company's statement of cash flows when reconciling net income to cash flows from operating activities. Therefore, operating activities in 20X0 should reflect only a $200,000 increase in trade accounts payable. The remaining $100,000 increase in trade accounts payable should be disclosed as a noncash investing and financing activity, and the $10,000 cash down payment should be reflected as cash used by investing activities. In 20X1, the $100,000 payment to the dealer should not be reflected as a decrease in trade accounts payable when reconciling net income to cash flows from operating activities. Instead, the payment should be reflected as a financing activity, and operating activities should reflect a $450,000 increase in trade accounts payable. The applicable portions of the statements of cash flows for 20X1 and 20X0 should reflect the following: 20X1 CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Increase in trade accounts payable CASH FLOWS USED BY INVESTING ACTIVITIES Purchase of equipment CASH FLOWS FROM FINANCING ACTIVITIES Payment of shortterm trade account used to finance equipment acquisition 20X0

450,000

200,000 (10,000)

(100,000 )

In addition, the noncash aspects of the preceding transaction should be disclosed separately, for example, in a schedule of noncash investing and financing transactions such as follows: Acquisition of equipment Cost of equipment Trade account payable Cash down payment for equipment The disclosure also could be made in a note to the financial statements, such as: Noncash investing and financing activities in 20X0 consist of financing the purchase of equipment through a $100,000 trade account. It is believed that if the amount of change in the accounts payable balance related to nonoperating items is immaterial, the statements of cash flows for both the year of purchase and the year of payment could reflect the amount as an increase (decrease) in accounts payable. Converting Debt to Equity Converting debt to equity is a financing transaction since longterm financing is capitalized; however, the transac tion does not involve cash. Thus, the debt reduction should be disclosed in the financial statements in a separate schedule or otherwise. If a separate schedule were presented, appropriate captions, depending on the specific circumstances, would be as follows:  Stock issued in exchange for longterm debt 56 $ $ 110,000 (100,000 ) 10,000

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 Longterm debt converted to common stock Converting Stock Converting one class of stock to another, such as preferred to common, is treated in a manner similar to converting debt to equity. An amount equal to the par value of the preferred stock and any related additional paidin capital that is converted should be disclosed. For example, assume that 1,000 shares of $100 par value preferred stock ($100,000) is converted to 9,000 shares of $10 par value common stock. A schedule of noncash investing and financing transactions would report the transaction in a manner such as the following: Preferred Stock Converted to Common Stock Common stock Additional paidin capital $ $ Noncash Dividends The fair value of property that is distributed as a dividend is required to be charged to retained earnings. At the date that property dividends are declared, the company should recognize a gain or loss for the difference between the carrying value and the fair value of the assets that are distributed. For example, if property with an undepreciated cost of $85,000 and a fair value of $150,000 is distributed as a dividend, the company would recognize a gain of $65,000 ($150,000 * $85,000) when the dividend is declared. The gain should be subtracted from net income to arrive at cash flows from operations as follows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation Gain on distribution of property (Increase) decrease in: Trade accounts receivable Inventories Prepaid expenses Increase (decrease) in: Trade accounts payable Accrued liabilities Income taxes payable NET CASH PROVIDED BY OPERATING ACTIVITIES $ 105,000 8,000 (65,000 ) 34,175 (10,800 ) (500 ) (750 ) (9,600 ) 1,275 61,800 90,000 10,000 100,000

The transaction also would be shown in the schedule of noncash investing and financing transactions as follows: Property dividends Fair value of property distributed as dividends Undepreciated cost Gain on distribution $ $ 150,000 (85,000 ) 65,000

For stock dividends, it is believed that an amount equal to the fair value of the shares issued should be separately disclosed as a noncash transaction. For example, if 100 shares of common stock ($10 par value) with a fair value of $1,200 are distributed as a dividend, a schedule of noncash investing and financing transactions would report the transaction in a manner such as the following:

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Common stock distributed as a dividend Common stock Additional paidin capital Fair value of stock dividend

$ $

1,000 200 1,200

If a sufficient number of shares are issued so that the transaction would be classified as a stock split, it is believed that whether the transaction should be separately disclosed as a noncash transaction would depend on the legal requirements of the state of incorporation of the company. For example, some states require an amount equal to the par value of the shares issued to be capitalized to retained earnings. In those circumstances, it is believed that the stock split should be disclosed as described in the preceding paragraph. However, if state regulations require the transaction to be accounted for by increasing the number of shares outstanding and decreasing the par value per share, there would be no formal entry to record the transaction, and thus, it is believed unnecessary to disclose as a noncash transaction. (The transaction would be disclosed in the notes to the financial statements, however.) Purchase (Sale) of a Business When a company is purchased or sold, the cash paid to acquire the company (or cash proceeds from sale of the company) should be shown as cash used (or provided) by investing activities. SFAS No. 95 (FASB ASC 21010503 through 505) only requires the fair value of assets acquired and the fair value of liabilities assumed to be disclosed as a noncash transaction. It does not require the major categories of assets obtained and liabilities assumed to be disclosed. The major categories of assets obtained and liabilities assumed, however, often are separately disclosed as a noncash transaction, for example, in a separate schedule, as follows: Acquisition of ABC Company Working capital other than cash Equipment and leasehold improvements Intangibles and other assets Longterm debt assumed Cash paid to acquire ABC Company $ 30,000 120,000 30,000 (90,000 ) 90,000

When less than 100% of a subsidiary is acquired, noncontrolling interests in the subsidiary at the date of acquisition generally are shown as follows: Acquisition of ABC Company Working capital other than cash Equipment and leasehold improvements Intangibles and other assets Longterm debt assumed Noncontrolling interests Cash paid to acquire ABC Company $ 30,000 120,000 30,000 (90,000 ) (20,000 ) 70,000

Increases in the parent company's investment in a subsidiary as a result of issuing additional common stock also should be disclosed, for example, in a schedule of noncash investing and financing transactions, as follows: Issuance of common stock to reduce noncontrolling interests in ABC Company Unrealized Gains and Losses on Marketable Securities Net unrealized gains and losses on some marketable equity securities are recognized in income in the period in which they occur. Net income should be adjusted for the effect of those unrealized gains and losses by adding back unrealized losses and subtracting unrealized gains to arrive at cash flows from operations. Conversely, unrealized gains and losses on other debt and equity securities do not affect net income. They are recorded by adjusting the 58 $ 10,000

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carrying amount of the securities and adjusting other comprehensive income for a similar amount. Unrealized gains and losses on those securities need not be added to or subtracted from net income to arrive at cash flows from operations. Since those changes are internal accounting adjustments, they are not investing activities and, there fore, disclosure of them as a noncash investing transaction is believed unnecessary. Accrued Interest on Stockholder Loans Stockholders often borrow funds from or loan funds to closely held corporations. In some instances, the interest accrued on loans receivable from or payable to stockholders is added to the principal balance of the loan. It is believed that the increase in the loan balance should be reported as a noncash investing and financing activity. The accrued interest income (or expense) should be subtracted from (or added to) net income in arriving at cash flows from operating activities, since the interest is derived from a noncash transaction.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 19. Jessie is preparing a supplemental disclosure of noncash investing and financing transactions for AppleCo. Which of the following best describes how Jessie should format the disclosure? a. In narrative form in the notes to the financial statements. b. Summarized in a schedule at the top of the cash flow statement. c. Summarized on the face of the financial statements. d. Some transactions should be disclosed in the notes and others in a schedule. 20. Dallas Manufacturing takes on a capital lease obligation to purchase a new machine from Machine Enterprises. First Mutual deposits the proceeds of the loan into Dallas Manufacturing's checking account, and Dallas Manufacturing drafts a check to Machine Enterprises. How will this transaction be reported in Dallas Manufacturing's financial statements? a. As an operating activity. b. As an investing activity. c. As a financing activity. d. As a noncash investing and financing activity. 21. Which of the following scenarios would be disclosed on the company's financial statements in a separate schedule of noncash investing and financing activities? a. BetaCo converts 2,000 shares of $75 par value preferred stock to 6,000 shares of $25 par value common stock. b. Gamma Inc. pays out dividends to stockholders over the course of the year that amount to $500,000. c. The Delta Company disposes of availableforsale securities for a total of $375,000 over the course of the year. 22. The Cosmos Company issues shares of common stock ($30 par value) as a dividend. The number of shares issued classifies this as a stock split. How will the Cosmos Company report this on its financial statements? a. In a separate schedule of noncash investing and financing transactions. b. In a separate note to the financial statements. c. The par value of the shares will be capitalized to retained earnings. d. The reporting method depends on the legal requirements of the state in which the company is incorporated.

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23. Shoe Town purchases Sneaker Space. Under SFAS No. 95, which of the following is required to be disclosed as a noncash transaction? a. Cash Shoe Town paid to acquire Sneaker Space. b. The cash proceeds Sneaker Space's owners made from the sale. c. Fair value of assets Shoe Town acquired and liabilities it assumed from Sneaker Space. d. The major categories of assets Shoe Town acquired and liabilities it assumed from Sneaker Space. 24. Dias, Kinch, & Brinkman (DKB) borrows funds from a closely held corporation. Interest accrued on the loan payable is added to the principal balance of the loan. How should DKB report this on its financial statements? a. Accrued interest expense is added to net income to arrive at cash flows from operating activities. b. The net loss of the accrued interest is recognized in income in the period in which it occurs. c. The carrying amount of the loan is adjusted and other comprehensive income is adjusted for a similar amount. d. The amount of the accrued interest is reported as part of the cash flow per share.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 19. Jessie is preparing a supplemental disclosure of noncash investing and financing transactions for AppleCo. Which of the following best describes how Jessie should format the disclosure? (Page 54) a. In narrative form in the notes to the financial statements. [This answer is correct. There are two ways Jessie can choose to format the supplemental disclosure of noncash investing and financing transactions. If Jessie chooses this method, the disclosure should be made in a separate note.] b. Summarized in a schedule at the top of the cash flow statement. [This answer is incorrect. One way Jessie can format the transactions of noncash investing and financing transactions is to present it in a schedule. If she does this, it is recommended that the schedule be presented below the statement of cash flows.] c. Summarized on the face of the financial statements. [This answer is incorrect. This type of presentation is not one of Jessie's choices for the supplemental disclosure of noncash investing and financing transactions. However, interest and income taxes paid are required to be disclosed either this way or in the notes.] d. Some transactions should be disclosed in the notes and others in a schedule. [This answer is incorrect. It is recommended that all of the noncash investing and financing transactions be disclosed in the same way, not split between two methods of presentation.] 20. Dallas Manufacturing takes on a capital lease obligation to purchase a new machine from Machine Enterprises. First Mutual deposits the proceeds of the loan into Dallas Manufacturing's checking account, and Dallas Manufacturing drafts a check to Machine Enterprises. How will this transaction be reported in Dallas Manufacturing's financial statements? (Page 55) a. As an operating activity. [This answer is incorrect. Acquiring assets by assuming liabilities is not considered an operating activity. Cash flows from operating activities are defined by exception; they are activities that are not investing or financing activities.] b. As an investing activity. [This answer is incorrect. This transaction would not be shown as an investing activity on the company's financial statements. If Dallas Manufacturing paid Machine Enterprises a cash down payment on the new machine, that payment would be shown as cash used by investing activities.] c. As a financing activity. [This answer is incorrect. The transaction discussed in the above scenario would not be considered a financing activity. Financing activities include proceeds and repayments of longterm borrowings and obligations (including capital leases) rather than net changes in longterm debt.] d. As a noncash investing and financing activity. [This answer is correct. The traditional form of this transaction would have been for First Mutual to send the check straight to Machine Enterprises. However, in the above scenario, Dallas Manufacturing acquires an asset by incurring a liability, just as it would have in the traditional form of the payment scenario. Therefore, it is believed that this transaction would be reported on Dallas Manufacturing's financial statements as a noncash investing and financing activity.]

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21. Which of the following scenarios would be disclosed on the company's financial statements in a separate schedule of noncash investing and financing activities? (Page 57) a. BetaCo converts 2,000 shares of $75 par value preferred stock to 6,000 shares of $25 par value common stock. [This answer is correct. BetaCo could report this transaction as a separate schedule of noncash investing and financing activities. Converting one class of stock to another class of stock is treated in a manner similar to the way that debt is converted into equity.] b. Gamma Inc. pays out dividends to stockholders over the course of the year that amount to $500,000. [This answer is incorrect. Gamma's transaction would be classified as a financing activity.] c. The Delta Company disposes of availableforsale securities for a total of $375,000 over the course of the year. [This answer is incorrect. This transaction would be classified as an investing activity.] 22. The Cosmos Company issues shares of common stock ($30 par value) as a dividend. The number of shares issued classifies this as a stock split. How will the Cosmos Company report this on its financial statements? (Page 58) a. In a separate schedule of noncash investing and financing transactions. [This answer is incorrect. Though this method could be used under some circumstances, other information in this scenario could change the way the Cosmos Company must deal with this situation.] b. In a separate note to the financial statements. [This answer is incorrect. Using a narrative form is acceptable for disclosures of noncash investing and financing transactions. However, other information in this scenario might change how the Cosmos Company must deal with the above scenario.] c. The par value of the shares will be capitalized to retained earnings. [This answer is incorrect. In some situations, the Cosmos Company could use this method for reporting the above scenario; however, there is other information that must be taken into account, as well before the final decision is made.] d. The reporting method depends on the legal requirements of the state in which the company is incorporated. [This answer is correct. The legal requirements of the state in which the company is incorporated have bearing on how a stock split should be disclosed. The Cosmos Company might be required to capitalize the par value of the shares to retained earnings or it might disclose the transaction as a noncash transaction, depending upon the applicable state laws.] 23. Shoe Town purchases Sneaker Space. Under SFAS No. 95, which of the following is required to be disclosed as a noncash transaction? (Page 58) a. Cash Shoe Town paid to acquire Sneaker Space. [This answer is incorrect. Shoe Town would report this as cash used by investing activities.] b. The cash proceeds Sneaker Space's owners made from the sale. [This answer is incorrect. Sneaker Space's former owners would report this as cash provided by investing activities.] c. Fair value of assets Shoe Town acquired and liabilities it assumed from Sneaker Space. [This answer is correct. Under SFAS No. 95, the fair value of assets acquired and the fair value of liabilities assumed must be disclosed as a noncash transaction.] d. The major categories of assets Shoe Town acquired and liabilities it assumed from Sneaker Space. [This answer is incorrect. SFAS No. 95 does not require that the major categories of liabilities assumed and assets obtained be disclosed; however, in practice, they are often separately disclosed as a noncash transaction.]

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24. Dias, Kinch, & Brinkman (DKB) borrows funds from a closely held corporation. Interest accrued on the loan payable is added to the principal balance of the loan. How should DKB report this on its financial statements? (Page 59) a. Accrued interest expense is added to net income to arrive at cash flows from operating activities. [This answer is correct. Since the interest in this scenario is derived from a noncash transaction, DKB should proceed by adding the accrued interest expense to net income, which allows the company to arrive at cash flows from operating activities.] b. The net loss of the accrued interest is recognized in income in the period in which it occurs. [This answer is incorrect. If DKB were recognizing net unrealized losses on some marketable equity securities, those losses would be recognized in income in the period in which they occur.] c. The carrying amount of the loan is adjusted and other comprehensive income is adjusted for a similar amount. [This answer is incorrect. If DKB were recognizing unrealized gains and losses on certain debt and equity securities, net income would not be affected. In that case, DKB would record the transaction by adjusting the carrying amount of the securities, and then by adjusting other comprehensive income by an equivalent amount.] d. The amount of the accrued interest is reported as part of the cash flow per share. [This answer is incorrect. SFAS No. 95 prohibits reporting an amount representing cash flow per share. It was concluded by the FASB that cash flow per share data is susceptible to misinterpretation.]

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REPORTING CASH FLOW PER SHARE


SFAS No. 95 prohibits reporting an amount that represents cash flow per share, a practice followed in the past primarily by some publicly held companies. In making that decision, the FASB concluded that cash flow per share data was susceptible to misinterpretation. For example, it may imply that cash flow is equivalent or superior to earnings as a measure of performance or that an amount representing cash flow per share is available for distribution to stockholders.

HOW TO PREPARE CASH FLOW STATEMENTS


The information needed to prepare a cash flow statement usually is obtained from comparative balance sheets and additional information about changes in accounts in sufficient detail to identify (a) the nature of cash flows (operating, investing, or financing), (b) gross cash receipts and payments, and (c) any noncash transactions. The following illustrates how to prepare a statement of cash flows for Big Time Company. The balance sheets and statement of income and retained earnings for Big Time Company follow: BIG TIME COMPANY BALANCE SHEETS December 31 20X2 ASSETS CURRENT ASSETS Cash Accounts receivable Notes receivablestockholder Accrued interest receivable Inventory PROPERTY AND EQUIPMENT Land Building Shop equipment Furniture Autos and trucks Accumulated depreciation OTHER ASSETS Cash value of life insurance Deferred charges TOTAL ASSETS $ $ 32,450 112,800 27,800 1,450 149,500 324,000 60,000 320,000 55,000 18,500 11,000 464,500 (195,850 ) 268,650 22,950 1,350 24,300 616,950 $ $ 56,250 121,600 11,400 800 183,300 373,350 60,000 320,000 40,000 18,500 23,500 462,000 (185,000 ) 277,000 19,350 2,700 22,050 672,400 20X1

TOTAL CURRENT ASSETS

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20X2 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Notes payable Current portion of longterm debt Accounts payable Accrued expenses Compensation Interest Payroll taxes Income taxes LONGTERM DEBT, less current portion STOCKHOLDERS' EQUITY Common stock Retained earnings $ 40,000 72,000 170,850 11,000 1,850 1,300 4,350 301,350 180,500 20,000 115,100 135,100 $ 616,950 $ $

20X1

50,000 67,500 179,400 8,150 1,400 950 2,250 309,650 242,500 20,000 100,250 120,250 672,400

TOTAL CURRENT LIABILITIES

TOTAL STOCKHOLDERS' EQUITY TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

BIG TIME COMPANY STATEMENT OF INCOME AND RETAINED EARNINGS Year Ended December 31, 20X2 REVENUE Sales Gain on sale of truck Interest income COST OF SALES Raw materials Direct labor Freight GROSS PROFIT $ 737,200 250 2,400 739,850 315,200 32,900 16,700 364,800 375,050

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SELLING AND ADMINISTRATIVE EXPENSES Officers' salaries Sales salaries Office salaries Payroll taxes Rent Office expense Officers' life insurance Professional fees Telephone Utilities Repairs and maintenance Insurance Provision for bad debts Depreciation Amortization Other taxes Interest expense INCOME BEFORE INCOME TAXES INCOME TAXES NET INCOME BEGINNING RETAINED EARNINGS Dividends paid ENDING RETAINED EARNINGS Additional financial information for Big Time Company is as follows: $

89,600 48,400 51,600 18,650 25,850 10,800 4,200 5,900 4,700 9,350 6,700 14,300 20,000 18,850 1,350 3,200 14,650 348,100 26,950 8,100 18,850 100,250 (4,000 ) 115,100

 The company's principal stockholder repaid $3,600 of his $11,400 receivable during the year. At December 31, 20X2, the stockholder borrowed an additional $20,000.  The company purchased machinery in exchange for a $5,000 down payment and a $10,000 equipment note. The first payment on the equipment note is due in 20X3.  A truck with an original cost of $12,500 and accumulated depreciation of $8,000 was sold for $4,750.  Notes payable shown as a current liability have original maturities of three months or less. Indirect Method The worksheet prepared using the indirect method in Exhibit 31 summarizes the changes in each financial statement caption and includes a draft" cash flow statement section.

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Exhibit 31 Illustrative Cash Flow Worksheet


A BIG TIME COMPANY CASH FLOW WORKSHEET Year Ended December 31, 20X2 ASSETS B C D Net Change Increase (Decrease) (C) (B) Ref. E F G H I J K L Draft Statement of Cash M Flowsa N

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Year End Balances Current 20X2 Prior 20X1

Gross Change in Financial Statement Amounts Account Analysis Description Amounts Ref. Expanded Account Analysis Description Amounts Ref.

Captions OPERATING ACTIVITIES: Net earnings (loss)

Amounts

Ref.

18,850

Accounts receivable

112,800

121,600

8,800

" "

Bad debt provision Other (incr.) decr. New loans Payments received

20,000 (11,200) (20,000) 3,600


" "

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Cash loan Noncash loan

(20,000) ()

Depreciation and amortization (Gain) loss Bad debt provision Deferred tax expense (benefit)

20,200 (250) 20,000 (3,600)

Notes receivableb

27,800

11,400

(16,400)

" "

Inventory

149,500

183,300

33,800

Cash valuelife insurance (Increase) decrease in:

Investmentsb

" "

Purchases Sales

()
" "

Accounts receivable Proceeds (Gain) loss Inventory Prepaid expenses Interest receivable

(11,200) 33,800 (650)

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Prepaid expenses Other current assets: Accrued interest

1,450

800

(650)
"

Depreciation Purchases Disposalsnet

18,850 (15,000) 4,500

" " " "

Cash purchase Noncash purchase Proceeds (Gain) loss

(5,000) (10,000) 4,750 (250)

Increase (decrease) in: Accounts payable Accrued liabilities (8,550) 5,750

Property and equipmentnet

268,650

277,000

8,350

" "

Other assets: Cash value of life insurance Deferred charges Total assets (excluding cash) 22,950 1,350 584,500 19,350 2,700 616,150 (3,600) 1,350 31,650
" "

Noncash income Amortization

(3,600) 1,350
"

Cash from operations INVESTING ACTIVITIES: Purchases of P&E (5,000) 4,750 (20,000) 3,600 () 16 74,350

LIABILITIES AND EQUITY Shortterm notesb 40,000 50,000

(B) (C) (10,000)


" "

"

Cash debt Noncash debt

Sales of P&Eproceeds Loans made Collections of loans Purchases of availableforsale securities Sales of availableforsale securities

New debt Reductions

(10,000)

"

Accounts payable Accrued liabilities

170,850 18,500

179,400 12,750

(8,550) 5,750

A BIG TIME COMPANY CASH FLOW WORKSHEET Year Ended December 31, 20X2 Other current liabilities:

D Net Change Increase (Decrease) (B)(C)

Year End Balances Current 20X2 Prior 20X1

Gross Change in Financial Statement Amounts Account Analysis Ref. Description Amounts Ref. Expanded Account Analysis Description Amounts Ref.

Draft Statement of Cash Flowsa

Captions

Amounts

Ref.

Total investing FINANCING ACTIVITIES:


"

(16,650)

Cash debt Noncash debt

10,000

Proceeds from S/T debt Proceeds from L/T debt Payments on S/T debt Payments on L/T debt

(10,000) (67,500) (4,000)

Debt (current and L/T portions)

252,500

310,000

(57,500)

" "

New debt Reductions

10,000 (67,500)

"

Deferred taxes (current and L/T portions)

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Dividends paid

Other longterm liabilities: Total financing


"

(81,500) (23,800) 56,250 $ 32,450 Cash dividend Noncash dividend (4,000) () Net increase (decrease) Cash BOY Cash EOY

Equity

135,100

120,250

14,850

" "

Dividends Earnings (loss)

(4,000) 18,850

"

Total liabilities and equity 616,950

672,400

(55,450) OTHER NONCASH ITEMS: P&E acquired (10,000) 10,000

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Cash

32,450

56,250

(23,800)

Debt issued

Notes:
a b

When the indirect method is used, interest paid (net of amounts capitalized) and income taxes paid during the period are required to be disclosed. Notes receivable, investments, and shortterm notes with maturities of 90 days or less, including demand notes, may be presented on a net change basis.

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The final statement of cash flows for Big Time Company using the indirect method is as follows. It provides a detailed discussion of each amount appearing in the statement of cash flows: CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization Gain on sale of truck Cash value of officers' life insurance Provision for bad debts (Increase) decrease in: Trade accounts receivable Interest receivable Inventories Increase (decrease) in: Trade accounts payable Accrued liabilities NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOWS FROM INVESTING ACTIVITIES Purchase of equipment Proceeds from sale of equipment Loans made Collection of loans NET CASH USED BY INVESTING ACTIVITIES CASH FLOWS FROM FINANCING ACTIVITIES Debt reduction: Shortterm Longterm Dividends paid NET CASH USED BY FINANCING ACTIVITIES NET DECREASE IN CASH CASH AT BEGINNING OF YEAR CASH AT END OF YEAR $ $ 18,850 a 20,200 b (250 )c (3,600 )d 20,000 e (11,200 )e (650 )f 33,800 f (8,550 )f 5,750 f 74,350 (5,000 )g 4,750 h (20,000 )i 3,600 j (16,650 )

(10,000 )k (67,500 )l (4,000 )m (81,500 ) (23,800 ) 56,250 32,450

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SUPPLEMENTAL DISCLOSURESn Operating activities reflect interest paid of $14,200 and income taxes paid of $6,000. Noncash investing and financing transactions: Acquisition of equipment Cost of equipment Equipment loan Cash down payment for equipment Notes:
a b

$ $

15,000 (10,000 ) 5,000

Cash flows from operating activities begins with net income of $18,850, as reported in the income statement. Depreciation and amortization ($18,850 + $1,350) are noncash expenses. Thus, they are added back to net income in arriving at cash flows from operations. Gain on the sale of the truck is subtracted from net income. Proceeds from sales of noncurrent assets are shown as investing activities. Increases in cash value of life insurance ($22,950 * $19,350) that are allowed to accumulate are included in net income as a reduction of insurance expense. Since the increases do not provide cash, however, they should be subtracted from net income in arriving at cash flows from operations. The net change in trade accounts receivable should be adjusted for the provision for bad debts that is presented separately as follows: Net decrease Add back provision for bad debts Net increase attributable to cash amounts $ $ (8,800 ) 20,000 11,200

When cash flows from operations are presented using the indirect method, net income should be adjusted for changes during the period in operating current assets and liabilities to approximate actual cash receipts and payments attributed to operations. If there are no material noncash entries posted to operating current assets and liabilities, the net change would be as follows: 20X2 Interest receivable Inventories Trade payables Accrued expenses Total $ 1,450 $ 149,500 (170,850 ) (18,500 ) (38,400 ) $ 20X1 Net Change 650 (33,800 ) 8,550 (5,750 ) (30,350 )

800 $ 183,300 (179,400 ) (12,750 ) (8,050 ) $

g h i j k

The cash down payment for equipment is shown as cash used by investing activities. Proceeds from the sale of the truck are shown as cash flows from investing activities. The additional stockholder loan in the amount of $20,000 is shown as cash used by investing activities. Cash collections of the stockholder loan are shown as cash flows from investing activities. Repayment of notes payable ($50,000 * $40,000) is shown as cash used by financing activities. (The net change is shown because the original maturities of the notes are three months or less.) 72

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l m n

Payment of the current portion of longterm debt is shown as cash used by financing activities. Dividends paid are shown as cash used by financing activities. Alternatively, the supplemental disclosures could be made in the notes to the financial statements rather than on the face of the cash flow statement.

Direct Method If Big Time Company prepared its statement of cash flows using the direct method, cash flows from operating activities would be presented as shown below. (Cash flows from investing activities, cash flows from financing activities, and the schedule of noncash investing and financing activities would be presented the same way using either the direct or the indirect method.) CASH FLOWS FROM OPERATING ACTIVITIES Collections from customers Interest collected Cash paid to suppliers and employees Interest paid Income taxes paid NET CASH PROVIDED BY OPERATING ACTIVITIES $ 726,000 1,750 (633,200 ) (14,200 ) (6,000 ) 74,350

Under the direct method, revenues and expenses presented in the income statement are adjusted for accrued amounts at the beginning and ending of the period and are grouped into categories. Noncash revenues and expenses are excluded. Amounts for Big Time Company are calculated as follows:  Collections from customers Sales per income statement Increase in accounts receivable Cash collected  Interest collected Interest income Increase in accrued interest receivable Cash collected  Cash paid to suppliers and employees Cost of sales Selling and administrative expenses Less interest expense presented separately Less noncash items: Depreciation Amortization Increase in cash value of life insurance Bad debt provision Decrease in inventory Decrease in trade payables Increase in accrued compensation and payroll taxes Cash paid 73 $ 364,800 348,100 (14,650 ) (18,850 ) (1,350 ) 3,600 (20,000 ) (33,800 ) 8,550 (3,200 ) $ 633,200 $ $ 2,400 (650 ) 1,750 $ $ 737,200 (11,200 ) 726,000

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 Interest paid Interest expense per income statement Increase in accrued interest payable $ $  Income taxes paid Income tax provision per income statement Increase in accrued income taxes payable $ $ 8,100 (2,100 ) 6,000 14,650 (450 ) 14,200

If Big Time Company prepared its cash flow statement using the direct method, it also would be required to present a separate schedule that reconciles net income to net cash provided by operating activities, such as shown below. Reconciliation of Net Income to Net Cash Provided by Operating Activities: Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization Gain on sale of truck Cash value of officers' life insurance Provision for bad debts (Increase) decrease in: Trade accounts receivable Interest receivable Inventories Increase (decrease) in: Trade accounts payable Accrued liabilities NET CASH PROVIDED BY OPERATING ACTIVITIES $ 18,850 20,200 (250 ) (3,600 ) 20,000 (11,200 ) (650 ) 33,800 (8,550 ) 5,750 $ 74,350

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 25. CommaCorp presents its statement of cash flows using the indirect method. Under that method, which of the following line items from the statement would be considered a supplemental disclosure? a. Cash down payment for equipment. b. Provision for bad debts. c. Depreciation and amortization. d. Cash at end of year. 26. If CommaCorp used the direct method instead of the indirect method to prepare its statement of cash flows, which of the following would be true? a. Noncash revenues and expenses are included in the statement of cash flows. b. Revenues and expenses are accrued as of the beginning of the period and disclosed separately. c. A statement reconciling net income to net cash provided by operating activities is included.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 25. CommaCorp presents its statement of cash flows using the indirect method. Under that method, which of the following line items from the statement would be considered a supplemental disclosure? (Page 71) a. Cash down payment for equipment. [This answer is correct. This information would be a line item in the Supplemental Disclosure category in CommaCorp's statement of cash flows. Other line items in that category could include, Acquisition of equipment," cost of equipment," and equipment loan."] b. Provision for bad debts. [This answer is incorrect. This line item would be located in Cash Flows from Operating Activities in CommaCorp's statement of cash flows. The net change in trade accounts receivable is adjusted for the provision for bad debts that CommaCorp would present separately.] c. Depreciation and amortization. [This answer is incorrect. These are noncash expenses and, thus, are added back to CommaCorp's net income to arrive at the cash flows from operations.] d. Cash at end of year. [This answer is incorrect. This is the total of CommaCorp's statement of cash flows, so it would not be added as a supplemental disclosure. To determine the cash at end of year, CommaCorp takes the total of cash flows for operating, investing, and financing activities and adds it to the cash at beginning of year.] 26. If CommaCorp used the direct method instead of the indirect method to prepare its statement of cash flows, which of the following would be true? (Page 74) a. Noncash revenues and expenses are included in the statement of cash flows. [This answer is incorrect. Under the direct method, noncash revenues and expenses would be excluded from CommaCorp's statement of cash flows.] b. Revenues and expenses are accrued as of the beginning of the period and disclosed separately. [This answer is incorrect. Under the direct method, CommaCorp would present revenues and expenses from the income statement that are adjusted for accrued amounts at both the beginning and the end of the period. They would also be grouped into categories (e.g., Interest collected and Income taxes paid), not disclosed separately.] c. A statement reconciling net income to net cash provided by operating activities is included. [This answer is correct. This separate statement is required if the direct method is used to present the cash flow statement.]

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TESTING INSTRUCTIONS FOR EXAMINATION FOR CPE CREDIT


Companion to PPC's Guide To Preparing Financial StatementsCourse 1 The Statement of Cash Flows (PFSTG081)
Test Instructions 1. Following these instructions is an examination consisting of multiple choice questions. You may complete the exam by logging on to our online grading system at OnlineGrading.Thomson.com. Click the purchase link and list of exams will appear. You may search for the exam using wildcards. Payment for the exam is accepted over a secure site using your credit card. Once you purchase an exam, you may take the exam three times. On the third unsuccessful attempt, the system will request another payment. Once you successfully score 70% on an exam, you may print your completion certificate from the site. The site will retain your exam completion history. If you lose your certificate, you may return to the site and reprint your certificate. If you prefer, you may continue to mail your completed answer sheet to the address below. In the print product, the answer sheets are bound with the course materials. For the CDROM product, answer sheets may be printed. The answer sheets are identified with the course acronym. Please ensure you use the correct answer sheet. Indicate the best answer to the following exam questions by completely filling in the circle for the correct answer. The bubbled answer should correspond with the correct answer letter at the top of the circle's column and with the question number. 2. If you change your answer, remove your previous mark completely. Any stray marks on the answer sheet may be misinterpreted. 3. Copies of the answer sheet are acceptable. However, each answer sheet must be accompanied by a payment of $75. If you complete three courses, the price for grading three is $214 (a 5% discount on three courses). In order to receive the discounted fees, all courses must be submitted for grading at the same time. OR the price for grading all four is $270 (a 10% discount on all four courses). 4. To receive CPE credit, completed answer sheets must be postmarked by December 31, 2009. Send the completed Examination for CPE Credit Answer Sheet along with your payment to the following address. CPE credit will be given for examination scores of 70% or higher. An express grading service is available for an additional $24.95 per examination. Course results will be faxed to you by 5 p.m. CST of the business day following receipt of your examination for CPE Credit Answer Sheet. 5. Only the Examination for CPE Credit Answer Sheet should be submitted for grading. DO NOT SEND YOUR SELFSTUDY COURSE MATERIALS. Be sure to keep a completed copy for your records. 6. Please allow a minimum of three weeks for grading. 7. Please direct any questions or comments to our Customer Service department at (800) 3238724. Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to: Thomson Reuters Tax & AccountingR&G PFSTG081 Selfstudy CPE P .O. Box 966 Fort Worth, TX 76101 If you are paying by credit card, you may fax your completed Examination for CPE Credit Answer Sheet and Course Evaluation to the Tax & Accounting business of Thomson Reuters at (817) 2524021.

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EXAMINATION FOR CPE CREDIT 1. A statement of cash flows must be presented as one of the basic financial statements in which of the following scenarios. a. Joanna's personal financial statements are prepared in accordance with generally accepted accounting principals (GAAP), and she presents both a balance sheet and an income statement. b. The Malt Shoppe is a profitoriented sole proprietorship. The Malt Shoppe prepares its financial statements using the income tax basis of accounting. c. BakerCorp is a profitoriented C corporation that presents financial statements prepared in accordance with GAAP . It includes both a balance sheet and an income statement in its basic statements. d. Helping Hands is a nonprofit organization that presents a balance sheet prepared in accordance with GAAP , but does not present an income statement. 2. Jacob must prepare a statement of cash flows in accordance with GAAP for HinkleCorp. In 2008, the corporation had several significant cash overdrafts. Based on the guidance in this course, what option does Jacob have when presenting the cash overdrafts in the statement of cash flows? a. He should not include them in the definition of cash and present them as a financing activity. b. He should include them in the definition of cash. c. He must present them in accordance with AICPA Technical Practice Aid TIS 1300.15. d. Do not select this answer choice. 3. Classify the following cash receipts. 1. Operating 2. Investing 3. Financing i. Sale of goods and services ii. Issuance of stock iii. Interest and dividends iv. Collections on loans v. Sale of property and equipment vi. Longterm borrowings a. 1., i. and iii.; 2., iv. and v.; 3., ii. and vi. b. 1., i. and v.; 2., ii. and iii.; 3., iv. and vi. c. 1., iv. and v.; 2., ii. and vi.; 3., i. and iii. d. 1., ii. and vi.; 2., i. and iv.; 3., iii. and v.

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4. The Hiller Corporation presents comparative financial statements. Which of the following correctly describes how this will affect the format and style of the statement of cash flows? a. The title must be changed to Comparative Statement of Cash Flows." b. The following captions must be used: Operations," Investments," and Financing." c. Captions are modified if the net results in each period are not the same. d. Changes must be presented in the order they appear on the statement of financial position. 5. In which of the following scenarios does the practitioner use a common practice that should make the statement of cash flows more understandable? a. Joshua presents related items separately. b. Allison presents items in the order of significance. c. Harvey repeats all applicable notes from other statements. d. Dina uses a subtotal when a single item comprises the operating cash flows. 6. Which of the following describes cash flows from operating activities? a. They include all transactions and events that are not investing or financing activities. b. They include cash paid to extinguish debt. c. They include obtaining resources from owners and providing them with a return on/of their investment. d. They include amounts derived from accruals, deferrals, and allocations. 7. Which of the following lists includes all the generally accepted formats for cash flows from operations permitted by GAAP? a. Discounted cash flow and free cash flow methods. b. Direct and indirect methods. c. Indirect, direct, and discounted cash flow methods. d. Indirect, direct, discounted cash flow, and free cash flow methods. 8. Cal has been hired by Mac2 to prepare its financial statements. When preparing the presentation of cash flows from operating activities for the statement of cash flows, when would Cal be required also to present a reconciliation of net income to cash flows from operating activities as a separate schedule? a. If he uses the direct method. b. If he uses the indirect method. c. If interest paid is disclosed. d. If income taxes paid is disclosed.

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9. Larry, the preparer of the financial statements, uses the indirect method as the basic format for MileCo's cash flows from operating expenses. Which of the following accurately describes procedures Larry must follow related to the use of this method? a. He may derive interest payments by adjusting interest charged to operations by the change in accrued interest expense and reduce the amount for interest paid and capitalized as part of inventory. b. He must deduct cash payments for operating costs and expenses from the cash receipts and individually lists the cash effects of each major type of revenue and expense. c. He must disclose income taxes paid net of receipts of income tax refunds, and he must disclose the gross amount of receipts and payments, along with the fact that a net amount is presented. d. He must adjust net income for noncash items and changes in operating current assets and liabilities during the period. 10. Extraordinary items, cumulative accounting adjustments, and discontinued operations are not required to be separately disclosed. Which of the following scenarios most accurately describes a way to deal with one of these items when preparing information on cash flows for operations? a. ABC Company classifies the noncash tax benefits from realizing loss carryforwards arising in prior years as an extraordinary item. b. DEF Company uses the indirect method of reporting cash flows for operations and thus noncash extraordinary items are excluded from the cash flows. c. HIJ Company changes from the FIFO method of valuing inventories to the LIFO method. Since it uses the indirect method, the cumulative accounting adjustment will be reflected in net income. d. KLM Company elects to disclose cash flows from discontinued operations separately, but only for six months after the operations were discontinued. 11. Good Stuff Inc. uses the indirect method for preparing cash flows from operating activities. Which of the following scenarios best describes an adjustment that Good Stuff might need to make to arrive at net cash flows from operating activities? a. All copyrights and trademarks owned by Good Stuff are considered current assets and associated revenues and expenses are included in net income in the period that the asset is acquired. b. Increases in the cash value of insurance policies held by Good Stuff are added to net income. Increases allowed to accumulate do not affect net income until the accumulation is complete. c. Depletion is the amount expense for natural resources that Good Stuff allocates as units are removed. As depletion does not affect cash, it should not be added back to net income to arrive at cash flows from operations. d. Increases in Good Stuff's deferred income tax liabilities are added back to net income, but changes allocated to gains on availableforsale marketable securities do not affect the net income. 12. Meta Enterprises uses the equity method of accounting to account for its longterm investments in common stock. How will the company's share of undistributed earnings be accounted for? a. It is subtracted from net income to arrive at cash flows from operations. b. It is recorded as investment earnings and no adjustment to net income is required. c. It is a noncash item and reported as an expense on the consolidated income statement. d. It will be recognized in income during the period in which they are distributed as dividends. 80

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13. Which of the following is an investing activity? a. Providing services. b. Lending money. c. Borrowing money. d. Issuing stock. 14. Metal Heads purchases a new machine with a list price of $100,000. The company trades in a used machine with an undepreciated cost of $8,000. The tradein allowance on the used machine is $7,000. Metal Heads makes a down payment of $20,000 on the new machine. The rest is financed with a loan amount of $73,000 that will be paid in 12 semiannual installments plus interest. The interest rate is 15%. Calculate the amount that will be included in cash flows from investing activities. a. $20,000. b. $27,000. c. $83,950. d. $100,000. 15. What type of installment sales includes both operating and investing aspects? a. Longlived assets. b. Shortterm investments. c. Inventory. d. Bonds purchased above par. 16. Which of the following is classified as an operating activity on the statement of cash flows? a. The principal amount of a loan made by the company. b. Interest collected on loans the company made. c. Liabilities assumed in the purchase of a company. d. Cash paid to acquire a company. 17. In 2008, Linda borrows money from the Rose Garden, a closely held corporation. The corporation records the borrowing as a stockholder loan receivable and offsets dividend distributions against the loan receivable. In 2009 and subsequent years, how should the offsetting be reported on the statement of cash flows? a. As an operating activity. b. As an investing activity. c. As a financing activity. d. As a supplemental disclosure.

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18. Little Angels acquires equipment in a capital lease transaction. The capital lease obligation is $100,000. The company borrows $15,000 cash as a shortterm debt payable in less than three months, $20,000 of other shortterm debt, and $200,000 of longterm debt. Little Angels pays $5,000 on the capital lease obligation, $6,000 on the shortterm debt payable in less than three months, $12,000 on the other shortterm debt, and $25,000 on the longterm debt. Calculate the net cash provided by financing activities that Little Angels will show on its cash flow statement. a. $100,000. b. $129,000. c. $187,000. d. $271,000. 19. Which of the following scenarios best illustrates how noncash investing and financing activities should be dealt with in the financial statements? a. LaborCorp presents its noncash investing and financing activities on its statement of cash flows. b. MemorialCo presents its noncash investing and financing activities in a separate supplemental schedule. c. Arbor Inc. reconciles its noncash investing and financing activities in a worksheet that is included in the financial statements. d. Valentine Ltd. excludes all noncash investing and financing activities from the financial statements. 20. Sampson & Sons Shipping purchases three new trucks from Bob's Motors for $150,000 in December 2008. Sampson pays Bob's Motors $25,000 cash at the time of purchase and agrees to pay the remaining balance in sixty days upon the vendor's notice. Sampson records the $125,000 liability in trade accounts payable. During 2008, the balance of trade accounts payable increased by $500,000, which includes the $125,000 owed on the new trucks. Which of the following best illustrates how Sampson's financial statements will be affected? a. When Sampson reconciles net income to cash flows from operating activities in 2008, the $125,000 is included as an increase in accounts payable. b. Sampson's 2008 operating activities will reflect a $375,000 increase and the $125,000 for the trucks is classified as a noncash investing and financing activity. c. Sampson will classify the full purchase price of the new trucks, $150,000, as a noncash investing and financing activity in the 2008 financial statements. d. In 2009, the $125,000 payment is reflected as a decrease in trade accounts payable when Sampson reconciles net income to cash flows from operating activities. 21. The Greyson Company converts debt into equity. How should this debt reduction be reported in the company's financial statements? a. In cash flows from operations. b. In cash flows from investing activities. c. In cash flows from financing activities. d. In a separate schedule.

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22. Retail Rentals distributes property as a dividend to its stockholders. The property has an undepreciated cost of $95,000 and a fair value of $200,000. How should Retail Rentals recognize this transaction at the date the property dividends are declared? a. $95,000 is recognized as a loss. b. $105,000 is recognized as a gain. c. $200,000 is recognized as a loss. d. $295,000 is recognized as a gain. 23. Assume the same details as in the question above. Which section(s) of Retail Rentals' financial statements will be affected? a. Cash flows from operating activities. b. Cash flows from operating, investing, and financing activities. c. Schedule of noncash investing and financing activities. d. Cash flows from operating activities and the schedule of noncash investing and financing activities. 24. If AlphaCorp purchases BetaCo, which of the following would be disclosed as a noncash transaction in the financial statements? 1. The fair value of assets acquired 2. The fair value of liabilities assumed 3. The major categories of assets obtained 4. The major categories of liabili ties assumed a. 1., 3., 5. and 7. b. 1., 2., 3. and 4. c. 1., 2., 7., and 8. d. 5., 6., 7., and 8. 25. Anna is preparing a cash flow statement. Which of the following lists all of the items generally needed for Anna to complete this task? a. Comparative balance sheets and information on cash flow per share. b. The nature of operating, investing, and financing cash flows; the statement of income and retained earnings; and any noncash transactions. c. The nature of operating, investing, and financing cash flows; gross cash receipts and payments; any noncash transactions; and comparative balance sheets. d. Comparative balance sheets, the statement of income and retained earnings, and information on cash flow per share, gross cash receipts and payments. 83 5. Cash paid to acquire the company 6. Cash proceeds from the sale of the company 7. Minority interests in the subsidiary at the date of acquisition 8. Increases in the parent company's invest ment in a subsidiary as a result of issuing additional stock

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26. PurpleCo presents its statement of cash flows using the direct method. Which of the following will be presented differently than if PurpleCo had used the indirect method? a. Cash flows from operating activities. b. Cash flows from investing activities. c. Cash flows from financing activities. d. Schedule of noncash investing and financing activities.

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GLOSSARY
Capital lease. A lease that meets one or more of the following criteria for capitalization. For both the lessee and the lessor (1) the lease transfers ownership of the property to the lessee by the end of the lease term, (2) the lease contains a bargain purchase option, (3) the lease term is equal to 75% or more of the estimated economic life of the lease property, and (4) the present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90% of the excess of the fair market value of the leased property at that time. Cash. Cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. Examples include certificates of deposit, money market accounts, and repurchase agreements that have the described characteristics. Cash equivalents. Shortterm, highly liquid investments that (1) are readily convertible to known amounts of cash and (2) are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Examples include Treasury bills, commercial paper, money market accounts that are not classified as cash, and other shortterm investments whose original maturity is three months or less. (Note that equity securities never meet the definition of cash equivalents.) Direct method. One of the two optional methods of presentation of the statement of cash flows. The direct method begins with cash receipts and deducts cash payments for operating costs and expenses, individually listing the cash effects of each major type of revenue and expense. Because the direct method explicitly shows only cash receipts and payments, no adjustments are necessary for noncash expenses such as depreciation or deferred income taxes. A reconciliation of net income to cash flows from operating activities is required to be presented in a separate schedule showing all major classes of operating items. Equity method of accounting. The equity method is a special accounting treatment for investments in equity securities used only when the investor (1) can exert significant influence or control over the investee and (2) does not consolidate the financial statements of the subsidiary. The equity method views the investee as a part of the investor (related entities). Under the equity method of accounting for investments in common stock, investment earnings are recognized in income when they accrue rather than when they are distributed as dividends. Financing activities. Financing activities include (1) obtaining resources from owners and providing them with a return on, and a return of, their investment; (2) borrowing money and repaying amounts borrowed, or otherwise settling the obligation; and (3) obtaining and paying for other resources from creditors on longterm credit. Generally accepted accounting principles (GAAP). Basic accounting principles and standards and specific conventions, rules, and regulations that define accepted accounting practice at a particular time by incorporation of consensus and substantial authoritative support. To prepare financial statements for other than governmental entities in accordance with GAAP , the CPA must apply those principles found in sources of established accounting principles as described in SAS 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Gross income. Total worldwide income received in the form of money, property, or services that is subject to tax unless specifically exempt or excluded by law. Income statement. A financial statement that shows an organization's revenues and expenses for a defined period of time. The income statement is the financial statement used most often by investors as it provides information concerning the firm's ability to sustain ongoing operations profitably. The income statement is also the statement that is most readily understood. Although there are many different methods of presenting income statement information, revenues, expenses, and extraordinary revenues and expenses are usually readily identifiable. Indirect method. One of the two optional methods of presentation of the statement of cash flows. The indirect method starts with net income and adjusts for (1) noncash items such as depreciation and deferred income taxes and (2) changes during the period in operating current assets and liabilities. Net income should only be adjusted 85

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for changes in operating current assets and liabilities. Changes in current assets and liabilities that arise from investing or financing activities should be shown as investing or financing activities, as appropriate. In addition, accounts payable may have aspects of financing or investing activities. In those cases, it would not be appropriate to include the net change in payables as an adjustment in arriving at cash flows from operations. Investing activities. Investing activities include (1) lending money and collecting on loans, (2) acquiring and selling or disposing of availableforsale or heldtomaturity securities, and (3) acquiring and selling or disposing of productive assets that are expected to generate revenue over a long period of time. Noncash investing and financing activities. Investing and financing activities that do not involve cash receipts and payments during the period. They are required to be excluded from the cash flow statement and reported separately. Because the disclosure of noncash investing and financing transactions is not selfbalancing, it is possible to inadvertently omit a noncash transaction from the schedule. Thus, all investing and financing transactions should be carefully reviewed to ensure that all noncash transactions are included. Operating activities. Operating activities include all transactions and events that are not investing or financing activities. Generally, however, amounts classified as operating activities (1) represent the cash effects of transactions or events, (2) result from a company's normal operations for delivering or producing goods for sale and providing services, and (3) are derived from activities that enter into the determination of net income. Thus, cash flows from operating activities include cash received from sales of goods or services and cash used in generating the goods or services such as for inventory, personnel, and administrative and other operating costs. Statement of cash flows. A statement that shows a company's cash receipts and payments during a period, classified by principal sources and uses, that is required to be presented as a basic financial statement when (1) the company is a profitoriented business enterprise or nonprofit organization, (2) the financial statements are prepared in accordance with GAAP , and (3) both a balance sheet and an income statement are presented.

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INDEX
A
ACCOUNTING CHANGE  Presentation in statements of cash flows . . . . . . . . . . . . . . . 21, 24 AGENCY TRANSACTIONS  Presentation in statements of cash flows . . . . . . . . . . . . . . . . . . 21 AMORTIZATION  Presentation in statements of cash flows . . . . . . . . . . . . . . . . . . 26 ASSET RETIREMENT OBLIGATION  Presentation of settlement in statements of cash flows . . . . . . 17  Statement of cash flows presentation . . . . . . . . . . . . . . . . . . . . 29

L
LANDLORD INCENTIVE ALLOWANCE  Statement of cash flows presentation . . . . . . . . . . . . . . . . . . . . 17 LEASES  Statements of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 LIABILITIES  Accrued liabilities  Agency obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Longterm debt  Conversion of debt to equity . . . . . . . . . . . . . . . . . . . . . . . . .  Issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Statements of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Shortterm debt  Statements of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21 56 47 47 47

B
BUSINESS COMBINATIONS  Presentation in statements of cash flows . . . . . . . . . . . 27, 40, 58

C
CAPTIONS  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 CASH  Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3  Certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3, 38  Overdrafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 CASH VALUE OF LIFE INSURANCE  Presentation in statements of cash flows . . . . . . . . . . . . . . . 26, 48

M
MARKETABLE SECURITIES  Statements of cash flows . . . . . . . . . . . . . . . . . . . . . . . . 30, 39, 58 MINORITY INTERESTS  Presentation in statements of cash flows . . . . . . . . . . . . . . . 29, 58

N
NONMONETARY TRANSACTIONS  Presentation in statements of cash flows . . . . . . . . . . . . . . . 57, 58 NONPROFIT ORGANIZATIONS  Basic financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3  Financial statements  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3  Noncontrolling interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30, 58

D
DEFERRED CHARGES  Debt issue costs  Presentation in statements of cash flows . . . . . . . . . . . 26, 47 DEPLETION  Presentation in statements of cash flows . . . . . . . . . . . . . . . . . . 27 DEPRECIATION  Presentation in statements of cash flows . . . . . . . . . . . . . . . . . . 27 DISCONTINUED OPERATIONS  Presentation in statements of cash flows . . . . . . . . . . . . . . . 21, 24

O
OTHER COMPREHENSIVE BASIS OF ACCOUNTING  Cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

P
PARTNERSHIPS  Federal tax deposit to retain fiscal year . . . . . . . . . . . . . . . . . . . 41  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 PRIORPERIOD ADJUSTMENTS  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 PROPERTY AND EQUIPMENT  Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . 27, 36, 55 PROPRIETORSHIPS  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

E
EXTRAORDINARY ITEMS  Presentation in statements of cash flows . . . . . . . . . . . . . . . . . . 21

F
FORM AND FORMAT  Statements of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12, 54

I
INCOME TAXES  Statement of cash flows presentation . . . . . . . . . . . . . . . . . . . . 27  Tax deposit to retain fiscal year . . . . . . . . . . . . . . . . . . . . . . . . . . 41 INTEREST  Statement of cash flows presentation . . . . . . . . . . . . . 17, 40, 59 INVESTMENTS  Common stockequity method  Statements of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . 29, 38  Minority interests in statements of cash flows . . . . . . . . . . . 29, 58  Partially owned subsidiary in statements of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29, 58, 58

R
RECEIVABLES  Installment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28, 38  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . 19, 28, 38, 40 RETAINED EARNINGS  Dividends  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . 17, 40, 57 REVENUE  Deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

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S CORPORATION  Federal tax deposit to retain fiscal year . . . . . . . . . . . . . . . . . . . 41  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 STATEMENT OF CASH FLOWS  Accounting changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21, 24  Acquisition of noncurrent assets . . . . . . . . . . . . . . . . . . . . . . 36, 55  Adjustments to arrive at cash flows from operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25  Agency transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21  Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26  Authoritative basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3  Basic elements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5  Basic financial statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3  Business combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40, 58  Capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47  Captions, primary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12  Cash defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3  Cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3, 38  Cash flow per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66  Cash value of life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 26, 48  Certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3, 38  Changes in operating current assets and liabilities . . . . . . . . . 19  Comparative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12  Conversion of debt to equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56  Conversion of stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57  Current operating assets and liabilities . . . . . . . . . . . . . . . . . . . 25  Debt issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47  Deferred charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26, 47  Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27  Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27  Depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27  Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27  Direct method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18, 73  Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21, 24  Disposal of noncurrent assets . . . . . . . . . . . . . . . . . . . . . . . . 27, 37  Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 40, 46, 57  Ending cash format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12  Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21  Federal tax deposit to retain fiscal year . . . . . . . . . . . . . . . . . . . 41  Financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 12, 46  Foreign operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3  Form and style . . . . . . . . . . . . . . . . . . . . . . . . 12, 18, 25, 36, 46, 54  Gross vs. net cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 36, 46  Indirect method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18, 19, 68  Installment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28, 38  Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26  Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 59  Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 40, 59

                                           

Interim financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 12, 36 Investment in partially owned subsidiary . . . . . . . . . . . . . . . 29, 58 Investments on the cost method . . . . . . . . . . . . . . . . . . . . . . . . . 29 Investments on the equity method . . . . . . . . . . . . . . . . . . . . . . . 29 Landlord incentive allowances . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Life insurance policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26, 48 Longterm borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Making loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . 30, 39, 58 Minority interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29, 58 Netting cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 36, 46 Noncash extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Noncash investing and financing transactions . . . . 5, 36, 46, 53 Noncash operating items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Noncontrolling interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30, 58 Nonmonetary transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 57, 58 Nonprofit organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5, 12 Order of presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12, 13 Other comprehensive basis of accounting . . . . . . . . . . . . . . . . . 3 Overdrafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Premium amortization and discount accretion . . . . . . . . . . . . . 30 Preparing cash flow statements . . . . . . . . . . . . . . . . . . . . . . . . . 66 Proprietorships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Purchase (sale) of a business . . . . . . . . . . . . . . . . . . . . 27, 40, 58 Reclassification and restatement . . . . . . . . . . . . . . . . . . . . . . . . 14 Restricted cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 S corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Settlement of an asset retirement obligation . . . . . . . . . . . . . . . 17 Shortterm borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Shortterm investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Stockholder loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Stock issuance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46, 58 Stock issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Title . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Tradeins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36, 55 Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Types of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Unclassified balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Unrealized gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . 30, 58 When to present . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Worksheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

STOCKHOLDERS' EQUITY  Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . 46, 49, 56, 58  Stock conversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57  Stock issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46, 58  Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

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COMPANION TO PPC'S GUIDE TO PREPARING FINANCIAL STATEMENTS

COURSE 2 COMMON PROBLEMS IN PREPARING NOTES TO FINANCIAL STATEMENTS (PFSTG082)


OVERVIEW COURSE DESCRIPTION: This interactive selfstudy course discusses notes to financial statements. Lesson One outlines form and style considerations along with determining if disclosures are necessary under GAAP . Lesson Two guides the learner through the preparation of disclosures. Lesson Three discusses disclosures related to risks and uncertainties. October 2008 Users of PPC Guide to Preparing Financial Statements Basic knowledge of financial statements 6 QAS Hours, 6 Registry Hours Check with the state board of accountancy in the state in which you are licensed to determine if they participate in the QAS program and allow QAS CPE credit hours. This course is based on one CPE credit for each 50 minutes of study time in accordance with standards issued by NASBA. Note that some states require 100minute contact hours for self study. You may also visit the NASBA website at www.nasba.org for a listing of states that accept QAS hours. FIELD OF STUDY: EXPIRATION DATE: KNOWLEDGE LEVEL: LEARNING OBJECTIVES: Lesson 1General Considerations for Financial Statement Notes Completion of this lesson will enable you to:  Use correct form and style for financial statement notes.  Summarize significant accounting policies and determine if disclosures are necessary under generally accepted accounting principles. Lesson 2Common Problems Associated with Preparing Disclosures Completion of this lesson will enable you to:  Prepare disclosures related to specific financial statement captions.  Assess issues related to general disclosures.  Develop other disclosures.  Provide information about financial instruments. Lesson 3Risks and Uncertainties Completion of this lesson will enable you to:  Assess disclosure issues related to applicability, nature of operations, and estimates.  Compare and contrast SOP 946 and SFAS No. 5 disclosures and apply the authoritative guidance to financial statement note disclosures.  Determine if concentration disclosures are needed. 89 Accounting Postmark by December 31, 2009 Basic

PUBLICATION/REVISION DATE: RECOMMENDED FOR: PREREQUISITE/ADVANCE PREPARATION: CPE CREDIT:

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TO COMPLETE THIS LEARNING PROCESS: Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to: Thomson Reuters Tax & AccountingR&G PFSTG082 Selfstudy CPE P .O. Box 966 Fort Worth, TX 76101 See the test instructions included with the course materials for more information. ADMINISTRATIVE POLICIES: For information regarding refunds and complaint resolutions, dial (800) 3238724 for Customer Service and your questions or concerns will be promptly addressed.

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Lesson 1: General Considerations for Financial Statement Notes


Introduction
Authoritative pronouncements mandate many types of disclosures but do not mandate the manner of presentation. Some disclosures are best presented in separate notes rather than in the basic financial statements. Descriptions of accounting policies and notes to financial statements are recognized in SAS No.29 as components of the basic financial statements" necessary for a fair presentation in accordance with generally accepted accounting prin ciples. Thus, notes are an integral part of financial statements. They should be used to present material disclosures required by generally accepted accounting principles that are not otherwise presented in the statements, that is, on the face of the statements. Organization of Course Some disclosures may be efficiently provided on the face of the financial statements, for example, the allowance for uncollectible receivables. Other disclosures may be provided either on the face of the financial statements or in notes depending on considerations such as space limitations. Disclosures that are typically provided on the face of the financial statements are not discussed in this course. This course explains disclosures for nonpublic companies commonly made in the notes. However, this course does not attempt to describe all possible disclosures. For those reasons, the course is not organized by financial statement caption, and there is not a discussion of disclosures related to every possible financial statement caption. Areas covered in this course are: 1. Form and Style Considerations 2. Determining Necessary Disclosures 3. Summary of Significant Accounting Policies 4. Common Problems in Preparing Frequent Disclosures 5. Common Problems in Preparing General Disclosures 6. Common Problems in Preparing Other Disclosures 7. Disclosure of Information about Financial Instruments 8. Risks and Uncertainties How to Use This Course This course focuses on practical guidance on drafting notes. The guidance given includes both form and style considerations as well as technical requirements for common problem areas. As noted previously, this course does not include examples of all disclosures required by GAAP . Lesson 1 covers form and style, determining necessary disclosures, and significant accounting policies in more detail. Learning Objectives: Completion of this lesson will enable you to:  Use correct form and style for financial statement notes.  Summarize significant accounting policies and determine if disclosures are necessary under generally accepted accounting principles. 91

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FORM AND STYLE CONSIDERATIONS FOR FINANCIAL STATEMENTS NOTES


Title and Format Title. When the notes are presented on separate pages, the pages should be appropriately titled as follows: ABC CORPORATION NOTES TO FINANCIAL STATEMENTS The format and capitalization policy of the note heading should be consistent with that used for heading the financial statements. Many accountants use the caption Notes to Financial Statements" without a date because notes relate to the accompanying statements, each of which is dated. However, other preparers use the balance sheet date in the caption. Arrangement. Generally, notes are presented on a separate page or pages after the basic financial statements. The notes should be arranged in the same order as the financial statement captions to which they relate, and each note should bear a descriptive caption corresponding to the related financial statement caption. In using that approach, the following additional guidelines are recommended:  If a note addresses items in more than one statement, its placement would be determined by the first statement that would ordinarily be encountered. For example, a note providing disclosure of assets and liabilities under capital leases and rent expense under operating leases would be placed with asset notes.  Commitments and contingent liabilities notes would be placed between liabilities and equity notes.  A subsequent events note would be the last note. Heading Individual Note Captions. This course uses the following style for heading of individual notes within the Notes to Financial Statements" section: NOTE CPROPERTY AND EQUIPMENT Using letters of the alphabet instead of numbers to identify notes is preferred because letters seem to soften what otherwise may appear to be an overwhelming sea of numbers. Also, the entire NOTE" caption is capitalized, which sets off the title from the text of the notes and facilitates location of specific notes. Wording The notes, as an integral part of the financial statements, are the responsibility of the client even though the accountant may assist with, or totally prepare, the statements and notes. The wording of the notes should follow that principle, and words such as we," us," client," and our" should not be used to avoid any implication of reference to the CPA. Use of the Company," the Corporation," or Management," is a more appropriate way of referring to the client. Referencing Notes in the Financial Statements. Generally accepted accounting principles do not require the financial statements to be referenced to the notes. However, it is common practice to do so. It is recommended that each of the financial statements be referenced to the noteseither by reference to specific items in the financial statements (apractice followed by many firms in the interest of clarity) or by a general reference to the notes (usually shown at the bottom of the page). This course recommends using only a general reference because it reduces both professional time and clerical time in production. The likelihood of referencing errors also is elimi nated. Examples of general references to the notes follow:  See accompanying notes.  See notes to financial statements. 92

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 The accompanying notes are an integral part of these financial statements.  See notes to consolidated financial statements. Comparative Financial Statements When comparative financial statements are issued, ARB No. 43 (FASB ASC 20510454) requires disclosures for prior periods to be repeated if they continue to be of significance. Many accountants believe that disclosures related to the income statement and the statement of cash flows generally should be presented for all periods; however, disclosures related to the balance sheet should be evaluated to determine whether they are still meaning ful. For example, information about commitments and contingent liabilities is disclosed primarily because it is helpful in assessing future cash flow. Accordingly, that information as of the preceding balance sheet date generally is not relevant. Exceptions to that policy are believed justifiable in the following situations:  An authoritative pronouncement requires disclosures only for the current period or future periods in comparative presentations. For example, SFAS No.47 (FASB ASC 47010501) requires disclosure of maturities of longterm debt for the five years following the current balance sheet.  An authoritative pronouncement requires disclosures for all periods presented. For example, SFAS No. 115 (FASB ASC 32010502) (as amended), requires disclosure of the following information about availableforsale securities for each balance sheet presented: (a) aggregate fair value, (b) total gains for securities with net gains in accumulated other comprehensive income, and (c) total losses for securities with net losses in accumulated other comprehensive income. SFAS No. 115 (FASB ASC 32010505) (as amended) also requires disclosure of the following information about heldtomaturity securities for each balance sheet presented: (a)aggregate fair value, (b) gross unrecognized holding gains, (c) gross unrecognized holding losses, (d) the net carrying amount, and (e) gross gains and losses in accumulated other comprehensive income for any derivatives that hedged the forecasted acquisition of heldtomaturity securities. One Financial Statement Presented Preparers are sometimes asked to present only one basic financial statement, for example, a balance sheet without statements of income and retained earnings and cash flows. In those situations, the preparer should present only the disclosures that relate to the financial statement presented. For example, if only a balance sheet is presented, there would be no need to disclose depreciation expense. Also, preparers are sometimes requested to present a full set of basic financial statements for some users and a single financial statement, such as a balance sheet, for others. In that situation, different sets of notes also should be prepared to provide a relevant presentation. Since that only involves eliminating some items from the notes of the full set, it should not be costly or timeconsuming. When a single statement is presented and notes are presented on separate pages, the title should include the name of the statement rather than the general term financial statement," such as: ABC CORPORATION NOTES TO BALANCE SHEETS

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 1. Hilda prepares the financial statements for the Mystery Barn, a nonpublic company using generally accepted accounting principles (GAAP), and presents the notes on separate pages. Which of the following would be most appropriate for the arrangement of the notes? a. Hilda arranges the notes in alphabetical order by financial statement caption. b. She orders notes that address two captions based on the first statement ordinarily encountered. c. She places liabilities and equity notes between commitments and contingent liabilities notes. d. Hilda places the subsequent events note first in the financial statement note arrangement. 2. Assume the same details as in the question above. Which of the following tasks is Hilda required to do? a. Hilda must reference the financial statements to the notes using a general reference such as, See accompanying notes." b. She must use letters of the alphabet to identify notes, such as, NOTE CPROPERTY AND EQUIPMENT." c. If the Mystery Barn issues comparative financial statements, Hilda must repeat significant disclosures from prior periods. d. If she is asked to present only a balance sheet, she must still include all of the notes from the complete set of financial statements to ensure necessary disclosures are made.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 1. Hilda prepares the financial statements for the Mystery Barn, a nonpublic company using generally accepted accounting principles (GAAP), and presents the notes on separate pages. Which of the following would be most appropriate for the arrangement of the notes? (Page 92) a. Hilda arranges the notes in alphabetical order by financial statement caption. [This answer is incorrect. Generally, Hilda should arrange the notes in the same order as the financial statement captions to which the notes relate.] b. She orders notes that address two captions based on the first statement ordinarily encountered. [This answer is correct. Hilda should place note providing disclosure of assets and liabilities under capital leases and rent expense under operating leases with asset notes, for example.] c. She places liabilities and equity notes between commitments and contingent liabilities notes. [This answer is incorrect. The reverse is appropriate, so Hilda should place commitments and contingent liabilities notes between liabilities and equity notes.] d. Hilda places the subsequent events note first in the financial statement note arrangement. [This answer is incorrect. Typically, Hilda should place the subsequent events note as the last note in the notes section.] 2. Assume the same details as in the question above. Which of the following tasks is Hilda required to do? (Page 93) a. Hilda must reference the financial statements to the notes using a general reference such as, See accompanying notes." [This answer is incorrect. This course recommends that each financial statement be referenced to the notes, but Hilda is not required to do so under GAAP .] b. She must use letters of the alphabet to identify notes, such as, NOTE CPROPERTY AND EQUIPMENT." [This answer is incorrect. As recommended by this course, using letters softens what could appear otherwise to be an overwhelming sea of numbers; however, Hilda is not required to use this lettering system.] c. If the Mystery Barn issues comparative financial statements, Hilda must repeat significant disclosures from prior periods. [This answer is correct. ARB No. 43 (FASB ASC 20510454) requires disclosures from prior periods to be repeated when comparative financial statements are issued if the disclosures continue to be of significance.] d. If she is asked to present only a balance sheet, she must still include all of the notes from the complete set of financial statements to ensure necessary disclosures are made. [This answer is incorrect. If Mystery Barn needs Hilda to present only one basic financial statement, such as a balance sheet, she should only present the disclosures that relate to the financial statement that is presented.]

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DETERMINING NECESSARY DISCLOSURES UNDER GAAP


Determining what is required for a fair presentation in conformity with GAAP involves consideration of both of the following: a. Specific disclosures required by authoritative pronouncements b. Disclosures not specifically required by authoritative pronouncements but that are necessary to keep the financial statements from being misleading Determining the disclosures that are necessary in specific circumstances may be complex and requires seasoned professional judgment. For determining other disclosures that may be necessary in specific circumstances, the following general advice can be used:  Assume that the reader is a business person who has a basic knowledge of accounting and is not a part of management.  Read the statements from the viewpoint of that type of reader and evaluate whether the information would affect the reader's conclusions about the statements. A reader of the financial statements should not reach the wrong conclusion about financial position and operating results based on a reasonable reading of the statements including the notes. Companies filing with the Securities and Exchange Commission (SEC) are required to provide certain disclosures that exceed GAAP requirements, for example, average rates of shortterm borrowings. Nonpublic companies are not required to provide those disclosures, and it is recommended that they not be provided. Some preparers consult Accounting Trends and Techniques (an annual publication of the staff of the American Institute of Certified Public Accountants) for sample notes. Although that is a good source of information, all of the companies included in that survey are public companies. Preparers should be careful to distinguish GAAP and SEC disclosure require ments when using Accounting Trends and Techniques.

SIGNIFICANT ACCOUNTING POLICIES


According to APB Opinion No. 22 (FASB ASC 23510501), all significant accounting policies followed by a company should be disclosed in its financial statements. The format, including the location, of the disclosure is flexible. However, it is preferable to use a separate summary that presents the information or to include it in the first note. Presenting this information as the first note is recommended. In addition, SOP 946, Disclosure of Certain Significant Risks and Uncertainties (FASB ASC 27510501), requires a company to disclose the nature of its operations. Many accountants already include it as the first item in the summary of significant accounting policies. Caption and Format Generally, the summary of significant accounting policies note is divided into subsections for each specific policy or financial statement caption discussed. The format used in this course includes first letter capitalization and underlining of the subcaptions as follows: NOTE ASUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations Use of Estimates Inventories Depreciation Income Taxes

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Content General Requirements. The accounting policies of a company are the specific accounting principles and methods of applying those principles that have been adopted for preparing the financial statements. An accounting policy is significant if it materially affects the determination of financial position, cash flows, or results of operations. Accord ing to APB Opinion No. 22, (FASB ASC 23510503) the disclosure of accounting policies should describe accounting principles and methods that involve any of the following: a. A selection from existing acceptable alternatives b. Industry peculiarities c. Unusual or innovative application of GAAP Application. If there are existing acceptable alternatives, a specific authoritative pronouncement will normally require disclosure. For example, APB Opinion No. 12 (FASB ASC 36010501) requires a description of depreci ation methods. Also, there generally are authoritative pronouncements that provide guidance on accounting policies peculiar to specific industries. However, there is little guidance on disclosure of unusual or innovative applications of GAAP . In general, preparers of financial statements should assume that readers have a fundamental knowledge of accounting principles, but not expert knowledge. That means, for example, that the accounting treatment of changes in a company's tax status might be considered unusual and would be disclosed. Practice Problems Methods That Approximate GAAP . If an accounting method approximates a generally accepted principle or method, using the GAAP description is recommended. Describing both the GAAP method and the method that approximates it only serves to confuse the reader. If the difference between methods is not material, the fact that a method is used that only approximates GAAP is not really significant. There are many examples of methods that approximate GAAP . For example, parts inventories are often priced at current replacement cost, which approximates the lower of FIFO cost or market. In all cases involving methods that approximate GAAP , describing only the GAAP method is recommended, and that recommendation is not repeated in relation to each caption to which it might apply. Numbers in Policy Notes. Normally the accounting policies note should only deal with policies, and numbers should be excluded. However, it is believed exceptions to that policy are justified when an additional note would have to be used only to disclose the number. For example, if the only inventory disclosures required for a company are the basis of valuation, method of determining cost, and inventory components, the policy note could be expanded to disclose the inventory components. More Than One Policy for a Caption. In some cases, primarily for inventory and depreciation, more than one accounting method may be used. Generally, the accounting policy note should describe only the primary or dominant method. The accounting policy disclosure is intended to identify the methods that have a significant effect on the financial statements. If one method accounts for most of the effect on the financial statements, only that method need be identified. For example:  Inventories are stated at the lower of cost or market value with cost determined using primarily the firstin, firstout method.  Depreciation is computed using primarily the straightline method. If two methods have a significant effect, both should be described. For example:  Inventories are stated at the lower of cost or market value. Cost is determined using the lastin, firstout (LIFO) method for groceries and primarily the firstin, firstout (FIFO) method for all other inventories.  Depreciation is computed using accelerated methods for buildings and production equipment and the straightline method for all other depreciable assets. 98

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Accounting Changes. In addition to the other disclosures required for a change in accounting principle, the relevant accounting policy note should be expanded to describe use of different methods during the periods covered by the financial statements. For example: Inventories are stated at the lower of cost or market. Prior to 20X2, cost was determined using primarily the firstin, firstout (FIFO) method. However, as described in Note X, effective January 1, 20X2, the Company adopted the lastin, firstout (LIFO) method to determine the cost of substan tially all of its inventories. Specifically Required Accounting Policy Disclosures Several authoritative pronouncements specifically require disclosure of an accounting policy. Some disclosures that are common for nonpublic companies are as follows:  Inventoriesthe basis for stating inventories and the method of determining cost (ARB No. 43, Ch.3A) (FASB ASC 21010501)  Depreciationa general description of the methods used in computing depreciation for major classes of depreciable assets (APB Opinion No. 12) (FASB ASC 36010501)  Cash Equivalentsthe policy used to determine which shortterm investments are treated as cash equivalents in the statement of cash flows (SFAS No. 95) (FASB ASC 23010501)  Marketable Securitiesthe basis on which the cost of a security sold or the amount reclassified out of accumulated other comprehensive income into earnings was determined (SFAS No. 115) (FASB ASC 32010509) and the policy for requiring collateral or other security for repurchase agreements or securities lending transactions (SFAS No. 140) (FASB ASC 86030501)  Notes Receivable or Loansthe policy for recognizing interest income on impaired loans, including how cash receipts are recorded (SFAS No. 114) (FASB ASC 310105015)  Advertisingthe policy used for reporting advertising (i.e., whether costs are expensed as incurred or when the advertising first takes place (SOP 937) (FASB ASC 34020501)  Sales and Similar Taxesthe policy regarding the presentation of sales and similar taxes (for instance, use, value added and certain excise taxes), that is, whether such taxes are presented on a gross or net basis (EITF Issue No. 063) (FASB ASC 60545503).  Shipping and Handling Coststhe policy for classifying shipping and handling costs. For example, whether such costs are included in cost of sales (EITF Issue No. 0010) (FASB ASC 60545502) In addition to the examples listed above, APB Opinion No. 22 (FASB ASC 23510504) identifies the following examples of required accounting policy disclosures:  Recognition of profit on longterm, constructiontype contracts  Basis of consolidation Recommended Accounting Policy Disclosures As previously mentioned, GAAP requires disclosure of all significant accounting policies. In addition to disclosures required by specific pronouncements, disclosure of the accounting methods prescribed by authoritative literature that are relatively complex, such as the following is recommended:  Investments in Debt and Equity Securitiesdescribe the accounting treatment of unrealized gains and losses for investments classified as trading securities, heldtomaturity securities, and availableforsale securities. 99

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 Deferred Income Taxesbriefly describe how current and deferred taxes are calculated.  Investments at Equitydisclose the lag if the investee's year end differs from the investor's year end. APB Opinion No. 18 (FASB ASC 32310356) recognizes that investees may not have the same year end as the investor and states that a lag in reporting should be consistent from period to period." It is recommended that the lag not exceed three months, which is consistent with GAAP for consolidations.  Derivativesdescribe the accounting treatment of gains and losses related to fair value, cash flow, or foreign currency hedges. Commonly Asked Questions about Specific Accounting Policy Disclosures The following paragraphs present recommendations on several commonly asked questions about disclosure of specific accounting policies. Methods of Applying LIFO. Two approaches (specific goods and dollar value) and various computational tech niques, such as link chain and double extension, are used in practice. Do those need to be disclosed? It is not believed that the method of applying LIFO needs to be disclosed. Most readers are only interested in whether LIFO is used, and, unaccompanied by other information, disclosure of the LIFO approach used does not enable users to quantify the effects of using LIFO. (This conclusion regarding disclosure is consistent with an AICPA Issues Paper on LIFO.) Some companies use an accelerated method until approximately the middle of the estimated useful life then switch to the straightline method; do both methods need to be disclosed? Disclosing the method that is currently being used is recommended. Comprehensive Income. If comprehensive income is not presented, should the notes disclose the reason why? Companies that do not have any items of other comprehensive income in any period presented do not have to report comprehensive income. In such cases, it is not believed that the notes need to disclose why comprehensive income is not presented. However, the summary of significant accounting policies could (but is not required to) include a statement that the company has not reported comprehensive income since it has no items of other comprehensive income.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 3. Assume the same details about the Mystery Barn as in questions 1 and 2 of the previous selfstudy quiz section. Which of the following is a basic rule of thumb to help Hilda decide if additional disclosures are necessary to keep the financial statements from being misleading? a. As long as the financial statements will be clear to members of the Mystery Barn's management, additional disclosures are not needed. b. As long as the specific disclosures mentioned in authoritative guidance are made, the statements are considered a fair presentation under GAAP . c. If disclosures are needed that exceed GAAP requirements, all of the disclosures required by the Securities and Exchange Commission (SEC) must be made. d. Additional disclosures are needed if they keep a business person with a basic knowledge of accounting who is not part of the company's management from making a wrong conclusion. 4. Which of the following should be considered when disclosing a company's summary of significant accounting policies? a. The format and location of the disclosure must meet the requirements laid out in APB Opinion No. 22 (FASB ASC 23510503). b. All accounting policies used by the company on a daytoday basis must be included in the summary. c. Accounting policies that involve unusual and innovative applications of GAAP must be included. d. Selecting accounting policies from existing alternatives is covered by other guidance and is not included. 5. Which of the following accounting policies are required disclosures under APB Opinion No. 22 (FASB ASC 23510504)? a. Basis of consolidation. b. Notes receivable or loans. c. Investments at equity. d. Sales and similar taxes.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 3. Assume the same details about the Mystery Barn as in questions 1 and 2 of the previous selfstudy quiz section. Which of the following is a basic rule of thumb to help Hilda decide if additional disclosures are necessary to keep the financial statements from being misleading? (Page 97) a. As long as the financial statements will be clear to members of the Mystery Barn's management, additional disclosures are not needed. [This answer is incorrect. It would not be correct for Hilda to use members of the Mystery Barn's management as a measuring stick against which to select disclosures for all readers.] b. As long as the specific disclosures mentioned in authoritative guidance are made, the statements are considered a fair presentation under GAAP . [This answer is incorrect. Disclosures in addition to those required by authoritative guidance may be necessary to keep financial statements from being misleading. Hilda must use her professional judgment and determine what disclosures are needed in the Mystery Barn's unique circumstances.] c. If disclosures are needed that exceed GAAP requirements, all of the disclosures required by the Securities and Exchange Commission (SEC) must be made. [This answer is incorrect. Only public companies filing with the SEC are required to make such disclosures, so this would not be applicable to the Mystery Barn, which is a nonpublic company.] d. Additional disclosures are needed if they keep a business person with a basic knowledge of accounting who is not part of the company's management from making a wrong conclusion. [This answer is correct. Hilda must read the financial statements from this viewpoint to determine whether the disclosure information would affect such a reader's conclusions about the financial statements.] 4. Which of the following should be considered when disclosing a company's summary of significant accounting policies? (Page 98) a. The format and location of the disclosure must meet the requirements laid out in APB Opinion No. 22 (FASB ASC 23510503). [This answer is incorrect. The format and the location of the company's summary of significant accounting policies is flexible, though using a separate disclosure to present the information or presenting it in the first note is recommended.] b. All accounting policies used by the company on a daytoday basis must be included in the summary. [This answer is incorrect. Only significant accounting policies and methods for applying the principles must be included. Significant policies are those that materially affect the determination of financial position, cash flows, or the results of operations.] c. Accounting policies that involve unusual and innovative applications of GAAP must be included. [This answer is correct. Under APB Opinion No. 22 (FASB ASC 23510503), such policies should be included; however there is little official guidance on making this disclosure. Another disclosure mentioned in APB Opinion No. 22 is the disclosure of industry peculiarities.] d. Selecting accounting policies from existing alternatives is covered by other guidance and is not included. [This answer is incorrect. If there are existing acceptable alternatives, a specific authoritative pronouncement normally requires disclosure. APB Opinion No. 22 (FASB ASC 23510503) also requires disclosure of such accounting policies in the summary.]

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5. Which of the following accounting policies are required disclosures under APB Opinion No. 22 (FASB ASC 23510504)? (Page 99) a. Basis of consolidation. [This answer is correct. This disclosure is required under APB Opinion No. 22 (FASB ASC 23510504). Another required disclosure is recognition of profit on longterm, constructiontype contracts.] b. Notes receivable or loans. [This answer is incorrect. The policy for recognizing interest income on impaired loans is required by SFAS No. 114 (FASB ASC 310105015).] c. Investments at equity. [This answer is incorrect. Though recommended because of the complex nature of the subject, this disclosure is not required by authoritative guidance.] d. Sales and similar taxes. [This answer is incorrect. The policy regarding presentation of sales and similar taxes (i.e., if they are presented net or gross) is required by EITF Issue No. 063 (FASB ASC 60545503).]

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Lesson 2:Common Problems Associated with Preparing Disclosures


Introduction
This lesson discusses common problems that are associated with disclosure preparation. Topics covered include disclosures related to specific financial statement captions, general disclosures, other disclosures, and financial instruments. Recommendations are given to help the user assess and solve common disclosurerelated problems. Learning Objectives: Completion of this lesson will enable you to:  Prepare disclosures related to specific financial statement captions.  Assess issues related to general disclosures.  Develop other disclosures.  Provide information about financial instruments.

FREQUENT DISCLOSURES
This section describes recommendations for common problems that arise in preparing note disclosures related to specific financial statement captions. LIFO Inventories Readers of financial statements are often interested in determining the effect LIFO has on the financial results. Although the differences between FIFO, weighted average, and specific identification should not be material, the differences between LIFO and those methods are frequently material. One problem in preparing the disclosures is that IRS regulations stipulate that the information may only be presented in the notes or supplementary schedules and not on the face of the financial statements, and they place certain limitations on the disclosure. The challenge is to prepare an informative narrative that does not violate IRS restrictions. An AICPA Issues Paper titled Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories suggests that the financial statements disclose the following information when inven tory costs are determined using the LIFO method:  LIFO reserve, i.e., the difference between inventory priced at LIFO and inventory priced at replacement cost or some other acceptable accounting method  The extent to which LIFO is used for companies that have not fully adopted LIFO, for example, the portion of ending inventory priced on LIFO, the portion of cost of sales resulting from the application of LIFO compared to reported cost of sales, or the dollar amount of balance sheet inventories priced at LIFO and other methods  The effect of LIFO inventory liquidations on income (Additional disclosures that are required in the year LIFO is adopted are discussed later in this lesson.) The LIFO conformity regulations still prohibit the disclosure of annual income or loss on any basis other than LIFO in the main body of a company's financial statements; for example, such disclosures cannot be shown on the face of the income statement or in the equity section of the balance sheet. However, the regulations do allow disclosure of a company's annual income on a FIFO basis in a supplementary schedule or in the notes to the financial statements. The AICPA Issues Paper referred to in the previous paragraph recommends that the effects of non discretionary variable expenses such as profit sharing plans, profitbased bonuses, and income taxes be consid ered in determining income statement or balance sheet amounts on a FIFO basis. (In practice, many companies using LIFO base bonuses and similar items on FIFO earnings.) 104

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It is believed that the methods of applying LIFO need not be disclosed. Property and Equipment APB Opinion No. 12 (FASB ASC 36010501) requires disclosure of the balances of major classes of depreciable assets by nature or function at the balance sheet date and a general description of depreciation methods by major class. (Accumulated depreciation generally is disclosed in total rather than by major classes.) Two common questions about preparing notes to meet those requirements are:  How do you group major classes of depreciable assets by nature and function?  Is it necessary or desirable to also disclose the bases, lives, and repairs and maintenance practices for the major classes of assets? Grouping Depreciable Assets by Major Class. The following steps are recommended for developing major classes of property and equipment:  The accounts should be grouped by type (land, buildings, leasehold improvements, and equipment).  If equipment consists of items with essentially the same characteristics, no further detail is needed.  If equipment consists of material amounts of items with significantly different characteristics, such as heavy machinery, automobiles, and furniture and fixtures, it should be distinguished by those characteristics.  Immaterial amounts should be presented either in an other" caption or combined with the material components. Although sometimes disclosed on the face of the balance sheet, the information may be conveniently presented in a table in the notes to the financial statements. Limiting Policies Disclosures to Depreciation Methods. It is recommended that accounting policies disclosures for property and equipment be limited to depreciation methods. The note heading should normally be depreci ation." Using the balance sheet caption, for example, equipment and leasehold improvements," is not as precise, since only depreciation policies are being discussed. Also, there is no need to use the term amortization" for capital leases and leasehold improvements. Instead, the simple term depreciation" is appropriate for all items included in property and equipment. Since GAAP requires only a general description, accelerated" and straight line" should be sufficient descriptions. Although more detailed descriptions, for example, declining balance" or 150% declining balance," are also acceptable, they generally do not provide the reader with additional useful information. Some preparers also disclose the following policies in the accounting policies note or the note on major classes of depreciable assets:  The basis of property and equipment  Accounting policies for repairs and maintenance and betterments  Estimated useful lives (typically ranges) The preceding disclosures are acceptable, but they are not required and do not normally provide the reader with useful information. Requiring disclosure of estimated useful lives also has the following disadvantages:  Many companies set lives on a casebycase basis rather than establish policies for classes of assets.  It complicates disclosures because generally accepted accounting principles require some capital leases and leasehold improvements to be depreciated over the lease term and others over their estimated useful lives. 105

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Longterm Debt In practice, the following terms of longterm debt are usually disclosed: a. Timing of payments b. Amount of scheduled payments and whether it includes interest c. Interest rate Common questions that arise in preparing note disclosure of the preceding information are as follows:  Is all that detail really necessary?  How do you disclose payment terms for combined categories of debt?  Does the schedule of longterm debt need to be apportioned between current and noncurrent?  Is it necessary to identify the creditor? Need for Detail on Rates, Dates, and Payments. Some preparers question whether all of the detail normally presented is really necessary. They note that the reader can generally assess the effect of debt on cash flows through the following:  SFAS No. 47, Disclosure of LongTerm Obligations (FASB ASC 47010501), requires disclosure of principal reductions during each of the next five years.  SFAS No. 34, Capitalization of Interest Cost (FASB ASC 83520501), requires disclosure of interest costs. Information on payment terms and interest rates of longterm debt can be useful to readers in more accurately assessing the effect of debt (including interest) on cash flows. Since the information must be gathered to compute the five years' maturities, disclosing it requires little additional time. Disclosing Payment Terms for Combined Debt. If notes have been combined because of immateriality, the preparer has the following alternatives in disclosing payment terms: a. Disclose only that the notes are payable in periodic installments, for example, Notes payable in monthly installments." b. Disclose the current total of installments and a range of current interest rates, for example, Notes payable in monthly installments currently totaling $1,000, including interest ranging from 8% to 12%." Since the grouping relates to immaterial items, either alternative is acceptable. If the second alternative is chosen, the total of installments will normally be of greater interest to a reader than a range of installments because it helps in the assessment of cash flows. Similarly, current amounts are of more use than comparative amounts. Need to Apportion Debt Schedule between Current and Noncurrent. Using captions that indicate that the current portion of longterm debt is included in current liabilities, such as Current portion of longterm debt" and Longterm debt, less current portion" is recommended. Also, GAAP requires disclosure of maturities during each of the next five years. Accordingly, it is believed that the note need only show the total of longterm debt and does not need to show how it is allocated between current and noncurrent. Is It Necessary to Identify the Creditor? There is no requirement in authoritative literature to identify the lender by name, and providing such detail is not recommended unless the additional information would be useful to the reader, for example, when statements are prepared primarily for management use. Income Taxes Summary of Disclosure Requirements. The following paragraphs discuss the disclosure requirements that are believed to most frequently affect small businesses: (a) disclosing common types of temporary differences, (b) 106

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disclosing components of net deferred tax assets and liabilities, (c) disclosing available operating loss carryfor wards, (d) disclosing the benefits of operating loss carryforwards, and (e)disclosing the reasons for variances between the tax provision allocated to continuing operations and the expected provision. FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes" (FASB ASC 740105015), requires additional disclosures relating to unrecognized tax benefits. Disclosing Significant Temporary Differences. SFAS No. 109 (FASB ASC 74010508) requires the types of temporary differences that give rise to significant portions of a deferred tax asset or liability to be disclosed. It does not prescribe how the differences should be disclosed. This course, however, recommends disclosing them in the accounting policies note using a caption such as Income Taxes." Since temporary differences are defined as differences between the financial and tax bases of assets and liabilities, describing them by referring to balance sheet, rather than income statement, accounts (for example, accounts receivable instead of bad debts) is recom mended. In drafting disclosures about temporary differences, questions may arise about which types of temporary differ ences to disclose when there are several types of temporary differences or when the net deferred tax assets or liabilities for a particular tax jurisdiction are not significant. Since the deferred tax assets or liabilities presented in the balance sheet are the net result of offsetting current deferred tax assets and liabilities and noncurrent deferred tax assets and liabilities, disclosing significant temporary differences that give rise to the gross amounts of deferred tax assets and liabilities before (a) reduction of deferred tax assets for a valuation allowance and (b) offset for presentation in the financial statements is recommended. In other words, it is believed that temporary differences should be disclosed if, when considered individually, the temporary difference causes a material difference between taxable income and GAAP pretax income. It is also believed that it often may be helpful to readers of the financial statements of small businesses to disclose a brief description of how the accounting for the transactions differs for financial and tax reporting even if the GAAP treatment is disclosed more fully in another policy note. The following note illustrates how a company might disclose its accounting policies for income taxes and the types of its temporary differences: NOTE AACCOUNTING POLICIES Income taxes Income taxes are provided for the tax effects of transactions reported in the financial statements and consist of taxes currently due plus deferred taxes. Deferred taxes are recognized for differ ences between the basis of assets and liabilities for financial statement and income tax purposes. The differences relate primarily to depreciable assets (use of different depreciation methods and lives for financial statement and income tax purposes), allowance for doubtful receivables (deductible for financial statement purposes but not for income tax purposes), and profit on installment sales (deferred for income tax purposes but recognized for financial statement pur poses). The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be deductible or taxable when the assets and liabilities are recovered or settled. Deferred taxes also are recognized for operating losses and tax credits that are available to offset future taxable income. Disclosing Components of Net Deferred Tax Assets and Liabilities. For each tax jurisdiction, all current deferred tax assets and liabilities should be offset and presented as a single amount and all noncurrent deferred tax assets and liabilities should be offset and presented as a single amount. However, SFAS No. 109 (FASB ASC 74010502) requires the gross amounts of deferred tax assets (before reduction for a valuation allowance) and liabilities and the total valuation allowance to be disclosed. The disclosure will generally be made in a note to the financial state ments. For example, a company that is subject only to federal income taxes may include information such as the following in the income tax note:

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NOTE HINCOME TAXES ...At the end of 20X1, deferred tax liabilities recognized for taxable temporary differences total $155,000. Deferred tax assets recognized for deductible temporary differences and operating loss carryforwards total $101,900, net of a valuation allowance of $5,000. or NOTE HINCOME TAXES ...The Company's total deferred tax liabilities, deferred tax assets, and deferred tax asset valuation allowances at December 31 are as follows: 20X2 Total deferred tax assets Less valuation allowance Total deferred tax liabilities Net deferred tax asset (liability) $ $ 28,000 7,000 21,000 20,000 1,000 $ 20X1 24,000 6,000 18,000 20,000 (2,000 )

Those amounts have been presented in the company's financial statements as follows: Noncurrent deferred tax asset Current deferred tax liability Net deferred tax asset (liability) $ 7,000 6,000 $ 1,000 $ 5,000 7,000 $ (2,000 )

Note that only the components of the total deferred tax asset or liability are required to be disclosed. It is not necessary to disclose the components of current and noncurrent categories separately. Some companies may decide to reconcile the amounts disclosed to amounts recorded in the financial statements, however. In some cases, it may be practicable to disclose the required information on the face of the balance sheet as follows: A company's financial statements include deferred tax assets and liabilities, but a valua tion allowance is not required: 20X2 Included in current liabilities Deferred income taxes, net of deferred tax benefits of $4,000 in 20X2 and 20X1 Included in noncurrent assets Deferred income tax benefits, net of deferred tax liabilities of $11,000 in 20X2 and $10,000 in 20X1 13,000 10,000 5,000 6,000 20X1

A company's financial statements include deferred tax assets, net of a valuation allow ance, but no deferred tax liabilities: Included in current assets Deferred income tax benefits, net of a valuation allowance of $6,000 in 20X2 (none in 20X1) 108 28,000 11,000

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However, disclosure on the face of the balance sheet generally is not practicable if a company has both taxable and deductible temporary differences and provides a valuation allowance for deferred tax assets. In those circum stances, it is believed that disclosure in the notes as illustrated in the Disclosing Components of Net Deferred Tax Assets and Liabilities" paragraph is the better alternative. If none of the deferred tax balance sheet accounts reflect the net result of offsetting (for example, the company has only deductible temporary differences and a valuation allowance is not required or has deductible differences that are classified as current and taxable differences that are classified as noncurrent), it is believed that no additional disclosure is required. In that case, the deferred tax asset and liability accounts are presented in the financial statements at their gross amounts. SFAS No. 109 (FASB ASC 74010502) also requires companies to disclose the net change during the year in the total valuation allowance. It is believed that the disclosure generally will be made in the income tax note of the notes to the financial statements. Available Operating Loss Carryforwards. SFAS No. 109 (FASB ASC 74010503) requires the amounts and expiration dates (or a reasonable aggregation of expiration dates) of operating loss carryforwards for income tax reporting to be disclosed. The loss carryforward for tax purposes is the amount that is available to offset future taxable income (in other words, the carryforward that would be reported in the company's tax return). The disclosure will generally be included in an income tax note such as the following: The company has a loss carryforward of $60,000 that may be offset against future taxable income. Substantially all of the carryforward expires in approximately equal amounts in 20X7 and 20X8. GAAP does not require disclosure of operating loss carryforwards for financial statement purposes. Disclosing the Benefits of Operating Loss Carryforwards. SFAS109 (FASB ASC 74010509) requires the components of the income tax provision that are attributable to continuing operations to be disclosed. One of the components required to be disclosed is the tax benefit of operating loss carryforwards. GAAP requires a deferred tax asset to be recognized for operating loss carryforwards. The benefit to be recognized in the financial statements is calculated by (a) multiplying the amount of the carryforward for tax purposes by the applicable tax rate and (b) reducing the deferred tax asset for a valuation allowance if it is more likely than not that all or a portion of the asset will not be realized. Accordingly, deferred tax expense is reduced by the tax benefits attributable to the carryforward (that is, the deferred tax asset related to the carryforward, net of any valuation allowance) in the year that the net operating loss (NOL) arises, and realization of the carryforward in future years' tax returns generally has no effect on income tax expense. However, income tax expense in future years would be affected by changes in estimates of the amount of the carryforward or any related valuation allowance that occur after the tax benefits of the NOL are initially recognized in the financial statements but before the tax benefit of the NOL is realized in future tax returns. To illustrate how to determine the amount to be disclosed, assume the following facts: a. A loss for financial reporting of $10,000 in 20X1 (the first year of the company's operations) and income for financial reporting of $50,000 in 20X2 b. Taxable temporary differences of $5,000 at the end of 20X1 and $7,000 at the end of 20X2; there are no permanent differences c. Average graduated tax rate of 15% applies both to the taxable temporary difference and the loss carryforward d. No valuation allowance was considered necessary at the end of 20X1 for the deferred tax asset related to the NOL carryforward

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Income tax expense would be computed as follows for 20X1 and 20X2: 20X1 Current income taxes: GAAP income (loss) Temporary difference Taxable income (loss) before carryforward NOL carryforward Taxable income Current tax at 15% Deferred income taxes: Deferred tax asset (liability)EOY: Temporary Difference (20X1$5,000 at 15%) (20X2$7,000 at 15%) NOL carryforward ($15,000 at 15%) Deferred tax asset (liability)BOY Deferred tax expense (benefit) Total income tax expense (benefit) $ $ (10,000 ) (5,000 ) (15,000 ) 15,000 $ $ $ $ 20X2 $ 50,000 (2,000 ) 48,000 (15,000 ) 33,000 4,950

(750 ) 2,250 1,500 (1,500 ) (1,500 )

(1,050 ) (1,050 ) 1,500 2,550 $ 7,500

SFAS No. 109 (FASB ASC 7401020) defines income tax expense as the sum of current and deferred tax expense. According to question 18 of the FASB Special Report, A Guide to Implementation of Statement 109 on Accounting for Income Taxes (FASB ASC 740105580), the amount to be disclosed as the tax benefit of operating loss carryforwards is only the amount by which total income tax expense from continuing operations has been reduced by the NOL. In the preceding example, the NOL carryforward affects income tax expense (the sum of current and deferred tax expense) only in 20X1 when a deferred tax asset is recognized in the financial statements. There is no effect on income tax expense in 20X2 because the separate effects on current and deferred tax expense offset each other. In other words, the current tax expense will be reduced for the $2,250 tax benefit of the NOL realized on the tax return (tax of $48,000 at 15% = $7,200 before the NOL carryforward less tax of $33,000 at 15% = $4,950 after the NOL carryforward) and deferred tax expense will be larger by the same amount. Accordingly, the requirement for separate disclosure of the effects of the tax benefits of an NOL carryforward would not apply for 20X2. However, the disclosure requirement applies to the financial statements for 20X1. Generally, the tax benefits of the NOL carryforward would be disclosed in the income tax note. For example: NOTE XINCOME TAXES Income tax expense consists of the following components: 20X2 Current Deferred Tax benefit of net operating loss carryforward Total tax expense (benefit) $ 4,950 2,550 7,500 $ 20X1 750 (2,250 ) (1,500 )

Alternatively, in some cases, it may be practicable to disclose the components of income tax expense on the face of the income statement as follows:

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INCOME TAX EXPENSE (BENEFIT) Current Deferred, including tax benefit of net operating loss carryforward of $2,250 in 20X1

4,950 2,550

(1,500 )

Disclosing the Reasons for Variances between the Income Tax Provision Allocated to Continuing Operations and the Expected Provision. GAAP requires the reasons for significant variations between the income tax provision allocated to continuing operations and the expected provision to be disclosed. The expected provision should be calculated by applying domestic federal statutory rates (under the regular tax system) to pretax income from continuing operations as reported in the income statement. (It is believed that financial statement users should be expected to understand the effect of the graduated rate structure, and, accordingly, the expected provision should be calculated by applying the graduated rates. As a result, the tax benefit of graduated rates will not be a reconciling item.) For most small businesses, the relationship between income taxes allocated to continuing operations and expected income taxes will be affected principally by (a) permanent differences, (b) valuation allowances for deferred tax assets and subsequent changes in the valuation allowance, (c) income taxes assessed by other tax jurisdictions, (d) tax credits, (e) enacted tax rate changes, and (f) reversals of temporary differences at rates that differ from those used to calculate deferred income taxes at the beginning of the year. (For example, a company may calculate deferred taxes using an average graduated tax rate of 34%. The effect of the difference between 34% and the company's actual tax rate in the period that the temporary differences reverse will be reflected as an adjustment to income tax expense.) SFAS No. 109 (FASB ASC 740105013) does not require nonpublic companies to disclose a numerical reconcilia tion, and disclosing the nature of reconciling differences in narrative form is believed to generally be sufficient. Illustrative disclosures are as follows: a. Variances Caused by Permanent Differences. The income tax provision differs from the expense that would result from applying federal statutory tax rates to income before income taxes because certain investment income is not taxable. b. Variances Caused by Valuation Allowance for Deferred Tax Assets. The income tax provision differs from the expense that would result from applying federal statutory rates to income before income taxes because a valuation allowance has been provided to reduce deferred tax assets to the amount that is more likely than not to be realized. c. Variations Caused by Calculating Deferred Income Taxes Using an Average Tax Rate or a Flat Rate. The income tax provision differs from the expense that would result from applying federal statutory rates to income before income taxes because deferred income taxes are based on average tax rates. d. Variances Caused by Enacted Rate Changes. The income tax provision differs from the expense that would result from applying federal statutory rates to income before income taxes to reflect the benefit of an enacted tax rate reduction. Disclosing Investment Tax Credits. GAAP requires investment tax credits (ITC) and the amounts and expiration dates of ITC carryforwards to be disclosed. In addition, the method of accounting for investment tax credits is also required to be disclosed. That disclosure requirement arose because there are two methods of accounting for ITC. Under the deferral method, ITC is recognized in earnings over the depreciable life of the asset, and under the flowthrough method, all of the credit generally is recognized in earnings when used. Disclosure of the method of accounting for ITC was considered necessary because earnings reported in the financial statements could vary significantly depending on the method used. Since ITC has been repealed, accountants have questioned whether the method of accounting for ITC should continue to be disclosed. Disclosure is believed necessary only if the financial statements include a tax provision that is significantly affected by the credits. Accordingly, they believe that the method of accounting for ITC generally need not be disclosed if the company used the flow through method. In that situation, earnings would only be affected in comparative presentations that include years prior to 1986. Similarly, future earnings would not be affected by unused ITC carryforwards because GAAP requires a deferred tax asset to be recognized for tax credit 111

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carryforwards. Thus, it is believed that disclosure of the method used to account for ITC is required only so long as ITC benefits are being amortized under the deferral method. Although the Tax Reform Act of 1986 (TRA) did not affect the ability to carry forward ITC, it requires the available credit to be reduced by 35%. While the requirements to disclose the amount of carryforward available and the primary expiration dates still apply, it is believed that the amount disclosed should reflect reductions expected to be realized under TRA. It is not necessary to disclose original credits since the objective of the disclosure is to provide readers with information about the future effect of the credits on earnings. The following note illustrates an ITC disclosure: NOTE XINCOME TAXES The Company has investment tax credits totaling approximately $6,500 that are available for offset against future federal income taxes through 2010.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 6. Harold is grouping depreciable assets by major classes for disclosure in Omega Inc.'s financial statement notes. Which of the following is recommended? a. Harold must group the company's accounts according to the price Omega paid for each acquisition. b. If Omega's equipment consists of items with essentially the same characteristics, no more detail is needed. c. The disclosure must include Omega's accounting policies for repairs, maintenance, and betterments. d. If Omega's depreciable assets include immaterial amounts, Harold can exclude them from the disclosure. 7. Which of the following is a required disclosure related to deferred tax assets and liabilities under SFAS No. 109 (FASB ASC 74010502)? a. Types of temporary differences and carryforwards that result in significant portions of deferred tax assets. b. The net amounts of deferred tax assets and liabilities. c. Components of income tax expense, including current tax expense or benefit, deferred tax expense or benefit, and investment tax credits. d. The net change during the year in the total valuation allowance. 8. In which of the following scenarios is the financial statement disclosure dealt with appropriately? a. To complete the disclosure of components of net deferred tax assets and liabilities, Henderson Inc. offsets all current deferred tax assets and liabilities and presents them as a single amount. b. The ButterfieldWaits Foundation discloses the expiration dates (or a reasonable aggregation of expiration dates) and amounts of operating loss carryforwards for income tax purposes. c. HarrisMeyers discloses benefits of operating loss carryforwards. The company calculates the benefit by multiplying the amount carried forward for tax purposes by the applicable tax rate. d. Channing Inc. discloses that it uses the deferral method to account for investment tax credits, so all credit is recognized in earnings when it is used. 9. Blue Moon Inc., a nonpublic company, must disclose the reasons for variances between the income tax provision allocated to continuing operations and the expected provision. The following disclosure is included in the notes to Blue Moon's financial statements: The income tax provision differs from the expense that would result from applying federal statutory tax rates to income before income taxes because certain investment income is not taxable. Based on the text of this narrative disclosure, what caused the variance? a. Permanent differences. b. Valuation allowances for deferred tax assets. c. Calculating deferred income taxes using an average tax rate. d. Enacted tax rate changes. 113

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 6. Harold is grouping depreciable assets by major classes for disclosure in Omega Inc.'s financial statement notes. Which of the following is recommended? (Page 105) a. Harold must group the company's accounts according to the price Omega paid for each acquisition. [This answer is incorrect. Harold should group the accounts by type (e.g., buildings, land, equipment, and leasehold improvements.)] b. If Omega's equipment consists of items with essentially the same characteristics, no more detail is needed. [This answer is correct. Harold would not need to include more detail on the items in the disclosure under these circumstances. However, if Omega's equipment consists of material amounts of items with characteristics that are significantly different, Harold should distinguish the equipment by those characteristics.] c. The disclosure must include Omega's accounting policies for repairs, maintenance, and betterments. [This answer is incorrect. Though some preparers include this information it is not required, nor is it recommended for Harold to do so, as such a disclosure does not normally provide useful information to readers of the financial statements.] d. If Omega's depreciable assets are immaterial in amount, Harold can exclude them from the disclosure. [This answer is incorrect. Harold should present such amounts under an other" caption or combine them with material components.] 7. Which of the following is a required disclosure related to deferred tax assets and liabilities under SFAS No. 109 (FASB ASC 74010502)? (Page 109) a. Types of temporary differences and carryforwards that result in significant portions of deferred tax assets. [This answer is incorrect. This is a disclosure of accounting policies related to the nature of temporary differences.] b. The net amounts of deferred tax assets and liabilities. [This answer is incorrect. SFAS No. 109 (FASB ASC 74010502), requires the gross amounts of deferred tax assets (before reduction for evaluation allowance) and liabilities and the total valuation allowance to be disclosed.] c. Components of income tax expense, including current tax expense or benefit, deferred tax expense or benefit, and investment tax credits. [This answer is incorrect. The disclosure of income tax expenses includes components such as those listed above. Examples of other components include benefits of operating loss carryforwards and government grants.] d. The net change during the year in the total valuation allowance. [This answer is correct. Under SFAS No. 109 (FASB ASC 74010502), the deferred tax assets and liabilities disclosure should include the components of net deferred tax assets or liabilities recognized in the balance sheet (total deferred tax assets, total deferred tax liabilities, and total valuation allowance) and the net change during the year in the total valuation allowance.] 8. In which of the following scenarios is the financial statement disclosure dealt with appropriately? (Page 109) a. To complete the disclosure of components of net deferred tax assets and liabilities, Henderson Inc. offsets all current and noncurrent deferred tax assets and liabilities and presents them as a single amount. [This answer is incorrect. To correctly disclose components of net deferred tax assets and liabilities, Henderson should, for each tax jurisdiction, offset all current tax assets and liabilities and present as a single amount and offset all noncurrent deferred tax assets and liabilities and present as a single amount.] 114

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b. The ButterfieldWaits Foundation discloses the expiration dates (or a reasonable aggregation of expiration dates) and amounts of operating loss carryforwards for income tax purposes. [This answer is correct. The foundation's loss carryforward for tax purposes is the amount available to offset future taxable income (i.e., the amount reported on ButterfieldWaits' tax return).] c. HarrisMeyers discloses benefits of operating loss carryforwards. The company calculates the benefit by multiplying the amount carried forward for tax purposes by the applicable tax rate. [This answer is incorrect. This is only part of the calculation HarrisMeyers needs for this disclosure. If it is more likely than not that all or a portion of the asset will not be realized, the amount must then be used to reduce to deferred tax asset for a valuation allowance.] d. Channing Inc. discloses that it uses the deferral method to account for investment tax credits, so all credit is recognized in earnings when it is used. [This answer is incorrect. In this scenario, Channing is using the flowthrough method. The deferral method recognizes investment tax credits in earnings over the depreciable life of the asset. The disclosure of the accounting method is required by GAAP because both methods can be used to account for the credit.] 9. Blue Moon Inc., a nonpublic company, must disclose the reasons for variances between the income tax provision allocated to continuing operations and the expected provision. The following disclosure is included in the notes to Blue Moon's financial statements: (Page 111) The income tax provision differs from the expense that would result from applying federal statutory tax rates to income before income taxes because certain investment income is not taxable. Based on the text of this narrative disclosure, what caused the variance? a. Permanent differences. [This answer is correct. SFAS No. 109 (FASB ASC 740105013) does not require nonpublic companies like Blue Moon to disclose a numerical reconciliation, so it is believed that a narrative disclosure like the one illustrated above would be sufficient.] b. Valuation allowances for deferred tax assets. [This answer is incorrect. An example disclosure for this reason could be as follows: The income tax provision differs from the expense that would result from applying federal statutory rates to income before income taxes because a valuation allowance has been provided to reduce deferred tax assets to the amount that is more likely than not to be realized.] c. Calculating deferred income taxes using an average tax rate. [This answer is incorrect. The following is an example of this type of disclosure: The income tax provision differs from the expense that would result from applying federal statutory rates to income before income taxes because deferred income taxes are based on average tax rates.] d. Enacted tax rate changes. [This answer is incorrect. An example of a disclosure related to this reason could be worded as follows: The income tax provision differs from the expense that would result from applying federal statutory rates to income before income taxes to reflect the benefit of an enacted tax rate reduction.]

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COMMON PROBLEMS RELATED TO THE PREPARATION OF GENERAL DISCLOSURES


General disclosures in financial statements are frequent disclosures concerning matters that do not relate to a financial statement caption, such as contingencies, or that relate to several captions, such as related parties. Related Party Transactions General. SFAS No. 57, Related Party Disclosures (FASB ASC 85010501), requires the following disclosures for material related party transactions: a. The nature of the relationship involved b. A description of the transactions, including those to which no amounts or nominal amounts were ascribed, for each of the income statement periods presented, and such other information deemed necessary to understand the effects of the transactions on the financial statements c. The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period d. Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement In addition, disclosures may also be affected by the requirement to recognize the economic substance of leasing arrangements with related parties rather than the legal form. Typical Related Party Transactions. The most common related party disclosures for nonpublic companies include the following: a. Officer or stockholder loans to or from the company b. Purchases, sales, and related payables or receivables between affiliated companies c. Leases between stockholders and the company d. Guarantees or pledged personal assets of a stockholder The salary paid to an owner/manager is explicitly excluded from related party disclosure requirements by SFAS No. 57, Paragraph 2 (FASB ASC 85010501). Common questions that arise in preparing related party disclosures are:  What is meant by the nature of the relationship?  How much detail is necessary about settlement arrangements?  How do you account for the substance of a lease arrangement? Nature of Relationship. Disclosure of the relationship and amounts often may be conveniently provided through balance sheet captions. The nature of the relationship" is interpreted to mean position rather than an individual's name. Accordingly, captions usually simply refer to stockholders," officers," or affiliates." However, SFAS No. 57 (FASB ASC 85010503) requires related parties to be identified by name if that is necessary to an understanding of the effects of the transactions on the financial statements. Settlement Arrangements. Using separate balance sheet captions for related party open accounts and informal loans is normally sufficient to meet the requirement to disclose settlement arrangements. As a practical matter, 116

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loans usually fluctuate to avoid IRS problems with declaration of dividends. However, it is believed that the settlement terms of notes should be disclosed to conform with GAAP and that the disclosure normally may be provided most efficiently in a note. Leasing Arrangements with Related Parties. Many nonpublic companies have lease arrangements with related parties. Although some of the leases may be under written agreements, others are verbal. In addition, some of the written agreements are cancelable. SFAS No. 13 (FASB ASC 840102526) notes that in some leasing arrange ments it is clear that the terms of the transactions have been significantly affected by the fact that the parties are related. In those cases, GAAP requires accounting for the substance rather than the form of the transaction. In practice, it is extremely difficult to account for the substance of such related party arrangements. As an example, if a company leases its operating facilities from its stockholders under a cancelable arrangement, it is difficult to define a capitalization period even if the company will probably not move from the location. A similar problem exists with a written noncancelable lease that does not provide for renewals. Accordingly, disclosure of the nature of the arrangement is believed to usually be sufficient. Income Tax Disclosures. When the company is part of a group that files a consolidated tax return, SFAS No. 109 (FASB ASC 740105017) requires the following disclosures in its separately issued financial statements: a. The aggregate amount of current and deferred tax expense for each income statement presented b. The amount of any taxrelated balances due to or from affiliates as of the date of each balance sheet presented c. The principal provisions of the method by which the consolidated amount of current and deferred tax expense is allocated to members of the group d. The nature and effect of any changes in the method of allocating current and deferred tax expense to members of the group and in determining the related balances due to or from affiliates during each year for which the disclosures in (a) and (b) above are presented Pension Plans Definition of Pension Plan. One of the most common practice problems regarding pension plans is determining what compensation arrangements meet the definition of pension benefits. Appendix D of SFAS No.87, Employers' Accounting for Pensions (FASB ASC 7153020), defines pension benefits as periodic (usually monthly) payments made pursuant to the terms of the pension plan to a person who has retired from employment or to that person's beneficiary." Pension plans include the following: a. Written plans as well as plans whose existence may be implied from a welldefined, although unwritten, company policy b. Unfunded plans as well as insured plans and trust fund plans c. Defined benefit and defined contribution plans d. Deferred compensation contracts with individual employees if the contracts taken together are equivalent to a pension plan e. Deferred profitsharing plans that are, or are part of, an arrangement that is, in substance, a pension plan Pension plans exclude the following: a. Death and disability payments under a separate arrangement b. Paying retirement benefits to selected employees in amounts determined on a casebycase basis or after retirement 117

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c. Deferred profitsharing plans that are not, in substance, pension plans Required Disclosures for Defined Benefit Plans. SFAS No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits (revised 2003) (FASB ASC 71520), includes disclosure requirements for employers that sponsor one or more defined benefit pension plans or other defined benefit postretirement plans. SFAS No. 132(R) (FASB ASC 71520505) provides reduced disclosure requirements for nonpublic entities; however, entities controlled by a public entity must make the disclosures required of public entities. Disclosures about defined benefit pension plans cannot be combined with disclosures about defined benefit postretirement plans, except for certain multiemployer plans. However, an employer with two or more defined benefit plans may combine the disclosures for all of the employer's defined benefit pension plans and separately combine the disclosures for all of the employer's defined benefit postretirement plans. GAAP does not require disclosure of general descriptive information (such as employee groups covered, type of benefit formula, types of plan assets held and funding policy) about pension and other postretirement benefit plans. However, such information can often be useful, so it is recommended that employers provide general plan descriptions. The FASB issued SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plansan amendment of FASB Statements No. 87, 88, 106, and 132(R) (FASB ASC 715), in September 2006 to amend the recognition, measurement, and disclosure requirements related to defined benefit pension and other postretirement plans. The new recognition and disclosure requirements were generally effective for nonpublic entities for fiscal years ending after June 15, 2007. The revised requirement to measure plan assets and benefit obligations as of the date of an entity's yearend balance sheet, with certain exceptions, is effective for fiscal years ending after December 15, 2008. In the year an entity revises its measurement date for plan assets and benefit obligations to apply the new measurement date requirement, the entity should disclose the separate adjustments of retained earnings and accumulated other comprehensive income from applying the requirement. The following is an illustration of such a disclosure SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plansan amendment of FASB Statements No. 87, 88, 106, and 132(R), requires that plan assets and benefit obligations be measured as of the yearend balance sheet date. As a result the Company changed its measurement date for its defined benefit pension plan from October 31 to December 31. Application of this provision resulted in a $20,000 reduction of retained earnings and a $15,000 increase in accumulated other comprehensive income. Required Disclosures for Defined Contribution Plans. SFAS No. 132(R) (FASB ASC 71570501) requires employers to disclose the amount of cost recognized for all periods presented for defined contribution pension or other postretirement benefit plans separately from the cost recognized for defined benefit plans. The disclosures must describe the nature and effect of any significant changes during the period affecting comparability (such as a change in the rate of employer contributions, a business combination, or a divestiture). GAAP does not require employers to provide a general description of their defined contribution plans. However, such information can often be useful and it is recommended that employers provide general plan descriptions. Restrictive Debt Covenants General. A debtor loan agreement may contain several complicated restrictive covenants. If the borrower does not comply with the requirements, he will be in default and the debt will come due immediately. Thus, violations of debt covenants affect the classification of debt as current or noncurrent and also may have a significant effect on cash flows. The requirements of debt agreements (restrictive covenants) may be grouped in the following broad categories: a. TransactionsFor example, a borrower may be required to obtain lender approval before acquiring equipment above a certain dollar amount or increasing the salaries of the primary stockholders. b. ConditionsFor example, the borrower may be required to increase profits at a prescribed rate or to reduce the debtequity relationship to a prescribed level. 118

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If a violation of a restrictive covenant occurs, a waiver should be obtained. Violations of restrictions related to transactions are normally waived unconditionally, but for violations of restrictions related to conditions, the lender often will only waive his right to accelerate the due date subject to some caveat, such as no significant adverse changes in operations. Common questions that arise about preparing note disclosures about restrictive covenants relate to the following circumstances at the balance sheet date:  If there are no violations of covenants, does the note describing the covenants need to disclose compliance?  If there are violations of covenants, how does the existence and type of waiver affect disclosure? No Violations of Covenants. The notes do not have to disclose compliance. However, if the preparer wishes to address compliance, positive assurance should normally be avoided. Instead, wording such as management is not aware of any violations of the covenants" would be appropriate. Violation of Covenants. The existence of a waiver and the type of waiver obtained are believed to affect disclosure as follows: a. If an unconditional waiver has been obtained, neither classification as a current liability nor disclosure is required. b. If a waiver has not been obtained, disclosure of the condition is recommended and classification as a current liability is required. However, normally the financial statements are not issued before the waiver is obtained. The Technical Practice Aid at TIS 3200.17 addresses disclosure of debt covenant violations existing at the balance sheet date that have been waived by the creditor for a stated time period. The TPA states that disclosure of the existing violation and the waiver period should be considered (even if the debt is not callable) if the violation resulted from nonpayment of principal or interest on the debt, inability to maintain required financial ratios, or other financial covenants. If the lender waived the right to demand repayment for more than one year after the balance sheet date but retained the future covenant requirements (e.g., at interim dates during the next year), the account ing and disclosure requirements of EITF Issue No. 8630, Classification of Obligations When a Violation Is Waived by the Creditor" (FASB ASC 4701045 and 1055), apply. ContingenciesPledging Assets and Other Collateral Arrangements General. Authoritative pronouncements require disclosure of the following collateral arrangements:  SFAS No. 140, Accounting for Contingencies (FASB ASC 86030501), requires disclosure of company assets that are pledged as collateral for loans.  SFAS No. 57, Related Party Disclosures (FASB ASC 85010054), includes guarantees in its examples of related party transactions requiring disclosure. Some nonpublic companies have debt that is affected by both of the pronouncements because it is secured by all of the following: a. Company assets b. The company's voting stock c. Personal assets of the major stockholders d. The personal guarantees of the major stockholders and their spouses 119

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The following paragraphs provide recommendations on common questions that arise in preparing note disclo sures on pledged assets and other collateral arrangements. How Much Detail Should Be Provided? Collateral arrangements are specified in legal documents that are often detailed. Accordingly, problems arise in determining how much information about the arrangements should be disclosed in the notes to the financial statements. In developing the necessary disclosure, it is believed that the following limitations of financial statements should be considered:  The statement disclosures are not intended to be a substitute for legal agreements. At best they can notify readers of the key provisions that may affect their evaluation of the financial statements. Readers interested in further details, for example, prospective lenders assessing collateral, should look to the agreements.  The statements are not intended to provide an evaluation of whether the lender's investment is protected.  The statements are not intended to disclose assets available for pledging. However, GAAP does require disclosing the carrying amount and classification of any assets pledged as collateral that are not reported separately in the balance sheet. For many small and midsize private companies, all of the assets in specific balance sheet categories, such as equipment, land, inventory, and accounts receivable, may be pledged as collateral on debt. In those cases, the description of the category should enable the reader to relate the asset to a balance sheet caption. Some agreements are secured by assets now owned and hereafter acquired." In practice, if a company wants to finance the future acquisition of an asset, it usually can obtain a waiver of such a provision. Accordingly, it is believed unnecessary to disclose the commitment related to future acquisitions. Does Pledging of Daily Cash Receipts Have to Be Disclosed? Some collateral arrangements are secured by daily receipts and require the borrower to establish an account with the lender. Customers are directed to send remittances to that account, which is monitored by the lender. The substance of such an arrangement is that cash is pledged, thus meeting the requirements for disclosure. Normally, wording such as secured by daily receipts" is sufficient. Does the Absence of Pledging Have to Be Disclosed? GAAP only deals with assets that are pledged and does not require disclosure of the fact that some debt is unsecured. Some preparers believe that disclosure is unneces sary because the absence of security disclosures should be sufficient notification that the debt is unsecured. Others believe the disclosure may be readily provided, e.g., using a caption such as unsecured debt," and that it may avoid some confusion. Either approach is believed acceptable. However, the second alternative has an additional practical advantage in that it forces the preparer to reconsider whether there are collateral arrangements. What Terminology and Format Should Be Used? To describe collateral arrangements, using the terms secured" and unsecured" is recommended. Since secured" may imply that the value of the collateral is sufficient to permit full recovery of the asset, collateralized" is sometimes used. However, it is believed that collateralized" is not a word with which most readers are familiar and, therefore, its use is discouraged. If collateral arrangements are simple, for example, secured only by assets, they usually may be disclosed in the table describing longterm debt. However, more complex arrangements usually are best disclosed in separate paragraphs of the debt note. ContingenciesObligations under Guarantees FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" (FASB ASC 460), clarifies the accounting requirements for guaran tors and specifies the disclosures guarantors must make about their guarantee obligations. Under the Interpreta tion, guarantors must disclose the following information in their financial statements: a. The nature of the guarantee, including the guarantee's approximate term, how it arose, the events or circumstances that would require the guarantor to perform under the guarantee, and the current status, as of the balance sheet date, of the payment/performance risk of the guarantee. b. The maximum potential amount of future payments the guarantor could be require to make (undiscounted and not reduced by possible recoveries under recourse or collateralization provisions) or the reasons why 120

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an estimate of that amount cannot be made. (The disclosure is not applicable to product warranties or other guarantees related to the functionality of nonfinancial assets owned by the guaranteed party.) c. The carrying amount of the liability, if any, for the guarantor's obligations under the guarantee, including amounts recognized under SFAS No. 5, Accounting for Contingencies (FASB ASC 4502030). d. The recourse provisions that would enable the guarantor to recover amounts paid under the guarantee or collateral that could be sold. (If estimable, the extent to which proceeds from the sale of collateral would be expected to cover the maximum potential amount of future payments under the guarantee should be disclosed.) The following illustrates how a company might disclose a guarantee of a related party's or other entity's debt: The Company has guaranteed $200,000 of Midtown Supply Company's debt, which is due in annual installments with final payment due during the Company's fiscal year ended June 30, 20X5. The Company would be obligated to perform under the guarantee if Midtown Supply Company failed to pay principal and interest payments to the lender when due. Including accrued interest, the maximum potential amount of future (undiscounted) payments under the guarantee would be $225,000. However, if the Company were required to honor the guarantee, it would be entitled to property and equipment owned by Midtown Supply Company that collateralizes the loans. In accordance with generally accepted accounting principles, the Company has recog nized a guarantee liability of $25,000, which represents the fair value of its obligation to perform under the guarantee. As of June 30, 20X2, Midtown Supply Company is current with its debt payments. Based on information gathered as part of its monitoring of risks, the Company believes there is only a remote possibility Midtown Supply Company will not remain current with its debt payments and the Company will be required to perform under the guarantee. The following illustrates how a company might disclose its product warranty obligations: The Company accrues an estimate of its exposure to warranty claims based on both current and historical product sales data and warranty costs incurred. The majority of the Company's prod ucts carry a fiveyear warranty. The Company assesses the adequacy of its recorded warranty liability annually and adjusts the amount as necessary. The warranty liability is included in accrued liabilities in the accompanying balance sheet. Changes in the Company's warranty liability were as follows: 20X3 Warranty accrual, beginning of year Warranties issued during the period Adjustments to preexisting accruals Actual warranty expenditures Warranty accrual, end of year ContingenciesGoing Concern If a company's ability to continue as a going concern is in doubt, SAS No. 59 specifies that it may be necessary to disclose the principal conditions that raise a question about continued existence and related matters. The FASB currently has a going concern project on its agenda. The objective of the project is to include in the FASB authoritative literature guidance related to going concern issues, including (a) preparing financial statements as a going concern and the responsibility of an entity to evaluate its ability to continue as a going concern and (b) required disclosures when financial statements are not prepared on a going concern basis and when there is substantial doubt about the entity's ability to continue as a going concern. In October 2008, the FASB issued an exposure draft of a proposed SFAS, Going Concern. The FASB intends to issue the final SFAS in the first quarter of 2009. The proposed Statement will be effective for financial statements issued after the FASB Accounting Stan 121 $ 225,000 $ 350,000 61,000 (395,000 ) 241,000 $ 20X2 150,000 287,000 42,000 (254,000 ) 225,000

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dards Codification is ratified, which is anticipated to be in the second quarter of 2009. Common questions in disclosing such information concern when it is really necessary and how to word the information. SAS No. 59 notes that uncertainty about a company's ability to continue as a going concern relates to its inability to continue to meet its obligations as they become due without substantial disposition of assets outside the ordinary course of business, restructuring of debt, externally forced revisions of its operations, or similar actions. The auditors' evaluation of a company's ability to continue as a going concern is not merely a matter of evaluating the recoverability, classifications, and amounts of recorded assets and liabilities. SASNo. 59 requires auditors to modify their report if they have a substantial doubt about an entity's ability to continue as a going concern, even if recoverability of assets or classification of liabilities is not in question. Some readers interpret the going concern disclosures as predicting doom. In fact, many view them as causing a business to fail. Accordingly, the decision to disclose such information should not be taken lightly. Normally the disclosure is not provided unless there are serious concerns about the viability of the business. If disclosure is necessary, the following is recommended: a. The disclosure should include all relevant factors, such as: (1) Pertinent conditions and events giving rise to the assessment of the entity's ability to continue as a going concern, even if the information is apparent from the financial statements (2) The possible effects of such conditions and events (3) Management's evaluation of the significance of the conditions and events and any mitigating factors (4) Management's plans, including disclosure of possible discontinuance of operations (5) Information about the recoverability or classification of recorded assets or the amounts or classifications of liabilities b. The wording should be neutral and should not be unduly pessimistic or optimistic. c. If there are no mitigating factors or management has no specific plans to overcome the conditions, the note should be silent about their absence. ContingenciesLawsuits If there are material lawsuits against the company, SFAS No. 5 (FASB ASC 45020) requires disclosure of the following information unless the possibility of the loss is remote: A liability should be accrued whenever it is probable that an asset has been impaired or a liability incurred as of the balance sheet date and the amount can be reasonably estimated.) a. Nature of the contingency b. Estimate of the possible loss or range of loss or a statement that such an estimate cannot be made In June 2008, the FASB issued an exposure draft of a proposed SFAS, Disclosure of Certain Loss Contingencies, which would amend SFAS Nos. 5 and 141(R) to expand disclosures about certain loss contingencies within the scope of SFAS Nos. 5 and 141(R), including those related to pending or threatened litigation. Such disclosures would be required unless certain criteria are met. The proposed SFAS would (a) increase the number of loss contingencies that must be disclosed, (b) require specific quantitative and qualitative information to be disclosed about the loss contingencies, (c) require a reconciliation, in tabular form, of recognized loss contingencies, and (d) provide an exemption from certain disclosures if such disclosures would be prejudicial to an entity's position in a dispute. The proposed SFAS would not change the recognition and measurement guidance for loss contingencies in SFAS Nos. 5 and 141(R). The FASB planned to issue the final SFAS in the second quarter of 2009 and had tentatively decided that the effective date of the Statement would be no earlier than fiscal years ending after December 15, 2009. A statement asserting that the contingency is not expected to be material does not satisfy the disclosure require ments if there is at least a reasonable possibility that a loss exceeding amounts already recognized may have been 122

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incurred. In that case, the financial statements must either disclose the estimated additional loss or range of loss that is reasonably possible, or state that such an estimate cannot be made. Often an accountant will request that the client send a letter of inquiry to its attorneys to obtain the preceding information. (Such a letter is required to be obtained in audit engagements.) Although the lawyers' description of the litigation and the progress of the case to date may be used as a basis for the note to the financial statements, lawyers' evaluations may be unclear about the likelihood of an unfavorable outcome. In such cases, the accountant should request clarification either in a followup letter or in a conference with the lawyer and the client. Lawyers' evaluations should enable the accountant to classify the outcome of lawsuits as either probable," reasonably possible," or remote" because the accounting standards for accrual and disclosure are based on those terms. It is recommended that lawyers' responses to inquiry letters not be quoted or referred to in the financial statements without first consulting with the lawyers. A practice problem that sometimes occurs is whether to disclose a nuisance suit. Nuisance suits generally arise when anyone remotely connected with an event is sued in an attempt to collect as much money as possible. Generally, the damages claimed are clearly out of proportion with the damages suffered, and ultimately a settle ment will be reached for a much smaller amount. The following are examples of nuisance suits:  In traffic accidents involving a chain collision, a driver may sue everyone involved instead of the person that initiated the collision.  In malpractice suits, a patient may sue the hospital as well as the doctors and nurses actually involved with the case. In nuisance suits, lawyers are often willing to state that the chance of an adverse outcome is remote, and thus disclosure would not be required under GAAP . Subsequent Events There are two types of subsequent events that are often given the shorthand labels of Type I and Type II events. The key to proper treatment of subsequent events is identifying the event or condition and determining when the event or condition arose. Type I. Type I events are those that provide additional evidence about conditions that existed at the balance sheet date and that affect the estimates inherent in preparing the financial statements. The proper accounting treatment for those events is adjustment of the financial statements. In other words, new information available after the balance sheet dates affects the estimates that were used in preparing the financial statements and that information is considered in adjusting the financial statements at the balance sheet date. For example, a litigation accrual would be adjusted to the settlement amount if the litigation was in process at the balance sheet date and settled between the balance sheet date and the issuance of the financial statements. Most subsequent events that affect the realization of recorded assets, for example, receivables and inventories, or the settlement of estimated liabilities, for example, product warranty reserves, fall into the Type I category that requires the financial statements to be adjusted. That is often true because the recorded items relate to events or conditions that are ongoing and simply adjusted as new information provides a better basis for the estimates that were used. Assets and liabilities recorded at the balance sheet date should not be adjusted, however, if the event or changed condition clearly did not exist at the balance sheet date. For example, the financial statements should not be adjusted for an event arising after the balance sheet date that results in litigation or for a receivables loss resulting from a customer's major casualty (e.g., fire or flood) that occurred after the balance sheet date. Instead, those examples are Type II subsequent events, whose treatment is discussed in the next paragraph. Type II. The second type consists of events that occurred after the balance sheet date but that, nevertheless, must be disclosed to keep the financial statements from being misleading. The proper accounting treatment for those events is disclosure in the financial statements. Examples of the events include: a. Sale of a bond or capital stock issue 123

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b. Purchase of a business c. Loss of plant or inventories caused by fire or flood Exceptions to the balance sheet date cutoff for adjustment versus disclosure are stock dividends, stock splits, or reverse splits after the balance sheet date but before issuing the financial statements and revision of debt maturi ties. Those events should be given effect in the balance sheet with appropriate disclosure. Nonmarketable Equity SecuritiesThe Equity Method The significance of an investment accounted for by the equity method to the investor's financial position and results of operations should be considered in deciding the nature of disclosures, such as whether information about more than one investment should be combined, and their extent. However, according to APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (FASB ASC 32310503), as amended, by SFAS No. 94, the following disclosures generally apply: a. Parenthetically on the financial statements, in a note, or a separate schedule, the following information should be disclosed: (1) Investee's name and percentage of ownership (2) Investor's accounting policies for the investments including the names of investee corporations in which the investor holds 20% or more of the voting stock but that are not accounted for on the equity method and the reasons why the equity method is not considered appropriate and the names of investee corporations in which the investor holds less than 20% of the voting stock that are accounted for on the equity method and the reasons why the equity method is considered appropriate (3) Any difference at the balance sheet date between the carrying amount of the investment and the amount of underlying equity in net assets and the manner of accounting for the difference b. In a note or in a separate schedule, summarized information about assets, liabilities, and results of operations for investments in common stock of corporate joint ventures or other investments accounted for under the equity method that are, in the aggregate, material in relation to the investor's financial position or results of operations c. Material effects of potential conversion of securities or exercise of outstanding stock options and warrants d. Market value of investment if a quoted market price is available (not required for investments in subsidiaries) Sharebased Payment or Compensation Arrangements SFAS No. 123 (revised 2004), ShareBased Payment (FASB ASC 71810501), which is also referred to as SFAS No. 123(R), requires entities with one or more sharebased payment or compensation arrangements to disclose information that enables financial statement users to understand (a) the nature and terms of arrangements that existed during the period and the potential effects of the arrangements on shareholders, (b) the income statement effect of compensation cost arising from the arrangements, (c) the method of estimating the fair value of goods and services received or the fair value of the equity instruments granted or offered during the period, and (d) the cash flow effects of the arrangements. The following are minimum disclosure requirements necessary to meet those objectives. The entity may need to disclose additional information to meet the disclosure objectives. The following items should be disclosed about the entity's sharebased payment or compensation arrangements (separately for each type of award to the extent separate disclosure would be useful): a. A description of the arrangement, including the general terms of the awards, such as the required service period and other substantive conditions (including those related to vesting), the maximum contractual term of share options, and the number of shares authorized for awards 124

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b. The method used to measure compensation cost from sharebased payment arrangements with employees c. For the most recent year for which an income statement is presented: (1) The number and weightedaverage exercise prices for share options (or share units) outstanding at the beginning of the year, outstanding at the end of the year, exercisable or convertible at the end of the year, and granted, exercised or converted, forfeited, or expired during the year (2) The number and weightedaverage grantdate fair value (or calculated or intrinsic value for awards measured under those methods) of equity instruments nonvested at the beginning of the year, nonvested at the end of the year, and granted, vested, or forfeited during the year d. For each year for which an income statement is presented: (1) The weightedaverage grantdate fair value (or calculated or intrinsic value for awards measured under those methods) of equity options or other equity instruments granted during the year (2) The total intrinsic value of options exercised or converted, sharebased liabilities paid, and the total fair value of shares vested during the year e. For fully vested share options and share options expected to vest at the date of the latest balance sheet: (1) The number, weightedaverage exercise price, aggregate intrinsic value, and weightedaverage remaining contractual term of options outstanding (2) The number, weightedaverage exercise price, and weightedaverage remaining contractual term of options currently exercisable f. If the intrinsic value method is not used, for each year for which an income statement is presented: (1) A description of the method used during the year to estimate fair value (or calculated value) (2) A description of the significant assumptions used during the year to estimate fair value (or calculated value), including (a) the expected term of share options, including the method used to incorporate the contractual term and employees' expected exercise and postvesting employment termination behavior into the fair value; (b) expected volatility of the entity's shares and the method used to estimate it (if the calculated value method is used, disclose the reasons why it is not practicable to estimate expected volatility, the appropriate industry sector index and reasons for selecting it, and how historical volatility was calculated using the index); (c) expected dividends; (d) riskfree rates; and (e) discount for postvesting restrictions and the method for estimating it The following items should be disclosed about the entity's total sharebased payment or compensation arrange ments: a. For each year for which an income statement is presented: (1) The total compensation cost for sharebased payment arrangements (a) recognized in income as well as the total recognized related tax benefit and (b) capitalized as part of the cost of an asset (2) A description of significant modifications, including the terms of the modifications, number of employees affected, and total incremental compensation cost resulting from the modifications b. As of the latest balance sheet date presented, the total compensation cost related to nonvested awards not yet recognized and the weightedaverage period over which it is expected to be recognized c. The amount of cash received from exercise of share options and similar instruments granted under sharebased payment arrangements and the tax benefit realized from stock options exercised during the period 125

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d. The amount of cash used to settle equity instruments granted under sharebased payment arrangements e. A description of the entity's policy for issuing shares upon exercise or conversion of options, including the source of the shares and, if the entity expects to repurchase shares in the following annual period, an estimate of the amount of shares to be repurchased during that period

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 10. According to the guidance found in SFAS No. 57 (FASB ASC 85010501), which of the following is a required disclosure for a related party transaction? a. Only amounts due from related parties. b. A description of only significant related party transactions. c. The nature of the relationship involved in the transaction. d. An estimate of the amount of income used for related party transactions. 11. Which of the following would be included under the SFAS No. 87 (FASB ASC 7153020) definition of a pension plan? a. Making death and disability payments under a separate arrangement. b. Retirement benefits paid to selected employees in amounts determined after retirement. c. Plans whose existences is implied from a welldefined but unwritten company policy. 12. Which of the following scenarios concerning contingencies, other collateral arrangements and obligations under guarantees correctly illustrates the related disclosure? a. Milliners Inc. has no violations of its restrictive debt covenants, so it discloses its compliance and includes positive assurances about continued compliance in the future, as well. b. Parasol Mates violated a restrictive debt covenant and obtained an unconditional waiver. It discloses the violation and classifies the amount as a current liability. c. Stiletto Source secures a collateral arrangement by pledging daily receipts. In its financial statements, the company discloses the exact amounts remitted to the lender. d. Shawl Studios discloses the following about its guarantee: its nature, maximum potential amount of future payments, the liability's carrying amount, and recourse provisions for recovering amounts paid. 13. A lawsuit is filed against Sunshine Farms. Losing the lawsuit means there is a significant possibility that Sunshine Farms will incur a loss that exceeds amounts already recognized. Which of the following scenarios best illustrates the affect that the lawsuit will have on the company's financial statements? Unless otherwise noted, assume that the company's chances of losing the lawsuit are evaluated as reasonably possible." a. Sunshine Farms includes a disclosure of the nature of the contingency and an estimate of the possible loss or range of loss. b. Sunshine Farms includes a statement asserting that the lawsuit contingency is not expected to be material. c. The lawyers' evaluation is unclear as to the likelihood of the outcome of the case, so their responses are included verbatim in the disclosure. d. The lawsuit against Sunshine Farms is a nuisance suit. Because chances of an adverse outcome are great all relevant information must be disclosed.

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14. Define type II subsequent events. a. They provide additional evidence about conditions that exist at the balance sheet date and that affect estimates inherent in preparing the financial statements. Proper accounting treatment is to adjust the financial statements for these events. b. They occur after the balance sheet date, but must be disclosed to keep the financial statements from being misleading. Proper accounting treatment is to disclose them in the financial statements. c. Stock dividends, stock splits, or reverse splits after the balance sheet date but before financial statements are issued, and revision of debt maturities. Proper accounting treatment is to give them effect in the balance sheet and make an appropriate disclosure.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 10. According to the guidance found in SFAS No. 57 (FASB ASC 85010501), which of the following is a required disclosure for a related party transaction? (Page 116) a. Only amounts due from related parties. [This answer is incorrect. Amounts due to or from related parties as of the date of each balance sheet presented is required to be disclosed, as well as the terms and manner of settlement (if not otherwise apparent).] b. A description of only significant related party transactions. [This answer is incorrect. A description of all transactions is required, including those to which nominal or no amounts were ascribed. And this description is needed for each of the income statement periods presented. Other such information deemed necessary to understand the effects of the transactions on the financial statements should also be disclosed.] c. The nature of the relationship involved in the transaction. [This answer is correct. The nature of the relationship between the related parties involved in the transaction is required by SFAS No. 57 (FASB ASC 85010501), as well as a description of the transactions, the dollar amounts of transactions, and amounts due as of he balance sheet date.] d. An estimate of the amount of income used for related party transactions. [This answer is incorrect. The dollar amounts of related party transactions for each of the periods for which income statements are presented must be disclosed, as well as the effects of any change in the method of establishing the terms from that which was used in the preceding period.] 11. Which of the following would be included under the SFAS No. 87 (FASB ASC 7153020) definition of a pension plan? (Page 117) a. Making death and disability payments under a separate arrangement. [This answer is incorrect. These payments are excluded from the definition of a pension plan. However, unfunded, insured, and trust fund plans would all be included in the definition.] b. Retirement benefits paid to selected employees in amounts determined after retirement. [This answer is incorrect. Such payments are not considered pension plans. However, both defined benefit and defined contribution plans can be considered pension plans.] c. Plans whose existences is implied from a welldefined but unwritten company policy. [This answer is correct. Both this type of plan and written plans fall under the definition of a pension plan.] 12. Which of the following scenarios concerning contingencies, other collateral arrangements and obligations under guarantees correctly illustrates the related disclosure? (Page 120) a. Milliners Inc. has no violations of its restrictive debt covenants, so it discloses its compliance and includes positive assurances about continued compliance in the future, as well. [This answer is incorrect. Milliners does not have to disclose compliance, but if it does, positive reassurance should be avoided. The company could use the following wording instead: Management is not aware of any violations of the covenants."] b. Parasol Mates violated a restrictive debt covenant and obtained an unconditional waiver. It discloses the violation and classifies the amount as a current liability. [This answer is incorrect. Because an unconditional waiver was obtained, Parasol Mates is not required to make a disclosure or to make the classification of the current liability. The disclosure would be recommended and the classification required if the waiver had not been obtained.] 129

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c. Stiletto Source secures a collateral arrangement by pledging daily receipts. In its financial statements, the company discloses the exact amounts remitted to the lender. [This answer is incorrect. The requirements would be met if the disclosure says that the loan is secured by daily receipts." Exact amounts are not required.] d. Shawl Studios discloses the following about its guarantee: its nature, maximum potential amount of future payments, the liability's carrying amount, and recourse provisions for recovering amounts paid. [This answer is correct. Nature includes the approximate term, how the guarantee arose, events/circumstances that require Shawl Studios to perform under the guarantee, and the current status of the balance sheet date, or the payment/performance risk. If the maximum potential amount cannot be estimated, Shawl Studios must disclose the reasons why. The carrying amount would include amounts recognized under SFAS No. 5 (FASB ASC 4502030). Shawl Studios could disclose collateral that could be sold instead of recourse provisions for recovering amounts paid, if applicable.] 13. A lawsuit is filed against Sunshine Farms. Losing the lawsuit means there is a significant possibility that Sunshine Farms will incur a loss that exceeds amounts already recognized. Which of the following scenarios best illustrates the affect that the lawsuit will have on the company's financial statements? Unless otherwise noted, assume that the company's chances of losing the lawsuit are evaluated as reasonably possible." (Page 122) a. Sunshine Farms includes a disclosure of the nature of the contingency and an estimate of the possible loss or range of loss. [This answer is correct. If the lawsuit is material and possibility of loss is not remote, Sunshine Farms is required to disclose this information under SFAS No. 5 (FASB ASC 45020).] b. Sunshine Farms includes a statement asserting that the lawsuit contingency is not expected to be material. [This answer is incorrect. This would not satisfy the requirements of SFAS No. 5 (FASB ASC 45020) because there is a reasonable possibility that a loss exceeding amounts already recognized may be incurred.] c. The lawyers' evaluation is unclear as to the likelihood of the outcome of the case, so their responses are included verbatim in the disclosure. [This answer is incorrect. It is recommended that the lawyers' responses not be quoted or referred to in the statements without first consulting the lawyers.] d. The lawsuit against Sunshine Farms is a nuisance suit. Because chances of an adverse outcome are great all relevant information must be disclosed. [This answer is incorrect. Generally, damages claimed in a nuisance suit are out of proportion to damages suffered, so, ultimately, a settlement is reached for a smaller amount. For such suits, lawyers are often willing to state that the chance of an adverse outcome is remote; therefore, disclosure would not be required under GAAP .] 14. Define type II subsequent events. (Page 123) a. They provide additional evidence about conditions that exist at the balance sheet date and that affect estimates inherent in preparing the financial statements. Proper accounting treatment is to adjust the financial statements for these events. [This answer is incorrect. This is the definition of Type I subsequent events. An example of this kind of subsequent event is when a litigation accrual is adjusted to the settlement amount when the litigation was in process at the balance sheet date and it is settled between the balance sheet date and issuance of the financial statements.] b. They occur after the balance sheet date, but must be disclosed to keep the financial statements from being misleading. Proper accounting treatment is to disclose them in the financial statements. [This answer is correct. Examples of Type II events include the sale of bonds or the issuance of capital stock, the purchase of a business, and the loss of plants or inventories caused by flood or fire.]

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c. Stock dividends, stock splits, or reverse splits after the balance sheet date but before financial statements are issued, and revision of debt maturities. Proper accounting treatment is to give them effect in the balance sheet and make an appropriate disclosure. [This answer is incorrect. These events are exceptions to the balance sheet date cutoff for disclosure versus adjustment. Such events must be given effect in the balance sheet and must have appropriate disclosure.]

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COMMON PROBLEMS RELATED TO THE PREPARATION OF OTHER DISCLOSURES


Other disclosures concern matters that do not necessarily occur every year, such as accounting changes or business combinations. Accounting Changes Accounting changes include (a) changes in accounting estimates, (b) changes in the reporting entity, and (c) changes in accounting principles. The following is a summary of disclosure requirements for accounting changes: a. Changes in Accounting Estimates. The effect of the change on income from continuing operations and net income should be disclosed if the change affects future years such as the estimated useful lives of property and equipment. Disclosure generally is not required for routine changes such as uncollectible accounts unless they are material. If the change in estimate has no material effect in the period of change but is reasonably certain to have a material effect in later periods, a description of the change should be disclosed whenever the financial statements of the period of change are presented. Also, if a change in accounting estimate has been effected by changing an accounting principle, the disclosures in item c. should also be made. b. Changes in Reporting Entity. Disclosure of the nature of the change and the reason for it should be made in the period of change. The effect on net income, income before extraordinary items, and other comprehensive income also should be disclosed for all periods presented. If the change has no material effect in the period of change but is reasonably certain to have a material effect in later periods, the nature of the change and the reason for it should be disclosed whenever the financial statements of the period of change are presented. c. Changes in Accounting Principles. Disclosure should include the following in the fiscal period in which the change is made: (1) The nature of the change, the reason for it, and why the new principle is preferable. If the change has no material effect in the period of change but is reasonably certain to have a material effect in later periods, this disclosure is required whenever the financial statements of the period of change are presented. (2) The method of applying the change, including (a) a description of any priorperiod information that has been retrospectively adjusted, (b) the effect of the change on income from continuing operations, net income, and any other affected financial statement line item for the current and prior periods retrospectively adjusted, (c) the cumulative effect of the change on retained earnings (or other components of equity) as of the beginning of the earliest period presented, and (d) the reasons for and a description of the alternative method used to report the change when retrospective application to all prior periods is impracticable. (3) If the indirect effects of a change in accounting principle are recognized, a description of the indirect effects of the change, including amounts that have been recognized in the current period, and the amount of the total recognized indirect effects of the accounting change that are attributable to each prior period presented, unless impracticable. (4) For interim periods subsequent to the date of adoption of the change in accounting principle, the effect of the change on income from continuing operations and net income for the postchange interim periods.

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Business Combinations Business combinations occur in a variety of waysone company may pay cash for the stock of another or a company may exchange its stock for another company's stock. The forms of combinations found most frequently for nonpublic companies are: a. One company acquires the assets and assumes the liabilities of another company. b. One company acquires the stock of another company in exchange for cash or notes and either retains the company as a subsidiary or liquidates it. Business combinations should be accounted for using the purchase method. In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations, as a replacement for SFAS No 141. SFAS No. 141(R) (FASB ASC 805) applies prospectively to business combinations occurring in fiscal years beginning on or after December 15, 2008. Earlier application is not permitted. The following disclosures are required for business combinations prior to the effective date of SFAS No. 141(R) (FASB ASC 805): a. Name and description of the acquired company and the percentage of voting equity interests acquired. b. The primary reasons for the combination. c. The cost of the acquired company and, if applicable, the number of shares and amount of stock issued or issuable. If goodwill is recognized from the transaction, the factors that contributed to the purchase price should also be disclosed. d. A condensed balance sheet, as of the acquisition date, that discloses the allocation of the purchase price to the assets acquired and liabilities assumed in the transaction by major balance sheet caption. e. The amount of purchased research and development assets acquired and written off in the period, if any. The location of the writeoffs in the income statement should also be disclosed. f. The reason for any purchase price allocation that has not been finalized. Should also disclose the nature and amount of any material adjustments made to the initial purchase price allocation in subsequent periods. g. If the portion of the purchase price assigned to intangible assets is significant in relation to the purchase price, the following additional disclosures should be made:  The total amount assigned, in total and by major intangible asset class.  The residual value, if significant, in total and by major intangible asset class.  If the acquired intangible assets have a finite useful life, the weightedaverage amortization periods, in total and by major intangible asset class. h. If the portion of the purchase price assigned to goodwill is significant in relation to the total purchase price, the following additional disclosures should be made:  The total amount of goodwill.  The amount of goodwill expected to be deductible for income tax purposes.  The amount of goodwill by reportable segment, unless not practicable or the combined entity is not required to disclose segment information in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (FASB ASC 280). 133

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i. The period for which results of operations of the acquired company are included in the income statement of the acquiring company. j. Contingent payments, options, or commitments specified in the acquisition agreement and the related accounting to be used. k. Consideration that is issued or issuable at the end of the contingency period or that is held in escrow. Additional disclosures are required if the business combination is between parties with a preexisting relationship or if the acquiring company plans to exit certain activities of an acquired company or involuntarily terminate or relocate employees of an acquired company. Discontinued Operations According to SFAS No. 144 (FASB ASC 2052050), certain amounts relating to the disposal of a component of an entity should be disclosed in the financial statements, such as income or loss from operations of the discontinued component and gain or loss on disposal. The FASB is currently working with the International Accounting Stan dards Board (IASB) on a joint project on reporting discontinued operations. Proposed FSP FAS 144d, Amending the Criteria for Reporting a Discontinued Operation, was issued in September 2008 to revise the definition of a discontinued operation and require additional disclosures for components of an entity that have been or will be disposed of. The comment period ends in January 2009 and the FASB intends to issue the final FSP in the second quarter of 2009. The proposed effective date is for fiscal years beginning after December 15, 2009. The following required disclosures are typically made in the notes to the financial statements: a. The facts and circumstances resulting in the expected disposal b. The segment in which the assets to be disposed of are included under SFAS No. 131 (FASB ASC 280) c. The expected manner and timing of disposal d. The carrying amount of the major classes of assets and liabilities of the disposal group if not separately disclosed on the face of the balance sheet e. The amount of any gain or loss recognized and where that amount is included in the income statement, if not disclosed on the face of the income statement f. Revenues and pretax profit or loss of the discontinued operation g. Description of any changes to the plan of disposal and the effects of the changes on the results of operations for all periods presented In addition, additional disclosures are required in situations where the discontinued operation generates continuing cash flows and in situations where the reporting entity has continued involvement with the component after disposal. Priorperiod Adjustments GAAP permits only corrections of errors in previously issued financial statements to be accounted for as prior period adjustments. Disclosure of priorperiod adjustments as required by APB Opinion No. 9, Reporting the Results of Operations, Paragraph 26 (FASB ASC 25010508 and 509), consists of the effects of the adjustment, both gross and net of tax, on net income for all periods presented. For single period financial statements, disclosure should include the effects of the adjustment, both gross and net of tax, on beginning retained earnings and net income of the preceding period. The amount of income tax applicable to the adjustment should also be disclosed. The disclosures should be made in the year in which the adjustment is made and need not be repeated in subsequent years.

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In addition, SFAS No. 154, Accounting Changes and Error Corrections (FASB ASC 25010507), requires the following disclosures when financial statements are restated to correct an error: a. A statement indicating that the previously issued financial statements have been restated. b. A description of the nature of the error. c. For each prior period presented, the effect of the error correction on each affected financial statement line item. d. The cumulative effect of the change on retained earnings (or other components of equity) as of the beginning of the earliest period presented. Environmental Remediation Costs SOP 961, Environmental Remediation Liabilities (FASB ASC 4103050), provides guidance for disclosing environ mental remediation liabilities and contingencies. The following paragraphs explain the SOP's disclosure require ments for accounting policies, accrued liabilities, unaccrued contingencies, and unasserted claims, as well as optional disclosures. In June 2008, the FASB issued an exposure draft of a proposed SFAS, Disclosure of Certain Loss Contingencies, which would amend SFAS Nos. 5 and 141(R), to expand disclosures about certain loss contingencies within the scope of SFAS Nos. 5 and 141(R) and to provide the principal guidance for disclosures of environmental remediation loss contingencies. The proposed SFAS would (a) increase the number of loss contin gencies that must be disclosed, (b) require specific quantitative and qualitative information to be disclosed about the loss contingencies, (c) require a reconciliation, in tabular form, of recognized loss contingencies, and (d) provide an exemption from certain disclosures if such disclosures would be prejudicial to an entity's position in a dispute. The proposed SFAS would not change the recognition and measurement guidance for loss contingencies in SFAS Nos. 5 and 141(R). The FASB planned to issue the final SFAS in the second quarter of 2009 and had tentatively decided that the effective date of the Statement would be no earlier than fiscal years ending after December 15, 2009. The disclosure requirements of SOP 946, Disclosure of Certain Significant Risks and Uncer tainties (FASB ASC 27510), also apply to environmental remediation liabilities. In addition, SFAS No. 5, Accounting for Contingencies (FASB ASC 45020), provides the primary guidance relevant to disclosures of environmental remediation loss contingencies. Disclosure of Accounting Policies. SOP 961 (FASB ASC 41030504) requires financial statements to disclose whether environmental remediation liabilities are measured on a discounted basis. In addition, companies are encouraged, but not required, to disclose (a) the circumstances that generally trigger accrual of environmental remediation liabilities (such as completion of the feasibility study) and (b) the company's policy for recognizing recoveries. Accrued Liabilities. The following disclosures should be made for accrued environmental remediation liabilities: a. The nature and amount of the accrual (if necessary for the financial statements not to be misleading) b. If any part of the accrued obligation is discounted, the discount rate used and the undiscounted amount of the obligation c. An indication that it is at least reasonably possible that the estimate of the accrued obligation (or any related thirdparty receivables) will change in the near term, if the criteria of SOP 946 (FASB ASC 27510508) for certain significant estimates are met Unaccrued Contingencies. For reasonably possible loss contingencies (including reasonably possible losses in excess of accrued amounts), the following disclosures should be made: a. A description of the contingency and an estimate of the possible loss (or the fact that such an estimate cannot be made) b. An indication that it is at least reasonably possible that the estimate will change in the near term, if the criteria of SOP 946 (FASB ASC 27510508) for certain significant estimates are met 135

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For probable but not reasonably estimable loss contingencies that may be material, the following disclosures should be made: a. A description of the remediation obligation b. The fact that a reasonable estimate cannot be currently made Unasserted Claims. Under SOP 961 (FASB ASC 410305013), if assertion of a claim is probable or if existing laws require the company to report the release of hazardous substances and begin a remediation study, a loss contingency should be disclosed subject to SFAS No. 5's (FASB ASC 45020503 and 504) disclosure provisions. Optional Disclosures. Companies are encouraged, but not required, to disclose the following: a. The estimated time frame for making environmental remediation disbursements (if expenditures are expected to occur over a long period) b. The estimated time frame for realizing recognized recoveries (if realization is not expected in the near term) c. The factors that cause the estimate of accrued environmental remediation liabilities, unaccrued contingencies, or thirdparty receivables to be sensitive to change if the criteria for significant estimates are met d. The reasons why an estimate of the loss (or range of the loss) cannot be made for probable or reasonably possible losses e. The estimated time frame for resolving the uncertainty as to the amount of a probable but not reasonably estimable loss f. The following information related to an individual site, if relevant to an understanding of the company's financial position, cash flows, or results of operations:  Total environmental remediation liability accrued for the site  Nature and estimated amount of any reasonably possible loss contingency  Involvement of other potentially responsible parties  Status of regulatory proceedings  Estimated time frame for resolving the contingency g. The amount recognized in the income statement for environmental remediation loss contingencies in each period h. The amount of any thirdparty recovery credited against environmental remediation costs in the income statement in each period i. The income statement caption that includes environmental remediation costs and related recoveries Companies may make the following additional note disclosures:  A conclusion about whether the total unrecorded exposure to environmental remediation obligations is material to the financial statements. Such conclusion is not a substitute for the disclosures required by GAAP . If management asserts that the unrecorded exposure is not material, that assertion must be supportable.

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 A description of the general applicability and impact of environmental laws and regulations on their business and how those laws and regulations may result in loss contingencies for future remediation. Those disclosures often acknowledge the uncertainty of the effect of possible future changes in environmental laws and their application. Those disclosures normally are made on a companywide basis, considering exposures from all the company's sites.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 15. Pasta Prime changes the estimated useful lives of some of its property and equipment. The company discloses the effect of the change on its income from continuing operations, as the change will affect future years and it is material. What type of accounting change has Pasta Prime experienced? a. A change in accounting estimate. b. A change in reporting entity. c. A change in accounting principle. 16. Teddy Town discontinues operations of its Bear Essentials component. Which of the following disclosures should be made in the financial statements? a. A description of all assets and liabilities of both Teddy Town and Bear Essentials. b. Revenues of Bear Essentials calculated after all taxes are paid. c. At least three scenarios approximating the expected manner and timing of the disposal. d. The segment in which Bear Essentials' assets are to be disposed of. 17. Spinning Supplies discovers and error in its most recently issued set of financial statements. On the next set of statements, Spinning Supplies accounts for this error as a priorperiod adjustment. Which of the following disclosures must the company make under APB Opinion No. 9 (FASB ASC 25010508 and 509)? a. The gross and net effects of the adjustment on net income for all periods presented. b. The amount of income tax paid during the current year and the year of the error. c. A description of the nature of the error Spinning Supplies made. d. A statement that indicates the priorperiod statements have been restated.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 15. Pasta Prime changes the estimated useful lives of some of its property and equipment. The company discloses the effect of the change on its income from continuing operations, as the change will affect future years and it is material. What type of accounting change has Pasta Prime experienced? (Page 132) a. A change in accounting estimate. [This answer is correct. In this scenario, Pasta Prime has disclosed a change in accounting estimate. If the change had no material effect in the period of change but is reasonably certain to have a material effect on later periods, Pasta Prime should disclose a description of the change when the financial statements of the period of change are presented.] b. A change in reporting entity. [This answer is incorrect. A change in estimated useful life is not a change in reporting entity. If Pasta Prime had experienced a change in reporting entity, in the period of change, Pasta Prime would disclose the nature of the change and the reason for it. Effect on net income, income before extraordinary items, and other comprehensive income would also be disclosed for all periods presented.] c. A change in accounting principle. [This answer is incorrect. A change in estimated useful life is not a change in accounting principle. If a change in accounting principle had been experienced, Pasta Prime would need to disclose the change in the fiscal period in which the change is made. The following are some examples of the information that would be disclosed: (1) the nature of the change, (2) the method of applying the change, (3) a description of indirect effects, and (4) for interim periods subsequent to the date of the adoption of the change, the effect of the change on income from continuing operations.] 16. Teddy Town discontinues operations of its Bear Essentials component. Which of the following disclosures should be made in the financial statements? (Page 134) a. A description of all assets and liabilities of both Teddy Town and Bear Essentials. [This answer is incorrect. Teddy Town needs to disclose the carrying amount of the major classes of assets and liabilities or Bear Essentials if not separately disclosed on the face of the balance sheet.] b. Revenues of Bear Essentials calculated after all taxes are paid. [This answer is incorrect. A correct disclosure would be the revenues and pretax profit or loss of Bear Essentials.] c. At least three scenarios approximating the expected manner and timing of the disposal. [This answer is incorrect. Teddy Town should disclose the expected manner and timing of the disposal of Bear Essentials.] d. The segment in which Bear Essentials' assets are to be disposed of. [This answer is correct. This disclosure is included under SFAS No. 131 (FASB ASC 280). Another necessary disclosure is the facts and circumstances that resulted in the expected disposal of Bear Essentials.] 17. Spinning Supplies discovers and error in its most recently issued set of financial statements. On the next set of statements, Spinning Supplies accounts for this error as a priorperiod adjustment. Which of the following disclosures must the company make under APB Opinion No. 9 (FASB ASC 25010508 and 509)? (Page 134) a. The gross and net effects of the adjustment on net income for all periods presented. [This answer is correct. This disclosure is required under APB Opinion No. 9, Reporting the Results of Operations (FASB ASC 25010508 and 509). If Spinning Supplies presented singleperiod statements, it should also include the gross and net effects of the adjustment on beginning retained earnings and net income of the preceding period.] b. The amount of income tax paid during the current year and the year of the error. [This answer is incorrect. Under APB Opinion No. 9 (FASB ASC 25010508 and 509), Spinning Supplies should disclose the amount of income tax applicable to the adjustment.] 140

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c. A description of the nature of the error Spinning Supplies made. [This answer is incorrect. This disclosure is required by SFAS No. 154 (FASB ASC 25010507), not APB Opinion No. 9 (FASB ASC 25010508 and 509). Another such disclosure is the cumulative effect of the change on retained earnings as of the beginning of the earliest period Spinning Supplies presents.] d. A statement that indicates the priorperiod statements have been restated. [This answer is incorrect. This disclosure, required by SFAS No. 154 (FASB ASC 25010507), must be made in addition to disclosures required by APB Opinion No. 9 (FASB ASC 25010508 and 509). Another such disclosure is the effect of the error correction on each affected financial statement item for each prior period presented.]

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DISCLOSURE OF FINANCIAL INSTRUMENT INFORMATION


SFAS No. 107, Disclosures about Fair Value of Financial Instruments (FASB ASC 825105010) (as amended) primarily requires certain entities to disclose the fair values of financial instruments for which it is practicable to estimate fair values. Identifying financial instruments that are subject to the disclosure requirements of SFAS No. 107 (FASB ASC 825) often is difficult. This lesson defines financial instruments and provides detailed guidance on identifying those financial instruments for which specific disclosures are required. Then it discusses credit and market risk disclo sures and fair value disclosures. Identifying Financial Instruments There are three major categories of financial instruments: cash, evidence of an ownership interest in an entity, and a contract that requires the exchange of cash or other financial instruments. Identifying cash and ownership interests is straightforward. a. Cash. It is believed that cash for this purpose is the same as cash connected with the statement of cash flows. Therefore, it includes currency on hand, demand deposits, and other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit or withdraw additional funds at any time. Although cash equivalents are not cash, they are normally financial instruments because they are contracts with the characteristics described in the discussion that begins in the Unconditional Receivablepayable Contract" paragraph. b. Evidence of an Ownership Interest in an Entity. Evidence of an ownership interest in an entity includes common stock, preferred stock, certificates of interest or participation, and warrants and options to subscribe to or purchase stock from the issuing entity. c. Contracts That Require the Exchange of Cash or Other Financial Instruments. Under Paragraph 3 of SFAS No. 107 (FASB ASC 8251020), a contract is a financial instrument if it both: (1) Imposes on one entity a contractual obligation to (a) deliver cash or another financial instrument to a second entity or (b) exchange other financial instruments on potentially unfavorable terms with the second entity, and (2) Conveys to that second entity a contractual right to (a) receive cash or another financial instrument from the first entity or (b) exchange other financial instruments on potentially favorable terms with the first entity. Generally, if the conditions for a financial instrument are met for the issuer, they will also be met for the holder. Likewise, if they are met for the holder, they will also be met for the issuer. Considering the Definition of an Asset or a Liability. The definition of a financial instrument in item c. of the previous paragraph requires a contractual right and a contractual obligation. Since contractual rights and obliga tions meet the definitions of assets and liabilities provided in FASB Concepts Statement No. 6, Elements of Financial Statements, an agreement that does not meet the definition of an asset and a liability is not a financial instrument. The definition of assets and liabilities contained in FASB Concepts Statement No. 6 requires the occurrence of a transaction or event. It further notes that when the transaction occurs depends on the agreement. Therefore, if the transfer is based on future performance, there is no obligation prior to that performance. Accordingly, that agree ment is not a financial instrument. The unexpired or future portions of the following common agreements are not financial instruments because they do not meet the definition of an asset or a liability:  Deferred Compensation and Pension Plan Agreements. Deferred compensation and pension plan agreements often provide benefits based on past and future service. There is no contractual right or 142

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obligation related to payments for future service until that service is provided, and the agreement for that service is not a financial instrument.  Covenants Not to Compete That Have Economic Substance. These covenants provide for payments based on the passage of time. However, there is no contractual right or obligation related to payments for the unexpired term of the agreement; thus, the agreement for the unexpired term is not a financial instrument.  Operating Lease. A noncancelable operating lease requires payments based on the passage of time. Since there is no contractual right or obligation related to payments for the unexpired term of the lease, the agreement for those periods is not a financial instrument.  Royalty Agreement. A royalty agreement requires payments based on some factor such as sales or production. There is no contractual right or obligation for royalty payments related to future sales or production. Therefore, the agreement for those future transactions is not a financial instrument. For each of those agreements, however, a contractual right or obligation exists for the expired portion. Therefore, that portion is a financial instrument with the characteristics discussed later in this lesson. Using the Fundamental Financial Instrument Approach to Identify Financial Instruments. In August 1990, the FASB issued a discussion memorandum, Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both. The discussion memorandum uses the fundamental financial instru ment approach to identify financial instruments. Although not authoritative, that approach is believed useful in determining whether an agreement that meets the definition of an asset or a liability is a financial instrument. The approach defines six basic categories of financial instruments. Five of the categories deal with contracts and the sixth deals with equity instruments. (Cash is excluded because the discussion memorandum focuses on financial instruments with liability and equity characteristics.) The five contract categories are distinguished primar ily by whether they involve a oneway transfer of financial instruments or an exchange of financial instruments and whether future performance is contingent or fixed. The following paragraphs illustrate how the approach may be used to identify common agreements that are financial instruments. Unconditional Receivablepayable Contract. An unconditional receivablepayable contract both: a. Imposes on one entity an unqualified contractual obligation to deliver a specified amount of cash or other financial instrument to a second entity on demand or on or before a specified date, and b. Conveys to that second entity an unqualified contractual right to receive a specified amount of cash or other financial instrument from the first entity on demand or on or before a specified date. This category includes the items considered to be cash equivalents, some shortterm investments, loans receivable and payable, and the contractual rights and obligations under expired portions of the contracts. The following are common examples:  Cash equivalents such as U.S. Treasury bills, commercial paper, and money market accounts that are not classified as cash  Shortterm investments with original maturities of three months or less  Trade accounts receivable, notes receivable, and receivables from stockholders that will be settled in cash  Shortterm and longterm notes payable  Accrued receivables and payables for operating items such as vacation pay, bonuses, interest, and warranty claims and returns that will be settled in cash  Receivables and payables related to the expired portion of a deferred compensation agreement, a covenant not to compete, an operating lease, a retirement plan, or a royalty agreement (However, a 143

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deferred compensation agreement and a retirement plan are excluded from the fair value disclosure requirements of SFAS No.107 (FASB ASC 8251050), as amended.)  Leases that effectively transfer the benefits and risks of ownership of an asset from the lessor to the lessee at the inception of the lease such as a capital lease or a direct financing lease (That type of lease is excluded from the fair value disclosure requirements of SFAS No.107 (FASB ASC 8251050), as amended, but is not excluded from the requirement to disclose concentrations of credit risk.) Each of the preceding examples involves a oneway transfer of a financial instrument, usually cash, either on demand or at specified dates. If the transfer is other than through a financial instrument, the requirements for a financial instrument are not met. The following are common examples:  A payment as a loan to a stockholder is a contractual right and obligation. But, if it will be settled through a charge to compensation or a dividend, it is not a financial instrument because the charge is not a transfer of a financial instrument.  A prepayment under a liability insurance contract or under a membership agreement is a contractual right and obligation to provide services. It is not a financial instrument, however, because it will be settled by providing services rather than transferring a financial instrument.  A prepayment to a supplier is a contractual right and obligation to provide merchandise. It is not a financial instrument, however, since it will be settled through the shipment of merchandise rather than the transfer of a financial instrument. Conditional Receivablepayable Contract. A conditional receivablepayable contract both: a. Imposes on one entity a contractual obligation to deliver a specified amount of cash or other financial instrument to a second entity if a specified event beyond the control of either entity occurs, and b. Conveys to that second entity a contractual right to receive a specified amount of cash or other financial instrument from the first entity if a specified event beyond the control of either entity occurs. Future performance under the contract is contingent, but the event is outside the control of both the holder and the issuer. All insurance policies are financial instruments under this category. As an example, under a life insurance policy, the holder receives cash and the issuer pays cash if the insured dies during the term of the policy; otherwise, no cash is transferred. However, certain insurance contracts are excluded from the fair value disclosure require ments of SFAS No. 107 (FASB ASC 8251050), as amended. Financial Option Contract. A financial option contract both: a. Imposes on an entity (the option writer) a contractual obligation to exchange other financial instruments with a second entity (the option holder) on potentially unfavorable terms if an event within the control of the holder occurs, and b. Conveys to the option holder a contractual right to exchange other financial instruments with the option writer on potentially favorable terms if an event within the control of the holder occurs. The holder will typically only exercise the option if it is favorable, and that situation is typically unfavorable to the option writer. Common examples are a fixedrate loan commitment, a mortgage loan with a prepayment right, and convertible debt. Each of those involves an exchange of financial instruments. A financial option contract is a financial instrument only if the option is potentially unfavorable to the option writer. To illustrate, a fixedrate loan commitment gives the holder the right to demand that the option writer provide a loan at a specified rate. Typically, the holder pays a fee for the commitment. If market interest rates decline, the holder has the option of exercising the commitment or finding a loan at current rates. However, if market rates increase, the 144

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holder has the option of exercising the commitment at the lower fixed rate. Although the option could be favorable to the option writer (for example, if rates decline but the holder exercises the option because other sources of financing cannot be located), the option is potentially unfavorable and is therefore a financial instrument. However, if the loan commitment is for a market rate, it is not believed to be a financial instrument because the option is not potentially unfavorable to the option writer. If the option involves an exchange of assets other than financial instruments, it is not a financial instrument. A common example is an option sold by a real estate developer to a homebuilder that permits the homebuilder to buy a prescribed number of developed lots at a fixed price. That option is not a financial instrument because exercising the option causes an exchange of cash for real estate, and real estate is not a financial instrument. Financial Guarantee or Other Conditional Exchange. A financial guarantee or other conditional exchange contract both: a. Imposes on one entity a contractual obligation to exchange other financial instruments with a second entity on potentially unfavorable terms if an event outside the control of either party to the contract occurs, and b. Conveys to that second entity a contractual right to exchange other financial instruments with the first entity on potentially favorable terms if an event outside the control of either party to the contract occurs. A common example is a guarantee of thirdparty indebtedness. In some situations a fee is charged for the guarantee. The guarantee is considered to be an exchange because exercise of the guarantee requires an exchange of cash for subrogating rights that place the guarantor in the same role as the lender had been. The definition in the previous requires that the event causing the transfer be outside of the control of either the holder or the guarantor. The following illustrate that point:  Assume that a wholesaler finances construction of its operating facilities through an industrial development bond and acquires a letter of credit equal to the principal outstanding from a bank. The letter of credit is a financial instrument of the bank (the guarantor) and of the industrial development authority (the holder). The default that triggers the payment is within the control of the wholesaler, and therefore the letter of credit is not a financial instrument of the wholesaler.  Assume that a developer acquires a performance bond covering its responsibility to build roads in a residential development. If the developer does not perform within a certain time, the municipality will complete the roads, and the bonding company will pay the municipality for the costs it incurs. The bond is a financial instrument of the municipality (the holder) and the bonding company (the guarantor). The bond is not a financial instrument of the developer since performance is within its control.  Assume that an individual owns all of the stock of two companies, one of which has guaranteed the bank debt of the other. Since the same individual controls both companies, the guarantor controls the performance of the debtor. Therefore, the guarantee is not a financial instrument. While theholder of the guarantee (the bank) has the contractual right in the event the debtor defaults, the event that causes the guarantor (the company) to exchange cash for subrogation rights is effectively within its control. (However, even though the guarantee is not a financial instrument, its disclosure is still required as a related party transaction as discussed previously in this lesson.) Financial Forward Contract. A financial forward contract both: a. Imposes on each of two entities an unconditional obligation to exchange other financial instruments with the other entity on potentially unfavorable terms, and b. Conveys to each of those entities an unconditional right to exchange other financial instruments with the other entity on potentially favorable terms. An example is a contract under which a corporation agrees to buy back a prescribed number of its shares at a price that will be determined based on the value of the company at the purchase date. The agreement involves an exchange of financial instruments (that is, cash in exchange for an equity interest). 145

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If the forward contract is not limited to the exchange of financial instruments, it is not a financial instrument. As an example, a commitment to acquire inventory at a fixed price is not a financial instrument because it requires an exchange of cash for inventory instead of for a financial instrument. Credit and Market Risk Disclosures The following summarizes the course's general approach to determining the credit and market risk disclosures required by SFAS No. 107 (FASB ASC 8251050) (as amended): a. Identify the financial instruments of the entity. Financial instruments consist of cash, an ownership interest in another entity, and certain contracts. All entities have financial instruments. Some financial instruments are recorded as assets or liabilities, but others are not. b. Determine whether the financial instruments are specifically excluded from the credit risk disclosure requirements. c. Identify whether the remaining financial instruments are subject to credit or market risk of loss. d. If the credit risk for those instruments relates to the actions of parties that are similarly affected by changes in economic or other conditions (referred to as concentrations of credit risk), describe the shared conditions, disclose the maximum loss that could result, describe the entity's policy of requiring collateral to minimize the risk, describe the collateral, and discuss the entity's access to the collateral. Financial Instruments Excluded from the Requirements of SFAS No. 107. SFAS No. 107 (FASB ASC 825105022) (as amended) specifically excludes the following financial instruments from its disclosure require ments for concentrations of credit risk:  Certain insurance contracts  Unconditional purchase obligations subject to the disclosure requirements of SFAS No. 47, Disclosure of LongTerm Obligations (FASB ASC 44010502) (Those requirements generally only apply to noncancel able agreements negotiated in connection with arranging financing for the facilities that will provide the contracted goods or services.)  Employers' and plans' obligations for pension benefits, postretirement health care and life insurance benefits, postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements  Financial instruments of a pension plan, including plan assets, when subject to the accounting and reporting requirements of SFAS No. 87, Employers' Accounting for Pensions (FASB ASC 715)  Warranty obligations and rights Determining Whether a Financial Instrument Is Subject to Credit or Market Risk. Credit and market risk disclosures relate to the risk of an accounting loss. Accounting loss is essentially a charge to earnings that would result from losing the contractual right or settling the contractual obligation of a financial instrument. Three types of risk could cause an accounting loss: credit risk, market risk, and the risk of theft or physical loss. These disclosures only deal with credit and market risk. a. Credit risk is the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract. b. Market risk is the possibility that future changes in market prices may make a financial instrument less valuable or more onerous. In general, credit risk is not believed to affect an evidence of ownership interest or a contractual obligation other than under a financial guarantee. Ownership interests are generally affected by market risk, and, since there are 146

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only two parties to a contractual obligation, a loss cannot result from the failure of another party to perform. The following illustrate why credit risk does not apply to contractual obligations:  Assume that a wholesaler has a note payable to a bank (an unconditional payable contract). The note is a contractual right of the bank and a contractual obligation of the wholesaler. The bank has no performance responsibilities. Thus, there is no credit risk to the wholesaler.  Assume that the founder of a company agrees that the company will buy the stock of venture capitalists at the end of five years (a financial forward contract). The agreement is a contractual right of the venture capitalists and a contractual obligation of the company. The venture capitalists have no performance responsibilities. The same conclusion would apply if the company provided the venture capitalists with an option (a financial option contract) instead of a commitment. However, credit risk would affect cash, contractual rights, and contractual obligations under financial guarantees as illustrated by the following:  The contractual right to cash deposits is subject to the risk that the financial institution will not pay when the cash is requested.  A contractual right under an unconditional receivable contract such as a cash equivalent, trade accounts receivable, or note receivable is subject to the risk that the other party will not pay the balance due.  A contractual right under a financial guarantee is subject to the risk that the issuer of the financial guarantee will not pay in the event of a default.  A contractual obligation under a financial guarantee is subject to the risk that the party whose debt is guaranteed will default. The following illustrate consideration of market risk:  The holder of an ownership interest is subject to the risk of a loss from a decrease in value, for example, because of a decline that is other than temporary or from a sale. However, the issuer of the interest does not recognize a loss from a decrease in value and, therefore, is not subject to market risk.  The holder of a contractual right under a fixed rate loan commitment is unaffected by changes in market rates of interest and thus has no market risk. However, the issuer of the commitment has market risk since it is subject to the risk of a loss that results from issuing a loan at a lower rate than market and then selling it.  The holder of a contractual right under an option to convert a note into common stock at fair market value is unaffected by a decrease in value because the option would not be exercised. Under AICPA Interpretation No. 1 of APB Opinion No. 26, Early Extinguishment of Debt (FASB ASC 47020404), the issuer would recognize no gain or loss on conversion and accordingly has no market risk. Disclosures Required for Credit or Market Risk. SFAS No. 107 (FASB ASC 825105023) (as amended) encourages but does not require disclosure of quantitative information about the market risks of financial instru ments. Such disclosure should be consistent with the way the company manages or adjusts market risks. For example, market risk disclosures could include (a) more details about current positions and activity during the period, (b) hypothetical effects on comprehensive income of possible changes in market prices, (c) the duration of the financial instruments, (d) an analysis of interest rate repricing or maturity dates, or (e) the company's value at risk from derivatives at the balance sheet date and the average value at risk during theyear. Disclosures Required for Concentrations of Credit Risk. Concentrations of credit risk of financial instruments are considered to occur if their holders would be similarly affected by changes in economic or other conditions in meeting their contractual obligations. [The FASB recently issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, which, among other things, amends SFAS No. 107 (FASB ASC 825105020) to clarify that the disclosure requirements about concentrations of credit risk apply to derivative instruments 147

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accounted for under SFAS No. 133 (FASB ASC 815). The new Statement is effective for financial statements for fiscal years and interim periods beginning after November 15, 2008. Early application is encouraged.] SFAS No. 107 (FASB ASC 825105021) (as amended) requires the following to be disclosed about each significant con centration of credit risk: a. Information about the activity, region, or economic characteristic that identifies the concentration b. The maximum amount of the accounting loss due to credit risk the entity would incur if parties to the financial instruments that make up the concentration failed completely to perform according to the terms of the contracts and the collateral or other security, if any, for the amount due proved to be of no value c. The entity's policy of requiring collateral or other security to support financial instruments subject to credit risk, information about the entity's access to that collateral or other security, and the nature and a brief description of the collateral or other security supporting those financial instruments d. The entity's policy of entering into master netting arrangements to mitigate the credit risk of financial instruments. That disclosure should include information about the master netting arrangements for which the entity is a party and a brief description of their terms, including the extent to which they would reduce the entity's maximum amount of loss due to credit risk. For most small to mediumsized businesses, significant concentrations of financial instruments with credit risk are believed to arise whenever customer financing is significant. For example, the credit risk associated with recourse provisions would be significant for a dealership that provides financing for a significant amount of its sales and sells the contracts to financial institutions in the same geographical region with recourse. (However, the disclosure of the concentration can be combined with the optional disclosure of the offbalancesheet risk.) Disclosing Concentrations of Credit Risk for Cash Deposits Cash deposits with banks, brokerdealers, and other financial entities are financial instruments with credit risk. Significant concentrations of credit risk can result when cash is deposited in a single financial entity or in two or more financial entities that are based in the same geographic region. (Maintaining deposits in two or more financial entities based in the same geographic region concentrates credit risk because the financial entities are similarly affected by changes in economic conditions.) To increase the yield on deposits, many banks offer accounts with some investment characteristics. To enable depositors to use these as interestbearing checking accounts, the funds typically are invested in repurchase agreements, commercial paper, and similar financial instruments that mature quickly, usually overnight. Some bank statements for such accounts indicate that they are not deposits or other obligations of the bank. Because of such descriptions and the nature of the investment vehicles themselves, some accountants question whether such accounts should be viewed as cash. Using the definition of cash discussed at the beginning of this section, it is believed that such accounts should be viewed as cash, and therefore are subject to credit risk. GAAP requires companies to disclose information about significant concentrations of credit risk. In practice, however, accountants disagree as to whether the amount of credit risk disclosed should be based on financial statement or bank statement balances and whether credit risk can be reduced by deposit insurance. Should Disclosures Be Based on Financial Statement or Bank Statement Balances? The amount of credit risk that should be disclosed is believed to be the cash balance reported by the financial entity (i.e., the bank statement balance). The objective of the disclosure requirement is to disclose concentrations of credit risk that result from maintaining cash deposits in financial entities. Therefore, the amount of that risk is the amount for which the financial entity is responsible. Generally, the financial entity is not responsible for:  Deposits in Transit. Undeposited receipts are a reconciling item between financial statement and bank statement balances. Although undeposited receipts can be misplaced, destroyed, or stolen, normally the payors are required to replace them because the payor's responsibility for a check is not eliminated until the bank on which the check was drawn has reduced its deposit obligation. The credit risk that exists related to undeposited receipts is the possibility that the debtor will not replace the receipt, not the risk that the financial entity will fail to perform. 148

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Deposits made, including wire transfers, also will be a reconciling item between financial statement and bank statement balances if they are received by the bank after its daily cutoff. Generally, the bank has no performance responsibility until it recognizes a deposit obligation. If the bank were to close, it probably would deny any responsibility for deposits made after its closing time for the day. The credit risk for those deposits is the same as for undeposited receipts.  Outstanding Checks. Checks that have been released but have not cleared the bank will be a reconciling item between financial statement and bank statement balances because the bank does not reduce its deposit liability until the checks clear. In the event of a bank failure, the bank would be responsible for its deposit liability, not its deposit liability reduced by outstanding checks. The company would be required to satisfy outstanding checks with other funds. Should Deposit Insurance Be Considered? Some, but not all, bank deposits are insured against bank failure. For example:  The Federal Deposit Insurance Corporation (FDIC) is a federal agency that insures the deposits of many banks. It covers up to $100,000 (up to $250,000 under the Emergency Economic Stabilization Act for the period from October 3, 2008 to December 31, 2009) of a depositor's regular checking accounts, interestbearing checking accounts, money market accounts, and certificates of deposits in a bank. The $100,000 limit generally applies to the depositor's combined deposits in the bank. That is, if a company has a demand account and an interestbearing checking account that each contain a balance of $60,000, the $20,000 excess of total deposits over the $100,000 limit would be uninsured. (Escrow accounts, such as those maintained by realtors for sales deposits, can be viewed as a collection of individual deposits. For that reason, some banks fully insure escrow accounts provided no individual balance exceeds $100,000.)  Repurchase agreements are uninsured, but they are secured by pools of marketable securities of federal agencies.  Master notes are uninsured, but some are secured by assets of the bank.  Commercial paper is uninsured and normally is unsecured. The Securities Investor Protection Corporation (SIPC) provides insurance for deposits with brokerdealers that is similar to that provided by the FDIC. GAAP does not address whether the credit risk for cash deposits can be reduced by insurance. Some accountants argue that it should not. They believe that insurance merely decreases the likelihood of loss, but has no effect on the overall amount of credit risk (i.e., there is still a risk that the insurance may not be collected). While that may be conceptually correct, this course maintains that credit risk for cash deposits should be reduced by amounts that are federally insured. Federal insurance will fail only in the event of a national financial catastrophe, and such a negligible risk should be ignored for purposes of disclosing concentrations of credit risk. Furthermore, in a Technical Practice Aid (TIS 2110.06), the AICPA stated that bank statement balances in excess of FDICinsured amounts represent a credit risk, and the uninsured cash balances should be disclosed if they represent a significant concentration of credit risk. The TPA further states that while a material uninsured cash balance with a single bank should generally be disclosed, numerous immaterial uninsured cash balances on deposit with several banks may not require disclosure. Judgment must be used in determining the threshold for significance, which will vary with individual circumstances. For example, the financial statement preparer should use judgment to determine the aggregate materiality of numerous immaterial uninsured cash balances on deposit with several banks. Disclosure Considerations. Financial statements should disclose the information discussed in the Disclosures Required for Concentrations of Credit Risk"paragraph about each significant concentration of credit risk for cash deposits at each date for which a balance sheet is presented. The disclosures may be made in a manner that is most effective and efficient for the reporting entity. Therefore, many entities will disclose all concentrations of credit risk (e.g., for cash deposits, trade accounts receivable, notes receivable, etc.) in a single note such as Significant Concentrations of Credit Risk." For example, assume that a company's cash balance at the end of 20X1 consists of the following: 149

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Bank Statement Balance Allen Fidelity Bank money market account Bailey Bank interestbearing checking account Commonwealth Bank Regular checking account Escrow accounts Unsecured master note Regal Bank Regular checking account Repurchase agreement collateralized by a GNMA pool $ 43,500 110,300 31,500 456,000 332,600 10,600 244,600 $ Petty Cash 1,229,100

Financial Statement Balance $ 43,500 110,300 (340,600 ) 426,800 332,600 20,500 244,600 837,700 900 $ 838,600

Assume further that all of the banks are local, and, with the exception of the Commonwealth Bank master note and the Regal Bank repurchase agreement, all of the deposits are federally insured. The concentration of credit risk is calculated as follows: Allen Fidelity Bank (None since all of the balance is federally insured) Bailey Bank ($110,300 bank statement balance less $100,000 maximum federal insurance) Commonwealth Bank Checking account (None since all of the balance is federally insured) Escrow accounts (None since all of the balances are feder ally insured) Master note (All of the balance is subject to credit risk since none of it is federally insured.) Regal Bank Checking account (None since all of the balance is federally insured) Repurchase agreement (All of the balance is subject to credit risk since none of it is federally insured.) $ 10,300 332,600 244,600 $ 587,500

The company's 20X1 balance sheet reports cash of $411,800 ($838,600 cash less the escrow obligation of $426,800). The disclosure of concentrations of credit risk for cash deposits may be disclosed as follows (20X0 amounts are assumed): NOTE XSIGNIFICANT CONCENTRATIONS OF CREDIT RISK Cash includes escrow accounts maintained for deposits by buyers under sales contracts and accordingly has been reduced by the Company's obligation under those arrangements of $426,800 at the end of 20X1 and $384,600 at the end of 20X0. The Company has concentrated its credit risk for cash by maintaining deposits in banks located within the same geographic region. The maximum loss that would have resulted from that risk totalled $587,500 at the end of 20X1 and $428,200 at the end of 20X0 for the excess of the deposit liabilities reported by the banks over the amounts that would have been covered by federal insurance. Shares of a pool of mortgage

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backed securities are pledged as collateral for $244,600 of that excess in 20X1 and $195,000 in 20X0. Credit risk for trade accounts and notes is concentrated as well because substantially all of the balances are receivable from individuals located within the same geographic region. Disclosures about the Fair Value of Financial Instruments SFAS No. 107, Disclosures about Fair Value of Financial Instruments (FASB ASC 825105010), requires disclosure of the fair value of all financial instruments for which it is practicable to estimate that value. The disclosures about the fair value of financial instruments do not apply to all entities, however. They are optional for a nonpublic entity that (a) has less than $100 million in total assets on the balance sheet date and (b) has no instrument that, in whole or in part, is accounted for as a derivative instrument, except for commitments related to the origination of mortgage loans to be held for sale, during the reporting period. A nonpublic entity is defined for this requirement as an entity that (a) does not trade its debt or equity securities in a public market (i.e., a stock exchange or an overthecounter market); (b) is not a conduit bond obligor for conduit debt securities traded in a public market; (c) does not file with a regulatory agency when selling its debt or equity securities in a public market; and (d) is not controlled by an entity that trades its debt or equity securities in a public market, is a conduit bond obligor for conduit debt securities traded in a public market, is a conduit bond obligor for conduit debt securities traded in a public market, or that files with a regulatory agency when selling its securities in public markets. For companies not exempt the fair value disclosure requirements, this course's general approach to determining the required disclosures, is as follows: a. Determine whether the financial instruments identified when performing step a. from the Credit and Market Risk Disclosures" paragraph are specifically excluded from the disclosure requirements. b. For each category of financial instruments (such as notes payable) subject to the disclosure requirements, determine if a quoted market price is available. c. If a quoted market price is available, use it to estimate the fair value of the instrument. d. If a quoted market price is not available, determine if it is cost effective to estimate fair value. e. For instruments for which fair market value has been determined, disclose the fair value and the methods and significant assumptions used to estimate fair value. f. For instruments for which it is not cost effective to estimate fair value, disclose the pertinent information about the financial instrument and the reasons why estimating fair value is not cost effective. The preceding steps can be reduced to a few simple decisions as outlined in Exhibit 21. Once certain questions are answered, specific actions regarding fair value disclosures can be taken to comply with GAAP .

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Exhibit 21 Applying the SFAS No. 107 (FASB ASC 8251050) Fair Value of Financial Instruments Disclosure Requirementsa FINANCIAL INSTRUMENT? YES SPECIFICALLY EXCLUDED FROM FAIR VALUE DISCLOSURE REQUIREMENTS? NO DOES CARRYING VALUE ALREADY APPROXIMATE FAIR VALUE (for trade receiv ables or payables)? NO DOES OTHER GAAP ALREADY REQUIRE DISCLOSURE OF FAIR VALUE? NO IS FAIR VALUE PRACTICABLE TO DETERMINE? YES DISCLOSE FAIR VALUE, METHOD OF DETERMINING FAIR VALUE, AND SIGNIFICANT ASSUMPTIONS Note:
a

NO

DISCLOSURE REQUIREMENTS DO NOT APPLY


YES

YES NO ADDITIONAL FAIR VALUE DISCLOSURE IS REQUIRED YES

NO

DISCLOSE WHY FAIR VALUE IS NOT PRACTICABLE TO DETERMINE AND PERTINENT INFORMATION ABOUT THE FINANCIAL INSTRUMENT

Nonpublic entities with less than $100 million in total assets on the balance sheet date are exempt from fair value disclosure requirements if the entities have not issued or held certain derivatives during the reporting period.

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Financial Instruments Excluded from the Disclosure Requirements. SFAS No. 107 (FASB ASC 82510508) specifically excludes the following financial instruments from the fair value disclosure requirements:  Employers' and plans' obligations for pension benefits, other postretirement benefits including health care and life insurance benefits, postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements  Substantively extinguished debt subject to the disclosure requirements of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (FASB ASC 40520)  Certain insurance contracts  Lease contracts  Warranty obligations and rights  Unconditional purchase obligations as defined in Paragraph 6 of SFAS No.47, Disclosure of LongTerm Obligations (FASB ASC 44010502)  Investments accounted for under the equity method in accordance with the requirements of APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (FASB ASC 323)  Minority interests in consolidated subsidiaries  Equity investments in consolidated subsidiaries  Equity instruments issued by the entity and classified in stockholders' equity in the balance sheet In addition, the requirements presume that the carrying value of trade receivables and payables approximates fair value. Therefore, fair value disclosures are required only when that is not the case. Determining the Fair Value of Financial Instruments. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (FASB ASC 820), which provides a common definition of fair value, establishes a framework to measure fair value within GAAP , and increases the disclosures about fair value measurements. It generally applies under other accounting pronouncements that require or permit fair value measurements, including the disclosure of fair value information for financial instruments. It is generally effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with early adoption encouraged. Although the effective date has been deferred for certain nonfinancial assets and nonfinan cial liabilities, the deferral does not apply to the financial instruments subject to the provisions of SFAS No. 107 (FASB ASC 8251050) regardless of whether the items are recognized or not. Disclosure Requirements. Entities subject to the requirement to disclose information regarding the fair value of financial instruments in accordance with SFAS No. 107 (FASB ASC 8251050) must disclose the following. [The disclosure requirements of SFAS No. 157 (FASB ASC 820) also apply to financial instruments recognized at fair value in the balance sheet.] a. For each financial instrument (or category of financial instruments) for which fair value has been determined, disclose the following either in the body of the financial statements or in the notes: (1) The fair value of the financial instrument (or category) (2) The methods and significant assumptions used to estimate fair value b. For each financial instrument (or category of financial instruments) for which it is not costeffective to estimate fair value, disclose the following: (1) Relevant information about the financial instrument (or category), such as the book value, effective interest rate, and maturity 153

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(2) The reasons why it is not practical to estimate fair value In some cases, it may be costeffective to disclose the fair value of a class or portfolio of financial instruments when it is not costeffective to disclose the fair value of an individual instrument. GAAP also requires the following related to these disclosures:  Fair value disclosures should be made in such a way that it is clear whether the reported amounts represent assets or liabilities and how the carrying amounts relate to those reported in the balance sheet.  The fair value of a financial instrument should not be combined, aggregated, or netted with the fair value of other financial instruments, except where netting is allowed under FASB Interpretation No. 39 (FASB ASC 21020451 and 81510455) or FASB Interpretation No. 41 (FASB ASC 210204511 through 4517).  A summary table must be provided that includes fair value and related carrying amounts of all financial instruments, with each crossreferenced to the note that provides the other fair value disclosures, if the fair value of financial instruments disclosures are made in more than one note. As a practical matter, small and midsized entities normally do not have enough financial instruments to prohibit financial statement readers from readily assessing the effect of fluctuations in financial instrument values without a table. Accordingly, in those situations, a separate table is believed unnecessary. Deciding when a table is neces sary depends on the facts and circumstances. To illustrate, if an entity discloses the fair value of notes receivable and notes payable in the separate financial statement notes addressing them, and in a separate note for an investment in a limited partnership discloses that determining its fair value is impractical, the reader can easily assess the impact of fluctuations in financial instrument values without a summary table.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 18. Three major categories of financial instruments exist. Which of the following describes the category of evidence of an ownership interest in an entity? a. It includes currency on hand, demand deposits, other kinds of accounts from which the customer may deposit or withdraw additional funds at any time, and cash equivalents. b. It includes certificates of interest or participation, preferred stock, common stock, and warrants and options to subscribe to or purchase stock from the issuing entity. c. It imposes a contractual obligation on one entity to deliver cash or another financial instrument to or exchange financial instruments on potentially unfavorable terms with a second entity. d. An agreement that does not meet the definitions of assets and liabilities provided in FASB Concepts Statement No. 6. 19. In which of the following scenarios is the financial instrument excluded from the concentration of credit risk disclosure requirements of SFAS No. 107 (FASB ASC 825105022)? a. ZipperCo purchases a shortterm investment with an original maturity of three months. b. Yellow Mufflers has an obligation to pay benefits into the pension plan it maintains for its employees. c. Xtreme Sportz is obligated to buy back 1,000 shares at a price determined on the purchase date. d. Waterfield Inc. has a mortgage loan with a prepayment right. 20. Majestic Macaroons is subject to the requirement to disclose information regarding the fair value of financial instruments in accordance with SFAS No. 107 (FASB ASC 8251050). Which of the following must the company disclose for each financial instrument for which it is not cost effective to estimate fair value? a. The fair value of the category of financial instruments. b. The methods and assumptions used in the attempt to estimate fair value. c. Relevant information about the instrument, such as book value. d. The carrying value of any trade receivables and payables.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 18. Three major categories of financial instruments exist. Which of the following describes the category of evidence of an ownership interest in an entity? (Page 142) a. It includes currency on hand, demand deposits, other kinds of accounts from which the customer may deposit or withdraw additional funds at any time, and cash equivalents. [This answer is incorrect. This describes elements of the cash category of financial instruments. Though cash equivalents are not cash, they are contracts that are normally considered financial instruments.] b. It includes certificates of interest or participation, preferred stock, common stock, and warrants and options to subscribe to or purchase stock from the issuing entity. [This answer is correct. These elements make up the evidence of an ownership interest in an entity category of financial instruments. Of the three categories, identifying financial instruments in this category and the cash category are relatively straightforward.] c. It imposes a contractual obligation on one entity to deliver cash or another financial instrument to or exchange financial instruments on potentially unfavorable terms with a second entity. [This answer is incorrect. This is half of the definition of the contracts that require the exchange of cash or other financial instruments category, found in Paragraph 3 of SFAS No. 107 (FASB ASC 8251020). The other half of that definition says that it conveys a contractual right to the second entity to receive cash or another financial instrument from or exchange other financial instruments on potentially favorable terms with the first entity.] d. An agreement that does not meet the definitions of assets and liabilities provided in FASB Concepts Statement No. 6. [This answer is incorrect. The definition of the contracts that require the exchange of cash or other financial instruments category requires contractual obligation and contractual right, which meet the definitions of assets and liabilities under FASB Concepts Statement No. 6. An agreement that does not meet these definitions is not a financial instrument.] 19. In which of the following scenarios is the financial instrument excluded from the concentration of credit risk disclosure requirements of SFAS No. 107 (FASB ASC 825105022)? (Page 146) a. ZipperCo purchases a shortterm investment with an original maturity of three months. [This answer is incorrect. Unconditional receivablepayable contracts such as this one are financial instruments subject to the disclosure requirements. Another example is shortterm and longterm notes payable contracts.] b. Yellow Mufflers has an obligation to pay benefits into the pension plan it maintains for its employees. [This answer is correct. This financial instrument is excluded from the disclosure requirements for concentrations of credit risk. Other examples include certain insurance contracts and warranty obligations and rights.] c. Xtreme Sportz is obligated to buy back 1,000 shares at a price determined on the purchase date. [This answer is incorrect. This financial instrument is a financial forward contract and is subject to the required disclosures. This type of agreement involves an exchange of financial instruments.] d. Waterfield Inc. has a mortgage loan with a prepayment right. [This answer is incorrect. This financial instrument is subject to the required disclosures. It is a financial option contract. Another example is a fixedrate loan commitment.] 20. Majestic Macaroons is subject to the requirement to disclose information regarding the fair value of financial instruments in accordance with SFAS No. 107 (FASB ASC 8251050). Which of the following must the company disclose for each financial instrument for which it is not cost effective to estimate fair value? (Page 153) a. The fair value of the category of financial instruments. [This answer is incorrect. If a quoted market price is not available, or it is not cost effective to estimate the fair value, the fair value cannot be disclosed.] 156

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b. The methods and assumptions used in the attempt to estimate fair value. [This answer is incorrect. The methods and assumptions must be disclosed when the fair value of the financial instrument or a category of financial instruments has been determined.] c. Relevant information about the instrument, such as book value. [This answer is correct. Relevant information about the financial instrument (or category), such as the book value, effective interest rate, and maturity, as well as the reasons why estimating fair value is impractical should be disclosed.] d. The carrying value of any trade receivables and payables. [This answer is incorrect. The carrying value of any trade receivables and payables is presumed by SFAS No. 107 (FASB ASC 8251050) to approximate fair value, so fair value disclosures are only required when this is not the case.]

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Lesson 3:Risks and Uncertainties


Introduction
In general terms, uncertainty stems from the inability to predict the future, and risks exist because uncertainty exists. SOP 946, Disclosure of Certain Significant Risks and Uncertainties (FASB ASC 275), requires financial statements to  Disclose risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term or the nearterm functioning of the company.  Communicate to financial statements users the inherent limitations in financial statements. GAAP does not require disclosure of all risks and uncertainties, which would be an impossible task, but requires disclosure of certain risks and uncertainties that meet specified criteria. SOP 946 (FASB ASC 27510501) requires disclosure in the following four areas:  Nature of operations  Use of estimates in the preparation of financial statements  Certain significant estimates  Current vulnerability due to certain concentrations The first two disclosures, nature of operations and use of estimates, are required for all financial statements. The second two are required only for estimates and concentrations that meet specified criteria. This lesson discusses these disclosure requirements in detail and provides practical guidance for applying the disclosure requirements. Learning Objectives: Completion of this lesson will enable you to:  Assess disclosure issues related to applicability, nature of operations, and estimates.  Compare and contrast SOP 946 and SFAS No. 5 disclosures and apply the authoritative guidance to financial statement note disclosures.  Determine if concentration disclosures are needed.  Formulate a plan for applying SOP 946 to the financial statement disclosures of a small or mediumsized business. Scope and Applicability The disclosure requirements apply regardless of an entity's size and also apply to interim financial statements. They are not required in condensed or summarized interim financial statements. Certain risks and uncertainties are explicitly excluded from the disclosure requirements, including those that might be associated with the following:  Management or key personnel (for example, loss of the owner/manager of a small business)  Proposed changes in government regulations  Proposed changes in accounting principles  Deficiencies in a company's internal control structure 158

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 Acts of God  War  Sudden catastrophes When an accounting pronouncement that is not yet effective will require retroactive application by priorperiod adjustment, an auditing interpretation (AU 9410) requires auditors to consider whether disclosure of the change is necessary for fair presentation. Nature of Operations All financial statements should include a description of the major products or services the reporting entity sells or provides and the entity's principal markets, including the locations of those markets. Finally, if the entity operates in more than one business, disclosures must indicate the relative importance of each business and the basis for determining relative importance. Relative importance can be based on such things as assets, revenues, or net income, and does not have to be quantified. It can be communicated by using terms such as predominantly," about equally," or major." Many financial statements already disclose the nature of the company's operations, including its major products or services and concentrations of credit risk. If all or most of a company's sales are credit sales, the disclosure for concentrations of credit risk may accomplish the disclosure of the company's principal markets. Consequently, the disclosure requirements will often require only minor modification of existing disclosures. Additional modification might be necessary if, for example, the company operates in more than one business. The following are examples of disclosures of an entity's nature of operations: Friendly Car Dealership (the Company), is principally engaged in the sale and service of new and used vehicles in Seattle, Washington. The Company operates as a franchised dealer for Domes tic Manufacturer, Inc. and Foreign Manufacturer, Inc. The Company also leases vehicles under longterm leases to businesses and individuals primarily in the Seattle area. ***** DoItRight Contractors, Inc. acts as the general contractor in constructing multifamily residential buildings in the Greater Chicago area. In addition, it provides property management services throughout the Midwest United States. The two business units are about equal in size based on gross profit contributions to the Company. ***** Southwest Sporting Goods, Inc. is engaged in retail sales of sporting goods with 17 stores located in Texas, Arkansas, Louisiana, Oklahoma, and New Mexico. Use of Estimates GAAP requires financial statement disclosures to include an explanation that preparation of financial statements requires the use of management's estimates. The disclosure will usually be standardized (that is, boilerplate). The following are examples of disclosures regarding the use of estimates: The preparation of financial statements in conformity with generally accepted accounting prin ciples requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the report ing period. Actual results could differ from those estimates. ***** 159

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Management uses estimates and assumptions in preparing financial statements. Those esti mates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Actual results could differ from those estimates. While it is believed that most financial statements will use the preceding standardized language to disclose the use of estimates, such language may not be appropriate in all cases. For example, estimates may not be pervasive in the financial statements of some small companies with simple operations, or some financial statements may not include any estimates. Certain Significant Estimates GAAP requires additional disclosures for certain significant estimates. The additional disclosures are required when estimates meet both of the following criteria:  It is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation, or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events. [Emphasis added.]  The effect of the change would be material to the financial statements. Existing Condition. The italicized wording in the first criterion along with the requirement that disclosure be evaluated based on known information available prior to the issuance of the financial statements, is intended to clarify that accountants are not expected to predict future events. Essentially, the italicized wording means that (a) the estimate is based on conditions that existed at the date of the financial statements, and (b) the disclosure criterion is met when it is known to be at least reasonably possible that the estimate may change due to future events. Some believe that the italicized wording has no real effect, and the first criterion is more easily understood if read without it. Reasonably Possible. While the existing condition" requirement helps to narrow the range of estimates that meet the criterion, the range is still very broad. That is primarily because of the use of the term reasonably possible," which has the same meaning in SOP946 (FASB ASC 275) as it does in SFAS No. 5, Accounting for Contingencies (FASB ASC 450). SFAS No. 5 (FASB ASC 4502020) provides the following definitions:  Probable. The future event or events are likely to occur.  Reasonably Possible. The chance of the future event or events occurring is more than remote but less than likely.  Remote. The chance of the future event or events occurring is slight. Consequently, reasonably possible" means anything more than remote but less than probable. SOP 946 (FASB ASC 275) uses the phrase at least reasonably possible, which means anything more than remote, or slight. The ranges of probabilities can be depicted as follows: 0% Remote (or slight) 0% Remote (or slight) At least reasonably possible Reasonably possible 100% Probable (or likely) 100%

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circumstances of each situation. However, quantitative guidelines can be helpful as a rule of thumb. The interpreta tion of reasonably possible is believed to vary in practice. Some interpret it to mean a likelihood of 1520% or more, whereas others use 2030% or more. In some cases, even a higher threshold (such as 40% or more) or a lower threshold may be appropriate. Accountants must apply judgment based on the individual circumstances of each situation. Disclosure should generally be considered more closely when a condition, situation, or set of circum stances makes an estimate more susceptible to change than it ordinarily would be. In addition, the more critical an estimate is to the financial statements, the more likely it is that disclosure is needed. As a practical matter, the disclosure can be used to provide an early warning to financial statement users that certain estimates, based on the best information available, are still somewhat soft. Near Term. This term is defined in SOP 946 (FASB ASC 2751020) as a period of time not to exceed one year from the date of the financial statements. That is the same time period established by SAS No. 59 for evaluating an entity's ability to continue as a going concern. Material. The second criterion significant estimates is that the effect of the change would be material to the financial statements. SOP 946 (FASB ASC 275105014) goes on to state: Whether an estimate meets the criteria for disclosure ... does not depend on the amount that has been reported in the financial statements, but rather on the materiality of the effect that using a different estimate would have had on the financial statements. Simply because an estimate resulted in the recognition of a small financial statement amount, or no amount, does not mean that disclosure is not required... [Emphasis added.] Consequently, disclosure might be required even if no estimate is recognized in the financial statements (that is, the estimate is zero). Estimates to Which this Disclosure Applies. The types of estimates that should be considered for disclosure are those used in the determination of the carrying amounts of assets or liabilities or in the disclosure of gain or loss contingencies. In other words, the disclosure requirements relate to estimates used to determine (a) recorded amounts and (b) disclosures of gain or loss contingencies. The disclosure requirements do not apply to estimates such as those used when disclosing the fair value of financial instruments in accordance with SFAS No. 107, Disclosures about Fair Value of Financial Instruments (FASB ASC 8251050). Also, disclosure should be consid ered for every estimate in the financial statements, but disclosure is not necessarily required for every estimate in the financial statements. As noted previously, disclosure should generally be considered more closely when a condition, situation, or set of circumstances makes an estimate more susceptible to change than it ordinarily would be. In addition, the more critical an estimate is to the financial statements, the more likely it is that disclosure is needed. As a practical matter, the disclosure can be used to provide an early warning to financial statement users that certain estimates, based on the best information available, are still somewhat soft," and changes in them may affect future financial statements. Known Information. The significant estimate criteria listed previously are to be considered using known informa tion available prior to issuance of the financial statements." Therefore, if management is unaware of information that would cause a significant estimate to change, disclosure is not required. However, that does not mean that disclosure can be avoided by the failure of management to exercise due care to be informed about relevant trends, events, and uncertainties that would be expected to affect significant estimates. This requirement is essentially the same as that of SFAS No. 5 (FASB ASC 45020252), which refers to information available prior to issuance of the financial statements." Illustrative Disclosures. If an estimate meets the criteria for disclosure as discussed previously, the disclosure must:  Describe the nature of the uncertainty, and  Indicate that it is at least reasonably possible that a change in the estimate will occur in the near term (although use of the words reasonably possible is not required). In addition, if the estimate involves a loss contingency subject to SFAS No. 5 (FASB ASC 450), the disclosure requirements of SFAS No. 5 (FASB ASC 450) must also be considered. As a result, the disclosure must include an 161

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estimate of the possible loss or range of loss, or state that such an estimate cannot be made. In June 2008, the FASB issued an exposure draft of a proposed SFAS, Disclosure of Certain Loss Contingencies, which would, among other items, remove this provision from SOP 946 and expanded disclosures about certain loss contingen cies within the scope of SFAS Nos. 5 and 141(R). The FASB planned to issue the final SFAS in the second quarter of 2009 and had tentatively decided that the effective date of the Statement would be no earlier than fiscal years ending after December 15, 2009. Disclosure of the factors that cause the estimate to be subject to change is encouraged but not required. The following are examples of disclosures that meet these requirements: Specialized drilling equipment is depreciated over its remaining useful life using the unitsofpro duction method. Due to current industry conditions, it is at least reasonably possible that the estimated remaining life of the equipment will change in the near term. ***** Recently, a large public construction company entered Hometown's primary market of Amarillo, Texas. Due to potential market loss, it is reasonably possible that the amount of the Company's deferred tax asset that it expects to be realized might change in the near future. ***** As a result of recent changes in the Company's market for certain products, carrying amounts for those inventories have been reduced by approximately $60,000 due to quantities in excess of current requirements. Management believes that this reduces inventory to the lower of cost or market, and no additional loss will be incurred upon disposition of the excess quantities. While it is at least reasonably possible that the estimate will change materially in the near term, no estimate can be made of the range of additional loss that is at least reasonably possible. Including a disclosure about an inventory valuation allowance (or about any estimate) should not be considered an indication that the estimate is materially misstated. It is merely an indication that the chances of the estimate changing by a material amount in the near term is more than remote. If a company has a number of estimates that have a reasonable possibility of changing within the next year by a material amount, it is possible to combine the disclosures about significant estimates into one financial statement note. That approach is illustrated for a construction contractor as follows: Significant estimates used in preparing these financial statements include those assumed in computing profit percentages under the percentageofcompletion revenue recognition method, those used in depreciating the Company's equipment, and those used in recording a liability for outstanding claims. It is at least reasonably possible that the estimates used will change within the next year. To take the approach one step further, it is possible to combine the significant estimates disclosure with the disclosure about the general use of estimates, as follows: Management uses estimates and assumptions in preparing financial statements. Those esti mates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and reported revenues and expenses. Significant estimates used in preparing these financial statements include those assumed in computing profit percent ages under the percentageofcompletion revenue recognition method, and those used in recording a liability for outstanding claims. It is at least reasonably possible that the significant estimates used will change within the next year.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 21. Which of the following is included under the scope and applicability of risks and uncertainties disclosures? a. Uncertainties related to management or key personnel. b. Interim financial statements. c. Acts of God. d. Proposed changes in government regulations.. 22. Which of the following scenarios best illustrates disclosure of the nature of its operations? a. Dueling Diamonds includes a description of its major products and discloses its principal markets and their locations. b. Emma's Closet operates several businesses. It discloses the most important business, its clothing outlet, and determines its relative importance. c. Because it has revenue of less than $1 million before taxes, Fluffy Fabrics is exempt from this disclosure. d. Gowntastic's sales are mostly credit sales, so the disclosure of concentrations of credit risk fulfills the SOP's requirements. 23. Whammy Inc. discovers that a condition existing at the balance sheet date may change a significant estimate used on its financial stations, resulting in a material effect to the amounts shown on the financial statements. When is a significant estimate disclosure required? a. If the future event it probable or likely. b. If the future event is reasonably possible. c. If there is even a remote chance the future event will occur.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 21. Which of the following is included under the scope and applicability of risks and uncertainties disclosures? (Page 158) a. Uncertainties related to management or key personnel. [This answer is incorrect. This area is explicitly excluded from the disclosure requirements. Another such exclusion is proposed changes in accounting principles.] b. Interim financial statements. [This answer is correct. The disclosure requirements apply to interim financial statements (other than summarized or condensed interim financial statements) and also apply regardless of an entity's size.] c. Acts of God. [This answer is incorrect. These are excluded from the disclosure requirements. War and sudden catastrophes are also excluded.] d. Proposed changes in government regulations. [This answer is incorrect. These are explicitly excluded from the disclosure requirements. Another exclusion are deficiencies in a company's internal control structure.] 22. Which of the following scenarios best illustrates disclosure of the nature of its operations under SOP 946? (Page 159) a. Dueling Diamonds includes a description of its major products and discloses its principal markets and their locations. [This answer is correct. All financial statements must include a description of major products or services, principal markets, and their locations. If an entity operates in more than one business, disclosures must indicate the relative importance of each business on the basis for determining relative importance.] b. Emma's Closet operates several businesses. It discloses the most important business, its clothing outlet, and determines its relative importance. [This answer is incorrect. Emma's Closet should disclose the relative importance of each business and the basis for determining that importance (e.g., assets, revenues, or net income). Relative importance can be expressed with terms such as predominantly" or major," and does not have to be quantified.] c. Because it has revenue of less than $1 million before taxes, Fluffy Fabrics is exempt from this disclosure. [This answer is incorrect. All financial statements, not just those of large entities or certain entities, are required to disclose the nature of operations.] d. Gowntastic's sales are mostly credit sales, so the disclosure of concentrations of credit risk fulfills the SOP's requirements. [This answer is incorrect. This disclosure may accomplish some of the necessary disclosures, but modification will most likely still be necessary. The concentrations of credit risk disclosure does not automatically take the place of the nature of operations disclosure.] 23. Whammy Inc. discovers that a condition existing at the balance sheet date may change a significant estimate used on its financial stations, resulting in a material effect to the amounts shown on the financial statements. When is a significant estimate disclosure required? (Page 160) a. If the future event it probable or likely. [This answer is incorrect. If the future event is probable, Whammy should make the disclosure. However, there are circumstances when an event is less than likely but still needs to be disclosed.]

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b. If the future event is reasonably possible. [This answer is correct. A company should disclose the existing condition if the event is at least reasonably possible (i.e., if the chance of the event occurring is anything more than remote). However, there is no requirement to assign quantitative amounts to the probability range, as this might restrict the auditor's professional judgment based on the individual circumstances.] c. If there is even a remote chance the future event will occur. [This answer is incorrect. If there is only a remote or slight chance that the future event will occur, Whammy does not need to make the disclosure.]

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How Do Disclosures of Risks and Uncertainties Relate to Disclosures of Loss Contingencies? Throughout the preceding discussion of certain significant estimates, numerous references are made to SFAS No. 5, Accounting for Contingencies (FASB ASC 450). A point of confusion for many practitioners is how the require ments for disclosing certain significant estimates according to SOP 946 (FASB ASC 275) relate to the requirements for disclosing loss contingencies under SFAS No. 5 (FASB ASC 450). The following paragraphs compare and contrast the requirements. Requirements of SFAS No. 5. SFAS No. 5 (FASB ASC 45020252) requires accrual of loss contingencies if they are probable and can be reasonably estimated. In addition, Paragraph 10 of SFAS No. 5 (FASB ASC 45020503) requires disclosure of loss contingencies if:  A loss contingency is probable, but it is not accrued because it cannot be reasonably estimated.  A loss contingency is reasonably possible, in which case it would not be accrued because it is not probable.  A loss contingency is probable and is accrued, but an exposure to loss exists in excess of the amount accrued. In those situations, the disclosure must indicate the nature of the contingency and must include:  An estimate of the possible loss or range of loss, or  A statement that such an estimate cannot be made. In June 2008, the FASB issued an exposure draft of a proposed SFAS, Disclosure of Certain Loss Contingencies, which would amend SFAS Nos. 5 and 141(R) to expand disclosures about certain loss contingencies within the scope of SFAS Nos. 5 and 141(R). Such disclosures would be required unless certain criteria are met. The proposed SFAS would (a) increase the number of loss contingencies that must be disclosed, (b) require specific quantitative and qualitative information to be disclosed about the loss contingencies, (c) require a reconciliation, in tabular form, of recognized loss contingencies, and (d) provide an exemption from certain disclosures if such disclosures would be prejudicial to an entity's position in a dispute. The proposed SFAS would not change the recognition and measurement guidance for loss contingencies in SFAS Nos. 5 and 141(R). The FASB planned to issue the final SFAS in the second quarter of 2009 and had tentatively decided that the effective date of the Statement would be no earlier than fiscal years ending after December 15, 2009. Differences in SOP 946 (FASB ASC 275) and SFAS No. 5 (FASB ASC 450). The following summarizes the differences in the requirements of SOP 946 and SFAS No. 5.  SOP 946 applies to estimates. SFAS No. 5 does not specifically apply to estimates; it applies to contingencies. So, for example, SFAS No. 5 would not apply to a profitable longterm contract because no loss contingency is involved. SFAS No. 5 also does not apply to depreciation or amortization because the eventual expiration of the utility of the asset is not uncertain." Additionally, SFAS No. 5 does not apply to accrued amounts owed for services received, such as advertising and utilities. They are not contingencies even though the accrued amounts may have been estimated. There is nothing uncertain about the fact that those obligations have been incurred.  SFAS No. 5 does not apply to the writedown of longlived operating assets (such as property, plant, equipment, or intangible assets). SOP 946 does.  SFAS No. 5 does not confine consideration to the near term, whereas SOP 946 does.  SFAS No. 5 disclosures are based on information available prior to issuance of the financial statements," whereas disclosures under SOP 946 are based on known information available prior to issuance of the financial statements." This difference is not believed to affect the application of the documents because the difference is more semantic than substantive. The SFAS No. 5 guideline seems broader, but has generally been applied in practice similar to the SOP's guideline. 166

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Consequences of Those Differences. Based on the above differences, the disclosure requirements of the two documents can be summarized as follows: a. When SFAS No. 5 and SOP 946 both apply, disclose the following: (1) Nature of the uncertainty (2) Estimate of possible loss or range of loss, or a statement that such estimate cannot be made (3) An indication that it is at least reasonably possible that a change in the estimate will occur in the near term b. When SFAS No. 5 applies, but not SOP 946 (for example, because the change in estimate is not expected to occur in the near term), disclose the following: (1) Nature of the uncertainty (2) Estimate of possible loss or range of loss, or a statement that such estimate cannot be made c. When SOP 946 applies, but not SFAS No. 5 (for example, because the estimate relates to property and equipment, an intangible asset, or a profitable longterm contract) disclose the following: (1) Nature of the uncertainty (2) An indication that it is at least reasonably possible that a change in the estimate will occur in the near term

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 24. In which scenario below does the company treat loss contingencies correctly, based on the guidance found in SFAS No. 5? a. BlueCorp accrues a probable loss contingency that cannot be reasonably estimated. b. Red Inc. discloses a probable loss contingency that cannot be reasonably estimated. c. PurpleCo accrues and discloses a probable loss contingency. Its exposure to loss is less than the amount accrued. d. Black Enterprises accrues a loss contingency that is reasonably possible. 25. When SFAS No. 5 applies to the disclosure of a risk or uncertainty but SOP 946 does not, which of the following disclosures must be made? a. The nature of the uncertainty, an estimate of possible loss or range of loss, and an indication that it is reasonably possible a change in estimate will occur in the near term. b. The nature of the uncertainty and an indication that it is reasonably possible a change in estimate will occur in the near term. c. The nature of the uncertainty and an estimate of possible loss or range of loss.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 24. In which scenario below does the company treat loss contingencies correctly, based on the guidance found in SFAS No. 5? (Page 166) a. BlueCorp accrues a probable loss contingency that cannot be reasonably estimated. [This answer is incorrect. In this case, SFAS No. 5 requires different treatment of the loss contingency. Another answer choice is better.] b. Red Inc. discloses a probable loss contingency that cannot be reasonably estimated. [This answer is correct. In this case, the contingency cannot be accrued because it cannot be reasonably estimated; therefore, it must be disclosed.] c. PurpleCo accrues and discloses a probable loss contingency. Its exposure to loss is less than the amount accrued. [This answer is incorrect. If a loss contingency is both probable and accrued, it must only be disclosed if the exposure to loss is in excess of the amount accrued.] d. Black Enterprises accrues a loss contingency that is reasonably possible. [This answer is incorrect. A contingency that is reasonably possible would not be accrued; it would be disclosed instead.] 25. When SFAS No. 5 applies to the disclosure of a risk or uncertainty but SOP 946 does not, which of the following disclosures must be made? (Page 167) a. The nature of the uncertainty, an estimate of possible loss or range of loss, and an indication that it is reasonably possible a change in estimate will occur in the near term. [This answer is incorrect. A disclosure consisting of these elements would be made if both SOP 946 and SFAS No. 5 applied to the situation.] b. The nature of the uncertainty and an indication that it is reasonably possible a change in estimate will occur in the near term. [This answer is incorrect. If SOP 946 applied but SFAS No. 5 did not, a disclosure of these elements would be made. An example of such circumstances would be if the estimate related to property and equipment.] c. The nature of the uncertainty and an estimate of possible loss or range of loss. [This answer is correct. These disclosures would be made in a situation when SFAS No. 5 applies but SOP 946 does not. SFAS No. 5 does not confine consideration to the near term.]

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Current Vulnerability Due to Concentrations SOP 946 (FASB ASC 2751050) also requires disclosure of concentrations that meet certain criteria. The types of concentrations that must be considered for disclosure are as follows:  Concentrations in the volume of business transacted with a particular customer, supplier, lender, grantor, or contributor  Concentrations in revenue from particular products, services, or fundraising events  Concentrations in the available sources of supply of materials, labor, or services, or of licenses or other rights used in the entity's operations  Concentrations in the market or geographic area in which an entity conducts its operations Certain of the concentrations are already disclosed in some financial statements. One example is economic dependence on major customers or suppliers. Another example is disclosure of concentrations of credit risk. Although concentrations of financial instruments are specifically excluded from the requirement to disclose vulner abilities due to concentrations, disclosure of market or customer concentrations may provide the necessary disclosure for credit risk concentrations also. What Is a Concentration? SOP 946 (FASB ASC 275105016) states that: Vulnerability from concentrations arises because an entity is exposed to risk of loss greater than it would have had it mitigated its risk through diversification. A concentration is of concern when it involves something that cannot be easily replaced. If, for example, a company purchases most of its raw material from a single supplier, that is not a concentration unless the supplier cannot be easily replaced. Concentrations may not necessarily be identifiable solely on the basis of dollars. For example, if a company purchases only a small amount of raw material from a supplier, but that raw material is critical to the company's production process, a concentration exists if the supplier cannot be easily replaced. Criteria for Disclosure. Disclosure of concentrations is required only if certain criteria are met. Those criteria are as follows, and they must all be met for disclosure to be required:  The concentration exists at the date of the financial statements.  The concentration makes the enterprise vulnerable to the risk of a nearterm severe impact.  It is at least reasonably possible that the events that could cause the severe impact will occur in the near term. The criteria are similar in some ways and use some of the same wording as the criteria for disclosing certain significant estimates. For example, the concentration must be an existing condition," and must be at least reasonably possible." Also, the criteria are to be considered using information known to management prior to issuance of the financial statements." Those and other terms used in both sets of criteria are discussed in prior paragraphs. Major Customers and Foreign Operations. The third criterion listed above is always considered to be met for the following concentrations:  Concentrations in the volume of business transacted with a particular customer  Foreign operations As a result, disclosure is required if those concentrations exist at the date of the financial statements and their loss could cause a severe impact to the company. The SOP , however, does not prohibit the disclosure from stating that 171

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the company does not expect that the business relationship with the customer will be lost (or the foreign operations will be disrupted). Severe Impact. One new term introduced in the second criterion in the Criteria for Disclosure" paragraph is severe impact." It is defined in SOP 946 (FASB ASC 2751020) as follows: A significant financially disruptive effect on the normal functioning of the entity. Severe impact is a higher threshold than material. Matters that are important enough to influence a user's decisions are deemed to be material, yet they may not be so significant as to disrupt the normal functioning of the entity.... The concept of severe impact, however, includes matters that are less than catastrophic. Thus, severe impact is a significant financially disruptive effect on the normal functioning of the company. It is more than just material, but less than catastrophic. An example of a catastrophic event is one that would result in bankruptcy, such as the inability to obtain financing. Loss of Owner/Manager. Individual owners/managers play a critical role in the success and viability of many small businesses. The loss of such an owner/manager would in many cases have a severe impact on the business. However, disclosure of this concentration is not required. Disclosure of the risks and uncertainties associated with management or key personnel is not required. Group Concentrations. Even if a company does not have concentrations with another entity or individual, the company might still have group concentrations that require disclosure. Group concentrations exist if a number of counterparties or items that have similar economic characteristics collectively expose the reporting entity to a particular kind of risk. So even if, for example, a company does not have a single major customer, it may have a disclosable concentration if a group of customers has similar economic characteristics. Such a concentration would exist if a small retail shop is located near a large resort and most of the shop's customers are visitors at the resort. Example Disclosures. For concentrations meeting the criteria SOP's, disclosures must include information that is adequate to inform financial statement users of the general nature of the risk associated with the concentration. Additional specific disclosures are required for concentrations of labor subject to collective bargaining agreements and for foreign operations. GAAP requires disclosure of the percentage of the labor force covered by collective bargaining agreements and the percentage covered by agreements that will expire within one year. (Some compa nies only consider such disclosure if the collective bargaining agreement is up for renewal within the next year.) For operations outside the company's home country, disclosure of the carrying amounts of net assets and the geo graphic areas in which they are located is also required. It is always considered at least reasonably possible that operations located outside an entity's home country will be disrupted in the near term. The following are examples of concentrations disclosures that meet these requirements: CutRite Tree Trimming Services conducts virtually all of its operations under a contract with a local utility company. ***** A majority of the computer chips used by the Company in its manufacturing process is supplied by Extel, Inc. ***** Helena Corporation has exclusive rights in the United States to produce and sell hair dryers bearing the name of a wellknown personality in the hair care industry. Approximately 85% of Helena's revenues are derived from sales of the hair dryers.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 26. Huffman Manufacturing purchases raw material from Layman Steel Co. Under what circumstances would this arrangement be a concentration of concern? a. If the cost of materials purchased equals over 50% of Huffman's revenues. b. If the amount of materials purchased is over 50% of the total amount Huffman purchases. c. If there is not another steel vendor readily available. d. If Huffman has only one raw materials supplier on the date of Huffman's financial statements. 27. A significant concentration is identified in one of Anderson & Vine's major foreign operations. The concentration exists as of the date of the financial statements, and loss of the operation will have a severe impact on the company. Under SOP 946, is the company required to make a disclosure? a. Yes, because Anderson & Vine meets two of the three criteria for disclosure of a concentration. b. No, because it is not at least reasonably possible that events causing the severe impact will occur in the near term. c. Yes, because Anderson & Vine's concentration is related to foreign operations. d. No, because the concentration is not related to volume of business transacted with a particular customer.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 26. Huffman Manufacturing purchases raw material from Layman Steel Co. Under what circumstances would this arrangement be a concentration of concern? (Page 171) a. If the cost of materials purchased equals over 50% of Huffman's revenues. [This answer is incorrect. Dollar amount is not the basis for determining if a situation would be considered a concentration.] b. If the amount of materials purchased is over 50% of the total amount Huffman purchases. [This answer is incorrect. Even if Huffman only purchases a small amount of its raw material from Layman, if that material is critical to production and cannot be easily replaced, it would be considered a concentration.] c. If there is not another steel vendor readily available. [This answer is correct. If another vendor is available so that the supplier can be easily replaced, it would not be a concentration, but in this case it would be because Huffman would have problems continuing its manufacturing if Layman's raw material was suddenly unavailable for purchase.] d. If Huffman has only one raw materials supplier on the date of Huffman's financial statements. [This answer is incorrect. This is one criteria necessary to determine if a concentration is material enough to be disclosed, but there are other criteria that must be met, as well.] 27. A significant concentration is identified in one of Anderson & Vine's major foreign operations. The concentration exists as of the date of the financial statements, and loss of the concentration will have a severe impact on the company. Under SOP 946, is the company required to make a disclosure? (Page 171) a. Yes, because Anderson & Vine meets two of the three criteria for disclosure of a concentration. [This answer is incorrect. In most circumstances, all three of the applicable criteria must be met for disclosure of a concentration to be required; however, Anderson & Vine meet the disclosure requirement due to another factor in the scenario.] b. No, because it is not at least reasonably possible that events causing the severe impact will occur in the near term. [This answer is incorrect. While it is necessary that this criterion to be met for disclosure of a concentration to be required, there are also other factors that must be taken into account in the Anderson & Vine scenario.] c. Yes, because Anderson & Vine's concentration is related to foreign operations. [This answer is correct. When a concentration is related to a foreign operation, the it is at least reasonably possible that the events that could cause the severe impact will occur in the near term" criterion for concentration disclosure is considered to always be met. Therefore, since the other two criteria are met in this scenario, Anderson & Vine is required to disclose the concentration. The company can, however, state in the disclosure that the company does not expect foreign operations will be disrupted.] d. No, because the concentration is not related to volume of business transacted with a particular customer. [This answer is incorrect. Volume of business transacted with a particular customer is not relevant to the Anderson & Vine scenario. However, in such a case, the it is at least reasonably possible that the events that could cause the severe impact will occur in the near term" criterion would always be considered met, so the company would have to disclose the concentration if the other two criteria were met, as well.]

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Summary of Disclosure Requirements. Exhibit 31 summarizes the disclosure requirements for significant risks and uncertainties. Exhibit 31 Disclosing Significant Risks and Uncertainties Nature of Operations When To Disclose? Always. Use of Estimates Always. Certain Significant Estimates  It is at least reason ably possible that the estimate of the effect on the finan cial statements of an existing condi tion will change in the near term due to future confirming events. AND  The change in esti mate would have a material effect on the financial state ments. Threshold for Disclosing? What To Disclose? N/A N/A Potential material effect on financial statements.  Nature of uncer tainty.  An indication that it is at least reason ably possible that a change in the esti mate will occur in the near term. Concentrations  A concentration exists at the financial statement date. AND  The concentration increases the compa ny's vulnerability to the risk of a nearterm severe impact. AND  It is reasonably pos sible that the events able to cause the severe impact could occur in the near term. Potential severe impact to the company.  Concentrations in business volume con ducted with a particu lar customer, supplier, lender, grantor, or contributor.  Concentrations in revenue from particu lar products, ser vices, or fundraising events.  Concentrations in available sources of materials, labor, ser vices, licenses, or rights.  Concentrations in the geographic area or markets in which a company operates.

 Description of Explanation that products or management services. estimates are used in preparing  Relative impor financial state tance of each ments. business.  Basis used to determine rela tive importance of each busi ness.  Principal mar kets and loca tions of the markets.

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Practical Considerations for Disclosing Significant Risks and Uncertainties The following paragraphs offer practical guidance for applying the requirements for disclosing significant risks and uncertainties and the disclosures typically required by SOP 946 for small and mediumsized entities. Nature of Operations. Using the following guidelines, a single description generally can address a company's major products or services, principal markets, and lines of business: a. Major Products or Services. Describe broad product and service groups. If the income statement presents sales by major product line, either repeat the major product lines or use a broader description. b. Principal Markets. General descriptions of industry and geographical concentrations normally give the reader enough information about principal markets, such as sells mainly to individuals in Lane and the surrounding counties" or distributes soft drinks in the metropolitan area." c. Lines of Business. Lines of business are not the same as major products and services, and most small and mediumsized entities have only one line. If there is more than one, disclose the relative importance of each line to the entity's financial results and describe how that determination was made. Often the most efficient approach for drafting the disclosure is to ask management how it views the importance of the lines. Typically, management will describe the lines' relative importance with words and phrases such as about equal" and mostly" and rough percentages such as 60%/40%." Those same types of words may be used in the note disclosure. (Some companies take the position that if the income statement clearly reflects the relative importance of the company's different lines of business, no additional disclosures are required.) The nature of operations disclosure generally will be either in the first note, with the summary of significant accounting policies, or combined with a note on credit risk, but may sometimes be provided as a required part of specialized industry disclosures. a. Disclosed in the First Note. The heading of the first note might be Nature of Business and (Summary of) Significant Accounting Policies," and the nature of operations disclosure might be the first disclosure in that note, with a heading such as Nature of Business (Activities)." Placement in the first note often is preferable when the description is short or does not fit logically with other disclosures. The following is an example of such a disclosure: Lane BuickGMC Truck, Inc. (Lane) sells new and used vehicles, repair services, and parts primarily to customers in the Chicago metropolitan area. b. Disclosed with a Note on Credit Risk. The note might be headed Nature of Business and Credit Risk." This is preferable when the nature of the company's business relates to its credit risk disclosure, as follows: The Company's operations consist primarily of distributing beer to local customers. Substantially all of the Company's sales are under its distributorship agreement with Big Factory Brewing Company. Because of laws prescribed by the state's Alcohol Beverage Control Board, the Company does not grant its customers credit. c. Disclosed as Part of Specialized Industry Disclosures. Disclosures required for some businesses, such as lessors and franchisors, often can include the nature of operations disclosure, as follows: NOTE DDESCRIPTION OF LEASING ARRANGEMENTS Tenor Associates leases its medical office facilities under agreements primarily with companies controlled by its partners. These lease agreements generally provide for a noncancelable term followed by an option to renew on a monthtomonth basis at the same rentals. These leases also provide for additional rentals to cover increases in the partnership's operating costs. Additional rentals assessed totaled $29,212 in 20X1; there were no assessments in 20X0. 176

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Future minimum lease payments to be received under existing noncancelable operat ing leases total $529,667 and are due $406,249 in 20X2 and $123,418 in 20X3. Rental income includes $306,448 in 20X1 and $285,207 in 20X0 from related companies. General Use of Estimates. The goal of disclosing the use of estimates is to alert readers that certain amounts reported in the financial statements are estimated. While the pervasiveness of estimates depends on the nature of operations, a brief discussion of the general use of estimates is usually the most efficient approach. The following exceptions to disclosure of the general use of estimates may be helpful: a. Estimates are not pervasive in the financial statements of some small, simple operations. In those situations, readers might want to know which amounts are estimated and that no material losses can result from them. b. If the statements have no estimates, for example, because the assets consist of cash and investments in traded securities, the disclosure is irrelevant and either of two alternatives is believed acceptable: (1) omit the disclosure or (2) if the entity is concerned that the reader may question why an estimates note is not included, draft the note to say that there are no estimates. This situation is believed to be rare. The disclosure probably is easiest for the reader to follow if it is either presented as an accounting policy or combined with the nature of operations description. a. Separate Policy Note. The disclosure often will be disclosed as a separate policy within the Summary of Significant Accounting Policies" note, using a subheading entitled Use of Estimates." In that case, the following disclosures may be provided: Generally accepted accounting principles require management to estimate some amounts reported in the financial statements; actual amounts could differ. or Because of normal business uncertainties, management must estimate some informa tion included in the financial statements, primarily, the net amounts the Company will realize from collecting receivables and the percentage of completion of contracts. or Although the preparation of financial statements often requires estimating some infor mation, estimates were not necessary to prepare the accompanying financial state ments. b. Combined with the Nature of Operations Description. If estimates are not pervasive, the use of estimates disclosure may be easily included with the nature of operations disclosure. Typically, this will be appropriate for small, simple operations. As an illustration, assume that a car repair shop has total assets of $178,051, which consist mainly of cash of $105,691, approved insurance payments due of $45,792, and prepaid expenses of $11,179. Its liabilities total $46,221 and consist of vendor accounts and compensation and payroll taxes. The following disclosure would be appropriate: Sam's Family Body Shop, Inc. (Sam's) repairs damaged automobiles and is reim bursed through insurance companies. Its customers are located primarily in the Den ton metropolitan area. Preparing the financial statements requires estimating the amounts that will actually be received from billings as well as some other amounts. Substantially all of the amounts due at yearend were subsequently collected. c. Combined with the Basis of Accounting Disclosure. Combining the use of estimates disclosure with the basis of accounting disclosure is helpful when a comprehensive basis of accounting other than GAAP is used. Usually, the note is the first or second policy note and is entitled Basis of Accounting." An appropriate disclosure under such circumstances follows: 177

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The financial statements are prepared on the basis of accounting used for federal and state income tax reporting. That basis differs from generally accepted accounting principles primarily because accrued bonuses, vacation pay, and warranty costs gen erally are recognized only to the extent they will be paid within prescribed periods. Preparing financial statements on the Company's income tax basis requires estimating these and some other amounts. Actual results normally only vary within a small range. Certain Significant Estimates. Since variances between estimated and actual amounts will be recorded in future financial statements, readers should be notified if there is a reasonable possibility that a variance from an estimate in the current statements will materially affect the following year's financial statements. Whether estimates need to be individually identified often depends on whether they are recurring: a. Recurring Estimates. Usually, the entity has enough history to develop an estimate that will vary only within a range of amounts that would not be material to the financial statements. Exceptions may occur in special situations. An example is a valuation allowance for a large balance due from a customer that announces it is considering Chapter 11 bankruptcy shortly before issuance of the entity's financial statements. b. New Estimates. Regardless of how much effort goes into new estimates, they often change significantly and sometimes the change is material to the financial statements. A liability under a new warranty program, the estimate of the number of new software packages that will be sold, and pending litigation are examples. One approach to assessing the likelihood of a material change is to estimate a range and compare the maximum variance with financial statement materiality. The disclosure does not need to use the specific terminology such as near term and reasonable possibility. Since the readers of the financial statements of small and mediumsized entities probably are not familiar with such terminology, using alternate language may result in more easily understandable information. Depending on the nature of the estimate, the disclosure might either be presented as a policy note or as a separate note. a. Policy Note. Including the disclosure for certain significant estimates with the policy note often is appropriate for new estimates that will become recurring estimates in future years, as the following illustrates: In 20X1, the Company began selling machinery to foreign entities with the understand ing that it will fix all defects that occur within one year after the customer accepts the machinery. Since these are new arrangements, management estimated the cost of warranty claims incurred through the end of the year using the results of warranty arrangements with domestic customers. Changes in the estimate will be reported in the results of operations of the years in which they occur. As the Company gains experience, it may find in 20X2 that its estimate in 20X1 was under or overestimated by an amount that is material to the 20X2 financial statements. b. Separate Note. As the following illustrates, including the disclosure for certain significant estimates in a separate note may be helpful when disclosing the effects of a material change in estimate: In 20X0, the Company began selling machinery to foreign entities with the understand ing that it will fix all defects that occur within one year after the customer accepts the machinery. Since these were new arrangements, management estimated the cost of warranty claims incurred through the end of the year using the results of warranty arrangements with domestic customers. During 20X1, management found that the estimate was understated by $382,229, which is included in cost of sales for the year. With this new information, management has revised its estimation procedures, and the provision at the end of 20X1 is higher than it would have been using the same proce dures used at the end of 20X0. As the Company gains additional experience, it may find that it needs to further revise its estimation procedures. Changes in the estimate will be reported in the results of operations of the years in which they occur; however, management does not expect that the effect of such changes in 20X2 will be material. 178

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Current Vulnerability Due to Concentrations. Disclosing current vulnerability due to concentrations informs the reader about concentrations that exist at the balance sheet date and expose the entity to the reasonable possibility of a severe impact within one year from the balance sheet date. This course interprets the term severe impact to mean a significant change in the way the entity conducts its business or provides services. That depends on the facts and circumstances. Typically, entities have contingency plans to compensate for the loss of a concentration. Cutting staff, consolidating operating facilities, and eliminating programs are common responses to such a loss. In addition to the related payments such as severance pay and lease termination settlements, delays in response to the loss lead to unabsorbed overhead and detain manage ment from other responsibilities. Such contingency plans by management probably indicate the existence of concentrations that should be disclosed. Revenue from Particular Customers, Grantors, or Contributors. Deciding whether to disclose sources of revenue based on whether management would change operations significantly in response to their loss is recom mended. For example, if management would eliminate staff positions in response to the loss of a major customer, the reader should be informed; otherwise, disclosure is not helpful. While disclosure depends on the facts and circumstances, the following guidelines may be helpful: a. If the source comprises at least 30%40% of total revenue, there is a rebuttable presumption that loss of the source would require a significant change in operations: (1) If 40% of revenues are from a large customer serviced through separate, dedicated facilities, one might argue that closing the facilities would not be disruptive. However, it probably would require significant changes in operations, for example, to negotiate lease termination payments and severance arrangements with employees at the facility. (2) If 40% of revenues come from one customer, there is a rebuttable presumption that loss of the customer would cause management to significantly change operations. Nevertheless, if the customer's account has an unusually low margin and the entity's staff and production capacity are already strained, management might not have to change operations at all if it lost the customer. Disclosing the existence of the customer in that instance might unnecessarily alarm readers of the financial statements. b. If the condition in Step a. does not exist, but loss of the source would have a material adverse effect on key operating statistics (such as causing violations of debt covenants or negative cash flows from operating activities), there is a rebuttable presumption that the loss would require a significant change in operations. For example, if a customer comprises 25% of revenues but the entity has only a marginal cash flow from operating activities and has excess capacity, loss of the customer probably would cause management to significantly change operations. This usually will be the case with notforprofit organizations with large contributors. Even if the contributor funds a special program, eliminating the program usually is disruptive to normal operations. In addition, since potential donors and others might view the organization differently if it eliminated a program, such action often must be taken carefully. c. If neither of the conditions in Steps a. and b. exists, there is a rebuttable presumption that loss of the source would not cause a significant change in operations. As a practical matter, the management of most small and mediumsized entities normally can readily assess whether the loss of a source would significantly disrupt their operations. The goal of the disclosure is to inform the reader of risk associated with concentrations of revenue. The way that is accomplished is flexible, as indicated below: a. Naming the customer is unnecessary. For example, the disclosure could refer to a local chain of home improvement stores or contracts with a state agency. b. If the source is disclosed in the statements, such as revenue from United Way, additional disclosure in the notes is unnecessary. 179

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c. The requirement only applies to continuing relationships; it does not apply to entities that have a small number of different customers each year, such as contractors. Disclosing that the entity is a contractor gives sufficient notice to the reader of the risk associated with a constantly changing customer base. Nevertheless, additional disclosure may be helpful, such as when the entity has an unusually large contract or when the inability to complete a contract would require a significant change in operations (for example, because the backlog of contracts was developed considering how long the contract would take to complete). d. The disclosure requirements do not apply to a contributor for a special fundraising event, such as a capital campaign, but it does apply to a contributor to a recurring fundraising event, such as the sponsor of a large annual banquet. e. The disclosure can be provided in a variety of ways. Although general discussions normally are sufficiently informative, more detailed disclosures may be helpful. f. Even though not required, mentioning contingency plans, such as the following, may help keep the reader from being unnecessarily alarmed: Approximately onethird of the revenue for each year is from a local foundation that funds most of the costs of the day care program. If that source of revenue were lost and other sources could not be found quickly enough, management would eliminate the program to minimize the damage to the agency's operations. Revenue from Particular Products, Services, or Fundraising Events. The goal of this disclosure is the same as the disclosure of customers and similar sources of revenues. However, accountants must also consider whether there is a reasonable possibility that the source will be lost. If so, consider the impact of the loss; if not, no further consideration is needed. It is believed that the risk considerations only are relevant when providing the source is not within management's control, as in the following situations: a. If a car dealer sells financing and similar products, the risk of loss is irrelevant. Continuing or discontinuing the products is entirely within management's control. On the other hand, if there is a reasonable possibility that a factory would take the dealer's franchise, the impact of such a loss must be disclosed if management would change operations significantly in response to the loss. Normally, that would be the case. b. If a notforprofit organization holds a fundraising event that requires special facilities (such as a stair climb in the tallest building in town) or special permission (such as floating rubber ducks down a river), the likelihood of not being able to use those facilities or obtain permission must be assessed. If there is a reasonable possibility of that, the impact must then be assessed. On the other hand, if there are no such special characteristics and holding the event is entirely within the organization's control, there is no risk to disclose. Volume of Business with a Supplier or Lender. The reader should know if there is a reasonable possibility of the loss of a supplier or lender that would cause management to change operations significantly. Naming the supplier or lender is not required. Whether the entity is likely to lose the supplier or lender depends on whether the supplier or lender will stop doing business with the entity, not whether the entity will stop doing business with the supplier or lender, as explained below: a. Usually, franchisees buy most of their products from their franchisor, often because the franchisor requires it. There is little likelihood of the franchisor no longer selling to the franchisee. b. Other suppliers usually discontinue relationships only if the entity requires special treatment, for example, unusually favorable payment terms or especially timely delivery so the entity can maintain only minimal inventories. c. Normally, the need to change lenders is reasonably possible only if the lender has indicated that it will not renew a line or refinance a balloon payment. The reasonable possibility of having to find new sources of large amounts of debt normally is something the reader should know. In that situation, disclosure is most helpful if combined with the debt disclosure, as follows: 180

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NOTE ESHORTTERM NOTE The shortterm note is payable to a bank under a $350,000 line of credit that expires in September20X1. Interest is payable monthly at prime plus 3%. The note is secured by the Company's customer accounts, inventories, and property and equipment, the assignment of an insurance policy on the life of its majority stockholder, and real estate owned by him. The note is guaranteed by the Company's stockholders and the wife of the majority stockholder and contains covenants that relate primarily to financial results. The bank has indicated that it will not renew the line when it expires, and management has begun negotiations with other banks to refinance the note.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 28. Bottles and Beakers (BB) is a small company with two lines of business. Which of the following best describes the nature of operations disclosure? a. If BB's income statement presents sales by major product line, the major product lines should be repeated or a broader description used. b. General descriptions of industry and geographical concentrations will usually give the reader the enough information. c. The relative importance to BB's financial results should be disclosed along with how that determination was made. d. The description must address the concentration of bank accounts between the two lines. 29. Violet Vapors is a small company with simple operations, and estimates are not pervasive in its financial statements. How should this be disclosed? a. By including a brief discussion of the general use of estimates. b. By noting estimated amounts and that no material losses can result from them. c. By omitting the estimates disclosure from the financial statements entirely. d. By drafting the note to say that estimates are not pervasive. 30. The Kramer Development Group contracts its services to a small group of different customers every year. How would this best be disclosed in the company's financial statements? a. Each customer must be mentioned by name. b. All contracts that make up a significant portion of revenue must be disclosed. c. The company must disclose that it is a contractor. d. Contingency plans for the risk of losing significant clients must be disclosed.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 28. Bottles and Beakers (BB) is a small company with two lines of business. Which of the following best describes the nature of operations disclosure? (Page 176) a. If BB's income statement presents sales by major product line, the major product lines should be repeated or a broader description used. [This answer is incorrect. This guidance applies to the description of major products or services.] b. General descriptions of industry and geographical concentrations will usually give the reader the enough information. [This answer is incorrect. This guidance applies to the description of principal markets. Wording such as sells mainly to individuals in Tarrant and surrounding counties" can be used.] c. The relative importance to BB's financial results should be disclosed along with how that determination was made. [This answer is correct. The most efficient way of doing this would normally be to ask BB's management how it views the relative importance of the two lines and to use that wording in the disclosure.] d. The description must address the concentration of bank accounts between the two lines. [This answer is incorrect. Cash concentrations may require disclosure, but this answer choice does not address the wording of the disclosure for the nature of operations.] 29. Violet Vapors is a small company with simple operations, and estimates are not pervasive in its financial statements. How should this be disclosed? (Page 177) a. By including a brief discussion of the general use of estimates. [This answer is incorrect. This is usually the most efficient approach to making the general use of estimates disclosure; however, Violet Vapors' situation has different elements to consider.] b. By noting estimated amounts and that no material losses can result from them. [This answer is correct. In the scenario described above, Violet Vapors has made the correct disclosure. Because of its simple operations and lack of pervasive estimates, it does not need to make the typical general use of estimates disclosure.] c. By omitting the estimates disclosure from the financial statements entirely. [This answer is incorrect. Omission of the disclosure would only be appropriate if no estimates at all were used in the financial statements. This situation is rare. An example would be if assets consist of cash and investments in traded securities; then the disclosure would be irrelevant.] d. By drafting the note to say that estimates are not pervasive. [This answer is incorrect. If no estimates at all were used in the financial statements, the company might want to draft a note saying so to keep readers from questioning the lack of a general use of estimates disclosure.] 30. The Kramer Development Group contracts its services to a small group of different customers every year. How would this best be disclosed in the company's financial statements? (Page 179) a. Each customer must be mentioned by name. [This answer is incorrect. Naming the customers is unnecessary. Instead, a disclosure could refer to an element common to the customers such as geographic location or type of business.] b. All contracts that make up a significant portion of revenue must be disclosed. [This answer is incorrect. Disclosing a concentration of revenue from a particular customer is only required if the relationship with the customer is continuing. In this scenario, Kramer is not required to make the disclosure. However, it is not prohibited from making the disclosure if it would be helpful.] 184

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c. The company must disclose that it is a contractor. [This answer is correct. This should be enough for the readers of Kramer's financial statements to notice the risk of a constantly changing customer base. However, additional disclosure could be made if helpful.] d. Contingency plans for the risk of losing significant clients must be disclosed. [This answer is incorrect. This is not a required contingency disclosure, but it could help readers from being unnecessarily alarmed if a contingency disclosure is made.]

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EXAMINATION FOR CPE CREDIT


Companion to PPC's Guide to Preparing Financial StatementsCourse 2 Common Problems in Preparing Notes to Financial Statements (PFSTG082)
Test Instructions 1. Following these instructions is an examination consisting of multiple choice questions. You may complete the exam by logging on to our online grading system at OnlineGrading.Thomson.com. Click the purchase link and list of exams will appear. You may search for the exam using wildcards. Payment for the exam is accepted over a secure site using your credit card. Once you purchase an exam, you may take the exam three times. On the third unsuccessful attempt, the system will request another payment. Once you successfully score 70% on an exam, you may print your completion certificate from the site. The site will retain your exam completion history. If you lose your certificate, you may return to the site and reprint your certificate. If you prefer, you may continue to mail your completed answer sheet to the address below. In the print product, the answer sheets are bound with the course materials. For the CDROM product, answer sheets may be printed. The answer sheets are identified with the course acronym. Please ensure you use the correct answer sheet. Indicate the best answer to the following exam questions by completely filling in the circle for the correct answer. The bubbled answer should correspond with the correct answer letter at the top of the circle's column and with the question number. 2. If you change your answer, remove your previous mark completely. Any stray marks on the answer sheet may be misinterpreted. 3. Copies of the answer sheet are acceptable. However, each answer sheet must be accompanied by a payment of $75. If you complete three courses, the price for grading three is $214 (a 5% discount on three courses). In order to receive the discounted fees, all courses must be submitted for grading at the same time. OR the price for grading all four is $270 (a 10% discount on all four courses). 4. To receive CPE credit, completed answer sheets must be postmarked by December 31, 2009. Send the completed Examination for CPE Credit Answer Sheet along with your payment to the following address. CPE credit will be given for examination scores of 70% or higher. An express grading service is available for an additional $24.95 per examination. Course results will be faxed to you by 5 p.m. CST of the business day following receipt of your examination for CPE Credit Answer Sheet. 5. Only the Examination for CPE Credit Answer Sheet should be submitted for grading. DO NOT SEND YOUR SELFSTUDY COURSE MATERIALS. Be sure to keep a completed copy for your records. 6. Please allow a minimum of three weeks for grading. 7. Please direct any questions or comments to our Customer Service department at (800) 3238724. Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to: Thomson Reuters Tax & AccountingR&G PFSTG082 Selfstudy CPE P .O. Box 966 Fort Worth, TX 76101 If you are paying by credit card, you may fax your completed Examination for CPE Credit Answer Sheet and Course Evaluation to the Tax & Accounting business of Thomson Reuters at (817) 2524021.

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EXAMINATION FOR CPE CREDIT 1. While preparing XYZ Corporation's financial statements, John decides to present the financial statement notes on separate pages. Which of the following titles would be most appropriate for the notes? a. XYZ CORPORATION NOTES b. NOTES TO XYZ'S FINANCIAL STATEMENTS DECEMBER 31, 20X1 c. XYZ CORPORATION NOTES TO FINANCIAL STATEMENTS d. NOTES TO FINANCIAL STATEMENTS XYZ CORPORATION FORT WORTH, TX DECEMBER 31, 20X1 2. Tom is engaged to prepare MegaCorp's financial statements. When writing the notes to the financial statements, what wording should Tom use to appropriately identify the responsibility for the notes? a. We/us/our. b. The corporation. c. The client. d. Tom must use the wording chosen by MegaCorp. 3. Mary is engaged to prepare the financial statements for Ice Sculptures Inc., and the company presents its financial statements under generally accepted accounting principles (GAAP). What disclosures must Mary consider so that the statements are a fair presentation in conformity with GAAP? a. Only specific disclosures required by authoritative guidance. b. Only specific disclosures required by the Securities and Exchange Commission (SEC). c. Disclosures necessary for a reader with a basic knowledge of accounting and who is not part of the company's management. d. Disclosures required by authoritative guidance and those necessary to keep the statements from being misleading. 4. Listed below are several scenarios related to the summary of significant accounting polices. Which of the following scenarios correctly addresses the proper method for summarizing significant accounting policies? a. Meta Manufacturing prices its parts inventory at current replacement cost. As this method only approximates GAAP , the disclosure includes a description of the method used and the GAAP method. b. The Jaminator Boutique uses two methods to account for depreciation, and includes the following disclosure, Depreciation is computed using primarily the straightline method." c. Mac2 used the FIFO method for inventory in 20X1, but changed to the LIFO method in 20X2. As the financial statements cover a fiscal year ending June 20X2, only the LIFO method is disclosed. d. Hollingsworth Enterprises includes relevant numbers for each accounting policy described in the summary of significant accounting policies disclosure. 188

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5. Which of the following accounting policy disclosures are required? 1. Inventories 2. Cash equivalents 3. Derivatives 4. Depreciation a. 1., 2., and 3. b. 6., 7., and 8. c. 3., 4., 5., and 8. d. 1., 2., 4., 5., and 7. 6. In which of the following scenarios is the financial statement disclosure dealt with appropriately? a. AlphaCo has depreciable equipment and discloses it by nature and function at the balance sheet date and includes a description of the depreciation methods used. b. BetaCorp uses the LIFO method for valuing inventory, and discloses annual income on the FIFO basis in the equity section of the balance sheet for comparison purposes. c. GammaCo discloses the following about its longterm debts: timing of payments, amounts with and without interest, and the name of the creditor. d. DeltaCorp combines immaterial notes to disclose the following: current total of installments, schedule and amounts of payments, included interest and interest rates. 7. Which of the following is not a required disclosure under SFAS No. 109 (FASB ASC 7401050)? a. Types of temporary differences that give rise to deferred tax assets. b. Operating loss carry forwards for financial statement purposes. c. Investment tax credits. d. Components of income tax expense. 8. Helen is drafting a disclosure of temporary differences under SFAS No. 109 (FASB ASC 74010508). How should she determine which temporary differences must be included in the disclosure? a. All temporary differences that give rise to a deferred tax asset or liability are required to be disclosed. b. All temporary differences that affect the balance sheet and the income statement are required to be disclosed. c. Significant temporary differences that give rise to a deferred tax asset or liability are required be disclosed. d. Disclosure of temporary differences is not required by SFAS No. 109 (FASB ASC 74010508). 5. Marketable securities 6. Deferred income taxes 7. Advertising 8. Investments in debt and equity securities

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9. In 20X1 (the first year of operation), MegaCorp had a loss for financial reporting of $15,000, and the company had an income of $75,000 for financial reporting in 20X2. MegaCorp had taxable temporary differences of $7,000 at the end of 20X1 and $10,000 at the end of 20X2. There were no permanent differences. An average graduated tax rate of 15% applies to both the taxable temporary difference and the loss carryforward. No valuation allowance was considered necessary at the end of 20X1 for the deferred tax asset related to the NOL carryforward. Calculate the total income tax expense or benefit in 20X2. a. A tax expense of $22,000. b. A tax expense of $7,500. c. A tax benefit of $6,450. d. A tax expense of $11,250. 10. A disclosure on which of the following subjects would be considered a general disclosure? a. Related parties. b. Property and equipment. c. Longterm debt. d. Detail on rates, dates, and payments. 11. Which of the following transactions is excluded from the related party disclosure requirements found in SFAS No. 57 (FASB ASC 85010501)? a. Stockholder loans to the company. b. Purchases between affiliated companies. c. Leases between the stockholder and the company. d. The salary paid to an owner or manager. 12. Which of the following scenarios correctly describes the required disclosures for defined benefit plans under SFAS No. 132(R) and SFAS No. 158? a. Londonderry Enterprises discloses employee groups covered, type of benefit formula, the type of plan assets held, and the plan's funding policy. b. Everyman Inc. is a nonpublic entity. It is controlled by MegaCo, a public entity. Everyman follows the reduced disclosure requirements for nonpublic entities under SFAS No. 132(R). c. Beakman Bevels includes the amount of cost recognized for its defined contribution plan in the same disclosure as the cost recognized for its defined benefit plan. d. When ChaseLowe revises its measurement date for plan assets and benefit obligations, it discloses the separate adjustments of retained earnings and accumulated other comprehensive income.

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13. Substantial doubt exists about Mighty Meats' ability to continue as a going concern. How should this be disclosed in the financial statements? a. The disclosure must be worded optimistically so readers of the financial statements do not interpret the disclosure as a prediction of Mighty Meats' impending doom. b. The disclosure must include all relevant factors, such as pertinent conditions and events, their possible effects, and information on the recoverability or classification of recorded assets and liabilities. c. If Mighty Meats' has no specific plans to overcome the conditions and mitigating factors do not exist, the disclosure must note their absence and elaborate as necessary. d. Disclosing doubt about the company's ability to continue as a going concern is up to Mighty Meats' discretion, as such a disclosure could cause the business to fail. 14. Which of the following disclosures applies separately to each of a company's sharebased payment or compensation arrangements? a. Summarized information about assets, liabilities, and results of operations for investments in common stock of corporate joint ventures presented in a separate schedule. b. The amount of cash used to settle equity instruments granted under sharebased payment arrangements. c. The weightedaverage grantdate fair value (or calculated or intrinsic value) of equity options or other equity instruments granted during the year for each year an income statement is presented. d. Material effects of the potential conversion of securities or exercise of outstanding stock options and warrants. 15. Define other disclosures. a. Disclosures related to cash, evidence of an ownership interested in an entity, or a contract that requires the exchange of cash or other financial instruments. b. Disclosures that related to specific captions found in the financial statements. c. Frequent disclosures concerning matters that are not related to a financial statement caption or that relate to several captions. d. Disclosures concerning matters that do not necessarily occur on an annual basis. 16. Dog Toys Inc. acquires Chew Bone Ltd. The business combination is accounted for using the purchase method. Which of the following disclosures is required? a. The name and description of Dog Toys, including its address and a list of major stockholders. b. The cost of Chew Bone and the number of shares and amount of stock issued or issuable. c. The amount of purchased research and development assets planned over the next five years. d. Portion of the purchase price funding severance pay for Chew Bone's departing management.

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17. Match the following disclosures to the relevant environmental remediation costs subject matter. 1. Accounting policies i. The discount rate used and the undiscounted amount of the obligation, if part of the obligation is discounted. ii. The estimated time frame for making environmen tal remediation disbursements. iii. A description and an estimate of the possible loss. iv. Whether environmental remediation liabilities are measured on a discounted basis.

2. Accrued liabilities 3. Unaccrued contingencies 4. Optional disclosures a. 1., iv.; 2., i.; 3., iii.; 4., ii. b. 1., i.; 2., iii.; 3., ii.; 4., iv. c. 1., iii.; 2., ii.; 3., i.; 4., iv. d. 1., ii.; 2., iii.; 3., iv.; 4., i.

18. Dunst & Johnson (D&J) is hired to build roads in a residential development in Beantown. D&J acquires a performance bond from Mutual Bonds to cover this responsibility. If D&J does not complete the roads within six months, Beantown will complete the roads, and Mutual Bonds must pay Beantown for the costs incurred while completing the job. What type of financial instrument is this contract? a. An unconditional receivablepayable contract. b. A conditional receivablepayable contract. c. A financial guarantee or other conditional exchange. d. A financial option contract. 19. Which of the following scenarios correctly describes a disclosure for a financial interest subject to credit or market risk? a. Sword & Sorcery Unlimited (S&S) divides its cash between Second National Bank and Compliance Credit Union, both located in Overton Valley. In its financial statements, S&S discloses this information as a significant concentration of credit risk for cash deposits. b. Science Fiction Retail (SFR) has a note payable to Second National Bank in Overton Valley. SFR makes financial statement disclosures, including information on the region and the bank's policy of requiring collateral, because this is a concentration of market risk. c. Marjorie holds the ownership interest in Nonfiction Enterprises. She makes the appropriate disclosures for the applicable credit risk in her financial statements, including details about current positions and activity during the period. d. The amount of credit risk that Compliance Credit Union must disclose includes deposits made after the bank's daily cutoff time and checks that have been released by have not yet cleared the bank.

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20. For which of the following entities are the disclosures about the fair value of financial instruments under SFAS No. 107 (FASB ASC 825105010) optional? a. JonesSmith, a nonpublic entity, has less than $100 million in total assets on the balance sheet date and has no instrument accounted for as a derivative instrument. b. Meyers & Epstein, a public entity, issues equity instruments that are classified in stockholder's equity on the balance sheet and has equity investments in consolidated subsidiaries. c. DewaltStone, a nonpublic entity holds several financial instruments for which it is impracticable to estimate fair value because a quoted market price is not readily available. d. Havisham Inc., a public entity, extinguished debt not subject to the disclosure requirements of SFAS No.140. 21. Disclosures related to risks and uncertainties are required in four areas. Which area(s) is (are) required for all financial statements? a. Nature of operations only. b. Current vulnerability due to certain concentrations only. c. Nature of operations and use of estimates in financial statement preparation. d. Current vulnerability due to certain concentrations and certain significant estimates. 22. Which of the following scenarios best illustrates the requirement to make additional disclosures for certain significant estimates? a. DawnCo includes a boilerplate disclosure explaining that its financial statements were prepared using management's estimates. b. An existing condition could change an estimate used by the Twilight House in the near term. The possible change is considered material and reasonably possible. c. An existing condition could change an estimate used by Morning Methods, the change in estimate is not expected to result in a significant financial change. d. In two years, an existing condition could change an estimate used by Midnight Times. The amount affected is material. 23. Which of the following disclosures about significant estimates is required under GAAP? a. The nature of the uncertainty and that it is reasonably possible a change will occur in the near term. b. An estimate of the possible loss or range of loss. c. A description of the factors that cause the estimate to be subject to change. d. How long management has known about the possibility of the future event. 24. Which of the following statements applies to SFAS No. 5, but not to SOP 946? a. Disclosures are based on information available prior to issuance of the financial statements." b. It applies to depreciation, amortization, and accrued amounts owed for services rendered. c. It applies to the writedown of longlived operating assets. d. Consideration is confined to the near term. 193

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25. Millie is hired to prepare Faire Carnival's financial statements. A disclosure must be made about uncertainty of an estimate related to a profitable longterm contract. What disclosure guidance should Millie follow? a. The guidance in SFAS No. 5 only. b. The guidance in SOP 946 only. c. The guidance in both SFAS No. 5 and SOP 946. d. Millie should use her professional judgment based on the unique circumstances. 26. SOP 946 requires companies to consider disclosing concentrations in which of the following situations? i. Concentrations in the volume of business transacted with a particular customer. ii. Concentrations in revenue from particular products. a. iii. b. i. and iv. c. i., ii., and iv. d. i., ii., iii., and iv. 27. Three criteria must be met for disclosure of a concentration to be required. Which of the following is one of the three criteria? a. The concentration exists at the end of the company's fiscal year. b. The concentration makes the enterprise vulnerable to risk of a severe impact within the next five years. c. It is reasonably possible the events that could cause the severe impact will occur in the near term. d. The concentration is part of a foreign operation. 28. If Rosewood Winery makes the following disclosure, where has the company placed the nature of operations disclosure? The Company's operations consist primarily of distributing wine to local customers. Substantially all of the Company's sales are under its distributorship agreement with Merlot Vineyards. Because of laws prescribed by the state's Alcohol Beverage Control Board, the Company does not grant customers credit. a. In the first note, with the summary of significant accounting policies. b. Combined with the note on credit risk. c. Provided as part of specialized industry disclosures. d. In the last note disclosure in the financial statements. iii. Concentrations in the available sources of materials used in the company's operations. iv. Concentrations in the geographic area in which a company conducts its operations.

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29. Which of the following is a recurring estimate? a. A valuation allowance for a large balance due from a subscription customer. b. A liability under a new warranty program. c. An estimate of the number of new software packages that will be sold. d. Pending litigation. 30. In which scenario would a concentration disclosure be unnecessary? a. Honest Al's Autopark is a franchise of a major automobile dealer. Due to downsizing, there is a reasonable possibility that the dealer may take away Honest Al's franchise within the next year. b. Helping Hands holds an annual fundraising carnival that provides a significant portion of its annual funding, and the property the city lets Helping Hands use for the carnival site is under construction this year. c. Mary's Stop & Buy is a franchise of the national Stop & Buy chain. Mary buys 90% of her merchandise from the franchisor. d. Stalwart Sales has taken out a loan with First Mutual Bank. The bank indicates that it will not refinance Stalwart Sales' balloon payment that is due next year.

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GLOSSARY
Accounting policies. Specific accounting principles, and the methods of applying those principles, that have been judged by management to be the most appropriate under the circumstances to present fairly the financial position and results of operations and statement of cash flows, in accordance with generally accepted accounting principles (GAAP), and that, accordingly, have been adopted by the reporting entity for preparing financial statements. A summary of significant accounting policies should be the first disclosure in the notes to the financial statements or may be listed in a separate section preceding the notes to financial statements. Amortization. The deduction of certain capital expenses over a fixed period of time. Amortization is claimed on Form 4562. Amortizable expenses include business startup expenses, qualified forestation or reforestation costs, goodwill, going concern value, covenants not to compete, franchises, trademarks, and trade names. Business combination. A business combination results when an entity acquires net assets that constitute a business or acquires equity interests of one or more other entities and obtains control over that entity or entities. Concentration. According to SOP 946, vulnerability from concentrations arises because an entity is exposed to risk of loss greater than it would have had it mitigated its risk through diversification. A concentration is of concern when it involves something that cannot be easily replaced. Defined benefit plan. A pension plan that defines the amount of pension benefit to be provided, usually as a function of one or more factors including age, years of service, or compensation. Accounting is difficult because annual expense is based on estimates of future benefits. The employer bears the investment risk and must provide sufficient funds to meet the defined level of benefit. Depreciation. The deduction of a reasonable allowance for the wear and tear of assets (excluding inventory) used in a trade or business or held for the production of income. In a more narrow sense, depreciation is the method used to write off the cost or other basis of assets over their estimated useful lives. Disclosure. Stating additional facts or explanations in footnotes to financial statements. Disclosure provides an explanation of a company's financial position and operating results. Anything which is material should be disclosed, including quantitative and qualitative information helpful to financial statement users. The SEC also requires special disclosures in filings with it. Financial instrument. There are three major categories of financial instruments: cash, evidence of an ownership interest in an entity, and a contract that requires the exchange of cash or other financial instruments. Cash includes currency on hand, demand deposits, and other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit or withdraw additional funds at any time. Evidence of an ownership interest in an entity includes common stock, preferred stock, certificates of interest or participation, and warrants and options to subscribe to or purchase stock from the issuing entity. Finally, a contract is a financial instrument if it (1) imposes on one entity a contractual obligation to (a) deliver cash or another financial instrument to a second entity or (b) exchange other financial instruments on potentially unfavorable terms with the second entity and (2) conveys to that second entity a contractual right to (a) receive cash or another financial instrument from the first entity or (b) exchange other financial instruments on potentially favorable terms with the first entity. Financial statements. The principal means of communicating financial information to those users external to the entity. They are a formal tabulation of names and amounts of items derived from the accounting records by simplifying, condensing, and aggregating. They are a fundamentally related set of tabulations that articulate with each other and derive from the same underlying data. The full set of nongovernment financial statements for a period should show the following:  Financial position at the end of the period (balance sheet)  Earnings (loss) for the period (income statement)  Comprehensive income or loss for the period (comprehensive income statement) 196

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 Cash flows during the period (statement of cash flows)  Investments by and distributions to owners during the period (statement of changes in owners' equity and the statement of retained earnings) Financial statements are representations of the assertions of management. The fairness of their presentation in conformity with generally accepted accounting principles (GAAP) is management's responsibility. Firstin, firstout (FIFO). A costflow assumption that matches the oldest costs to current sales revenues. It is based on the assumption that the oldest units are sold before units subsequently received (or produced) and thus are the first units used to determine cost of goods sold. As a result, the units left in ending inventory are the newest, or most recently received (produced), units. FIFO requires identification of inventory layers at different unit costs and can be used with either the periodic or perpetual inventory system with the same result. FIFO produces an inventory value that approximates current cost. The flow of costs approximates the usual physical flow of units (cash outflow is recognized in the same order as cash inflows). The criticism of this method is that it does not match current costs against current revenueas costs are rising, reported income will be higher than under LIFO or average cost. General disclosures. Frequent disclosures concerning matters that do not relate to a financial statement caption, such as contingencies, or that relate to several captions, such as related parties. Generally accepted accounting principles (GAAP). Basic accounting principles and standards and specific conventions, rules, and regulations that define accepted accounting practice at a particular time by incorporation of consensus and substantial authoritative support. To prepare financial statements for other than governmental entities in accordance with GAAP , the CPA must apply those principles found in sources of established accounting principles as described in SAS 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Going concern. The accounting assumption that maintains that an entity will remain in business at least for one year in the absence of information to the contrary. Such information may include the entity's ability to meet its obligations when due without disposing of assets outside the normal course of business, restructuring of debt, and so forth. Lastin, firstout (LIFO). A cost flow assumption which matches the latest (most recent) costs to current sales revenues. It is based on the assumption that the newest units with the most current acquisition costs are sold first and thus current costs are used to determine cost of goods sold. As a result, the units left in ending inventory are the oldest units. LIFO requires identification of inventory layers at different unit costs and can be used with either the periodic or perpetual inventory system, with slightly different results. It matches current costs against current revenueas costs are rising, reported income will be lower than under FIFO or average cost. It recognizes the flow of costs versus the usual physical flow of units (cash outflow is recognized in the reverse order as cash inflows). The criticism of this method is that it produces an inventory value that is not at current cost. Notes. Pieces of information disclosed in notes added to the end of financial statements, or parenthetically on the face of the financial statements, that amplify or explain, and are essential to the understanding of information recognized in the financial statements. Notes are considered integral parts of the financial statements prepared in accordance with GAAP . Other disclosures. Disclosures that concern matters that do not necessarily occur every year, such as accounting changes or business combinations. Recurring estimate. An estimate used by an entity with enough history to develop an estimate that will vary only within a range of amounts that would not be material to the financial statements. Related parties. SFAS 57 defines related parties as, among others, management, owners, family members of owners or management, affiliates, or any party that can significantly influence the management or operating policies" such that the entity might be prevented from fully pursuing its separate interests." Relatedparty transactions must be fully disclosed in the notes to the financial statements, including the nature of the relationship involved, a description of the transaction, the dollar amounts of the transaction, and amounts due to and from related parties. 197

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INDEX
A
ACCOUNTING CHANGE  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99, 100, 132 AMORTIZATION  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99  Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99      Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Business combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Commitments and contingencies  Collateral arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119  Going concern . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121  Lawsuits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122  Loss contingencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166  Obligations under guarantees . . . . . . . . . . . . . . . . . . . . . . 120  Restrictive debt covenants . . . . . . . . . . . . . . . . . . . . . . . . . 118 Comparative financial statements . . . . . . . . . . . . . . . . . . . . . . . . 93 Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Concentrations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171, 179 Consolidated financial statements . . . . . . . . . . . . . . . . . . . . . . . 99 Credit and market risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146 Debt covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 Defined contribution pension and other postretirement benefit plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98, 99, 100, 105 Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 Environmental remediation costs . . . . . . . . . . . . . . . . . . . . . . . 135 Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 Financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 Income taxes  Components of net deferred tax assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 107  Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 109  Permanent differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111  Reconciliation of expected and actual tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 111  Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 111  Tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 111  Temporary differences . . . . . . . . . . . . . . . . . . . . . . . . . . 99, 106  Variations in customary relationships . . . . . . . . . . . . . 106, 111 Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98, 100, 104 Investmentsequity method . . . . . . . . . . . . . . . . . . . . . . . . 99, 124 Investment tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 111 Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 Longterm construction contracts . . . . . . . . . . . . . . . . . . . . . . . . 99 Longterm debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Nature of operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159, 176 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Pension plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 Priorperiod adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 Property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Related party transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 Required by GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . 91, 93, 97, 99 Risks and uncertainties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 Significant estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160, 178 Subsequent events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Use of estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159, 177

B
BASIC FINANCIAL STATEMENTS  Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 BUSINESS COMBINATIONS  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133  Purchase method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133  Subsequent event . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123               

C
CAPTIONS  Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106  Note captions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92  Summary of significant accounting policies . . . . . . . . . . . . . . . 97 CASH  Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99  Concentrations of credit risk . . . . . . . . . . . . . . . . . . . . . . . 146, 147  Pledging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 COMPREHENSIVE INCOME  Disclosure in the notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 CONCENTRATIONS OF CREDIT RISK . . . . . . . . . . . . . . . 146, 147 CONSOLIDATED OR COMBINED FINANCIAL STATEMENTS  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 CONSTRUCTION CONTRACTORS  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 CONTINGENCIES AND COMMITMENTS  Disclosures  Collateral arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Going concern . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Lawsuits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Loss contingencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Obligations under guarantees . . . . . . . . . . . . . . . . . . . . . .  Violation of loan covenants . . . . . . . . . . . . . . . . . . . . . . . . .  Nuisance suits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

119 121 122 166 120 118 123

D
DEPRECIATION  ACRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98  Change in method  Planned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98, 99, 100, 105 DERIVATIVES  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 DISCLOSURES  Accounting changes . . . . . . . . . . . . . . . . . . . . . . . . . . 99, 100, 132  Accounting policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97, 105  Accounting principles  Alternative principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98  Methods that approximate GAAP . . . . . . . . . . . . . . . . . . . . . 98  Unique industry practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98  Unusual applications of GAAP . . . . . . . . . . . . . . . . . . . . . . . 98

                  

DISCONTINUED OPERATIONS  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

E
ENVIRONMENTAL REMEDIATION COSTS  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 EXPENSES  Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 EXTRAORDINARY ITEMS  Tax benefits of loss carryforward . . . . . . . . . . . . . . . . . . . . . 99, 109

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F
FAIR VALUE  Disclosures  Financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 FINANCIAL INSTRUMENTS  Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99  Disclosures  Authoritative literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142  Cash deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148  Concentrations of credit risk . . . . . . . . . . . . . . . . . . . . . . . . 147  Excluded from SFAS No. 107 . . . . . . . . . . . . . . . . . . . . . . . . . . 146  Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151  Identifying financial instruments . . . . . . . . . . . . . . . . . . . . . . . . 142  Market risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146, 147

M
MARKETABLE SECURITIES  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

N
NOTES TO FINANCIAL STATEMENTS  Arrangement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92  Basic financial statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91  Comparative statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93  Dating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92  Disclosure of certain significant risks and uncertainties  Certain significant estimates . . . . . . . . . . . . . . . . . . . . 160, 178  Current vulnerability due to concentrations . . . . . . . 171, 179  Nature of operations . . . . . . . . . . . . . . . . . . . . . . . . . . . 159, 176  Relationship to SFAS No. 5 . . . . . . . . . . . . . . . . . . . . . . . . . 166  Scope and applicability of SOP No. 946 . . . . . . . . . . . . . 158  Use of estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159, 177  Format and style . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92, 97  Note caption headings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92, 97  Referencing to notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92  Requirements for notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91, 97  Single financial statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93  Summary of significant accounting policies . . . . . . . . . . . . . . . 97  Title . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92  Wording . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

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INCOME TAXES  Deferred, liability method  Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . 106  Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109  Disclosures  Components of net deferred tax assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 107  Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 109  Permanent differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111  Reconciliation of expected and actual tax rate . . . . . 106, 111  Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 111  Tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 111  Temporary differences . . . . . . . . . . . . . . . . . . . . . . . . . . 99, 106  Variations in customary relationships . . . . . . . . . . . . . 106, 111  Investment tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106, 111 INTEREST  Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 INVENTORIES  Accounting changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98, 100, 104  LIFO  Change to LIFO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99  Conformity regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100, 104  Parts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98  Policies note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98, 99 INVESTMENTS  Common stockequity method  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99, 124

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PENSION PLANS  Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 PRIORPERIOD ADJUSTMENTS  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 PROPERTY AND EQUIPMENT  Collateral arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

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RECEIVABLES  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99  Related party . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116, 145 RELATED PARTY TRANSACTIONS  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 REVENUE  Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 RISKS AND UNCERTAINTIES  Certain significant estimates . . . . . . . . . . . . . . . . . . . . . . . 160, 178  Relationship to SFAS No. 5 disclosures . . . . . . . . . . . . . . 166  Concentrations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171, 179  Nature of operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159, 176  Scope and applicability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158  Use of estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159, 177

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LEASES  Related party . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116, 117 LIABILITIES  Collateral arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119  Longterm debt  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106  Violation of covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

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STOCKHOLDERS' EQUITY  Subsequent events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 SUBSEQUENT EVENTS  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

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COURSE 3 THE STATEMENT OF INCOME (PFSTG083)


OVERVIEW COURSE DESCRIPTION: This interactive selfstudy course examines the statement of income. Users will learn the basic format and style of the statement; when to recognize revenues, expenses, gains, and losses; as well as specific issues and accounting for income taxes. October 2008 Users of PPC's Guide to Preparing Financial Statements Basic knowledge of financial statements. 5 QAS Hours, 5 Registry Hours Check with the state board of accountancy in the state in which you are licensed to determine if they participate in the QAS program and allow QAS CPE credit hours. This course is based on one CPE credit for each 50 minutes of study time in accordance with standards issued by NASBA. Note that some states require 100minute contact hours for self study. You may also visit the NASBA website at www.nasba.org for a listing of states that accept QAS hours. FIELD OF STUDY: EXPIRATION DATE: KNOWLEDGE LEVEL: LEARNING OBJECTIVES: Lesson 1General Considerations Related to the Statement of Income Completion of this lesson will enable you to:  Identify the components of net income.  Use correct form and style for the statement of income.  Determine when to recognize revenues, expenses, gains, and losses.  Assess issues related to items that are required to be presented separately on the statement of net income. Lesson 2The Accounting and Presentation of Certain Expenses Related to the Statement of Income Completion of this lesson will enable you to:  Assess accounting and presentation issues related to depreciation, startup costs, research and development, and computer software.  Assess accounting and presentation issues related to rent expenses, advertising costs, and retroactive adjustment of workers' compensation and other expenses. Lesson 3Income Tax Accounting Completion of this lesson will enable you to:  Assess issues related to accounting for income taxes.  Implement various income tax calculations, including deferred taxes, loss carryforwards, and others. Accounting Postmark by December 31, 2009 Basic

PUBLICATION/REVISION DATE: RECOMMENDED FOR: PREREQUISITE/ADVANCE PREPARATION: CPE CREDIT:

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TO COMPLETE THIS LEARNING PROCESS: Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to: Thomson Reuters Tax & AccountingR&G PFSTG083 Selfstudy CPE P .O. Box 966 Fort Worth, TX 76101 See the test instructions included with the course materials for more information. ADMINISTRATIVE POLICIES: For information regarding refunds and complaint resolutions, dial (800) 3238724 for Customer Service and your questions or concerns will be promptly addressed.

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Lesson 1:General Considerations Related to the Statement of Income


Introduction
SAS No. 29 lists the statement of income as one of the basic financial statements necessary to present a company's financial position and results of operations in conformity with generally accepted accounting principles. The statement of income and the statement of retained earnings, individually or in combination, are designed to reflect, in a broad sense, the results of an entity's operations. This course discusses preparing income statements. Learning Objectives: Completion of this lesson will enable you to:  Identify the components of net income.  Use correct form and style for the statement of income.  Determine when to recognize revenues, expenses, gains, and losses.  Assess issues related to items that are required to be presented separately on the statement of net income.

COMPONENTS OF NET INCOME


Each item presented in the statement of income may be categorized according to one of the four components of net income. Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, uses the term comprehensive income" rather than the traditional net income" or earnings" to describe all changes in a company's equity (net assets) except those resulting from investments by owners and distributions to owners. According to Statement of Financial Accounting Concepts No. 6 the components of net income are: a. Revenues. Actual or expected cash inflows (or the equivalent) that have occurred or will eventuate as a result of an entity's ongoing major or central operations b. Expenses. Outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations c. Gains. Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners d. Losses. Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners Statements of Financial Accounting Concepts do not establish accounting standards that are enforceable under the AICPA Code of Professional Conduct. However, they may be considered in the absence of established accounting principles. Classifying amounts as revenues, gains, expenses, or losses varies among companies and depends on the nature of a company's operations. Events or circumstances that are sources of revenues for one company may be gains for another. The primary differences between revenues and gains and between expenses and losses are that (a) revenues and expenses result from an entity's ongoing major or central operations such as producing or delivering goods or rendering services, while gains and losses result from incidental or peripheral events or circumstances 203

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and (b) revenues and expenses usually are recorded at their gross amounts while gains and losses usually are recorded at net amounts. Accounting and presentation principles for specific items of revenue, expense, gain, or loss are discussed in more detail in the remainder of this course.

FORM AND STYLE CONSIDERATIONS FOR THE STATEMENT OF INCOME


Alternative Formats The income statement is usually presented in one of the following formats:  Singlestep Format. The singlestep format groups the components of net income into two categories: (a) revenues and gains and (b) expenses and losses. The difference between the two subtotals is net income or loss for the period. In practice, the strict singlestep format is often modified to show income taxes, or equity in net earnings or losses of investees as a separate caption preceding net income (or income before extraordinary items), rather than including those amounts among operating items.  Multiplestep Format. The multiplestep format shows various intermediate components of net income. Generally, operating results are presented separately from nonoperating results, e.g., costs and expenses are deducted from sales followed by nonoperating revenues, gains, expenses, and losses, and expenses are grouped by type or function. Intermediate components of net income that are frequently presented in multiplestep statements are gross profit, income from operations, and other income and expenses. Classifying Items Disclosure of the important components of the financial statements, such as sales or other sources of revenue, cost of sales, depreciation, selling and administrative expenses, interest expense, and income taxes, makes the infor mation more useful. The following guidelines about grouping (or presenting separately) items of revenues, expenses, gains, and losses in income statements were proposed by the FASB in a Concepts Statement. While the Statement was not adopted, the guidelines are believed useful.  It is useful to report separately items that have been unusual in amount judged by the experience of previous periods.  It is useful to distinguish among revenues, expenses, gains, losses, receipts, and payments, the amounts of which are affected in different ways by changes in economic conditions.  It is useful, when cost justified, to give enough detail to enable users to understand the main relationship among revenues, expenses, gains, and losses, and between cash receipts and payments. In particular, it is relevant to report separately (a) expenses that vary with volume of activity or with various components of income, (b) expenses that are discretionary, and (c)expenses that are stable over time or that depend on other factors, such as the level of interest rates and the rate of taxation.  The reporting of the net amounts of items, some of which have positive effects on comprehensive income and some of which have negative effects (as in the reporting of gains and losses), is acceptable only if knowledge of the relationships between the gross and net amounts is not likely to be particularly useful for the prediction of future results.  Reporting should distinguish among revenues, expenses, gains, and losses, the measurement of which is subject to different levels of reliability.  Reporting should distinguish items, the amounts of which must be known, for the calculation of summary indicators that users are known to use frequently; for example, for computations to be made of rate of return. Similarly, information should be provided to permit users to calculate interest coverage, debt service coverage, etc. 204

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Statement Title Authoritative literature does not prescribe a title for the income statement. The following titles are found most frequently in practice:  Statement of Income  Statement of Operations  Income Statement  Statement of Earnings Statement of Income" is the most frequently used title by nonpublic companies. Cash and tax basis statements should not use one of the preceding titles without modification. When the statement shows a net loss, some firms use the title Statement of Operations" rather than Statement of Income," although Statement of Income" is acceptable. Captions Captions within the income statement will vary based on the nature of a company's operations, the way revenues and expenses are recognized, the detail presented, and the format of the income statement, i.e., singlestep or multiplestep. The following are some practical guidelines:  If the income statement includes more than one revenue account, they are ordinarily listed under a heading such as Revenues" (singlestep format) or Operating revenues" (multiplestep format).  Amounts deducted in arriving at revenue presented on the income statement (for example, sales returns and allowances or discounts) should be disclosed on the face of the income statement or in the notes to the financial statements, if material.  For singlestep formats, expenses are ordinarily listed under a heading such as Costs and expenses" or Expenses."  Multiplestep formats usually present Cost of sales" either as (a) a separate line item, (b) a heading below which are listed elements of costs, or (c) as a separate line item under a heading such as Operating expenses." Other operating expenses may be listed under a heading such as Operating expenses" or may be classified by principal type, e.g., selling or administrative, and presented as separate line items without a heading.  Other income and expenses should be identified, if material, either on the face of the income statement or in the notes to the financial statements. Material income and expense items should not be obscured by classifying them under captions such as Other incomenet" or Other expensenet."

THE RECOGNITION OF REVENUES, EXPENSES, GAINS, AND LOSSES


Revenues Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue is recorded in financial statements when the following conditions are met: a. Amounts are realized or realizable, i.e., converted or convertible into cash or claims to cash. b. Amounts are earned, i.e., activities that are prerequisite to obtaining benefits have been completed. Accordingly, as a general rule, revenue from selling products is recognized at the date of sale, and revenue from rendering services is recognized when they have been performed and are billable. 205

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Paragraph 84 of SFAC No. 5 provides the following additional guidelines on recognizing revenue:  If sale or cash receipt (or both) precedes production and delivery (for example, magazine subscriptions), revenues may be recognized as earned by production and delivery.  If product is contracted for before production, revenues may be recognized by a percentageofcompletion method as earnedas production takes placeprovided reasonable estimates of results at completion and reliable measures of progress are available.  If services are rendered or rights to use assets extend continuously over time (for example, interest or rent), reliable measures based on contractual prices established in advance are commonly available, and revenues may be recognized as earned as time passes.  If products or other assets are readily realizable because they are salable at reliably determinable prices without significant effort (for example, certain agricultural products, precious metals, and marketable securities), revenues and some gains or losses may be recognized at completion of production or when prices of the assets change.  If product, services, or other assets are exchanged for nonmonetary assets that are not readily convertible into cash, revenues or gains or losses may be recognized on the basis that they have been earned and the transaction is completed.... Recognition in both kinds of transactions depends on the provision that the fair values involved can be determined within reasonable limits.  If collectibility of assets received for product, services, or other assets is doubtful, revenues... may be recognized on the basis of cash received. Various pronouncements provide specific guidance on revenue recognition for certain transactions or in certain industries. Revenue recognition principles for cash and tax basis financial statements do not necessarily conform to the principles cited in the previous two paragraphs. In response to numerous concerns about improper revenue recognition, in January 1999, the AICPA issued a nonauthoritative report, Audit Issues in Revenue Recognition." Although the report is designed to assist auditors, it summarizes key accounting literature regarding whether and when revenue should be recognized in accordance with GAAP and identifies transactions and circumstances that may indicate improper revenue recognition. The report points out that revenue may be improperly recognized due to (a)the absence of a firm agreement between the buyer and the seller, (b) lack of delivery of the product, and (c) an incomplete earnings process. The report lists the following circumstances that may indicate sales are improperly recorded:  Letters of intent are used instead of signed contracts.  Products are shipped before the scheduled shipment date without the customer's approval.  Products can be returned without obligation after a free tryout" period.  Customers can unilaterally cancel the sale.  Obligations to pay for products are contingent on the customer's resale to a third party or financing from a third party.  Sales are billed for products being held by the seller before delivery.  Products are shipped after the end of the period.  Products are shipped to a warehouse (or other intermediate location) without the customer's approval.  Sales are invoiced before products are shipped. 206

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 Part of a product is shipped and the part not shipped is a critical component of the product.  Sales are recorded based on purchase orders.  Obligations to pay for the product depend on the seller fulfilling material unsatisfied conditions.  Products that are still being assembled are invoiced.  Products are sent to and held by freight companies pending return to the seller for required customer modifications.  Products require significant continuing vendor involvement (such as installation or debugging) after delivery. In addition, Practice Alert 983, Responding to the Risk of Improper Revenue Recognition, issued by the AICPA's Professional Issues Task Force, also addresses revenue recognition issues. Although the nonauthoritative Practice Alert is intended for auditors, it includes information that may be useful to financial statement preparers. Similarly, the SEC staff has issued Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements (FASB ASC 60510S99), to provide additional guidance on recognizing, presenting, and disclosing revenue in financial statements filed with the SEC. Although SABs are not applicable to the financial statements of nonpublic entities, the guidance in SAB No.101 may be useful to all financial statement preparers. The SAB does not change any existing guidance on revenue recognition, but explains how the SEC staff applies that guidance to transactions not specifically addressed in the existing guidance. Whether to Recognize Revenue as a Principal or an Agent. Generally, principals recognize as revenue the amount charged to the customer and agents recognize as revenue the portion of the amount charged to the customer that they retain. While the issue of whether an entity should recognize revenue as a principal or an agent is not new, it is becoming more pronounced as entities adopt more of a virtual approach to business. For example, entities selling products over the Internet may keep no inventory but instead have an arrangement with a supplier to ship the product directly to the customer. EITF Issue No.9919, Reporting Revenue Gross as a Principal versus Net as an Agent," (FASB ASC 6054545) says that whether the entity should recognize revenue as a principal or an agent depends on the facts and circumstances and provides a variety of indicators that the entity should evaluate in reaching a decision. However, none of the indicators should be considered presumptive or determinative, and instead, the relative strength of each should be considered. The following are possible indicators that the entity should recognize revenue as a principal: a. The entity is the primary obligor in the arrangement. b. The entity has general inventory risk, either before the customer order or upon customer return. c. The entity has latitude in establishing price. d. The entity changes the product or performs part of the service. e. The entity has discretion in supplier selection. f. The entity is involved in the determination of product or service specifications. g. The entity has physical loss inventory risk, either after the customer order or during shipping. h. The entity has credit risk. In addition, the following are listed as possible indicators that the entity should recognize revenue as an agent: a. The supplier, not the entity, is the primary obligor in the arrangement. 207

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b. The amount the entity earns is fixed. c. The supplier, not the entity, has credit risk. Whether to Recognize Charges for Shipping and Handling as Revenue. EITF Issue No. 0010, Accounting for Shipping and Handling Fees and Costs" (FASB ASC 605454519 through 4521 and 60545502), requires entities to record as revenue charges to customers for shipping and handling, without regard to whether those charges are designed solely as cost recovery or to generate a profit. In addition, entities are required to disclose the following: a. The policy for classifying shipping and handling costs. b. If shipping and handling costs are significant and are not included in cost of sales, the total of those costs and the line items in which they are included in the income statement. The Effect of Sales Incentives on the Amount of Revenue Recognized. Entities may offer a variety of sales incentives, some of which are passed on by their primary vendors. For example, the incentives may entitle the customer to receive: a. a reduction in the price of a product or service at the point of sale, typically by presenting a coupon that was distributed through print media or by direct mail. b. a price reduction by subsequently submitting a refund or rebate claim, often to the manufacturer of the product. EITF Issue No. 019, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products)" (FASB ASC 60550), provides guidance on (a) how the entity should account for these types of incentives and (b) how the entity should recognize costs associated with sales incentives in which the entity gives the customer a free product or service such as a kitchen appliance or a gift certificate for use at another entity. Presentation of Sales and Other Similar Taxes in the Statement of Income. Entities often collect taxes (such as sales, use, value added, and certain excise taxes) from customers and send the amounts collected to the appropri ate taxing authority. EITF Issue No. 063, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)" (FASB ASC 60545503 and 504), addresses the presentation of such taxes in the statement of income. This guidance applies to any tax a governmental authority assesses that is imposed on and occurs simultaneously with a specific transaction between a seller and a customer that produces revenue (FASB ASC 60545152). It does not apply to certain tax schemes imposed during the inventory procurement process. Some entities present sales and similar taxes within the scope of the EITF on a gross basis. That is, they record the amount of taxes collected as revenues and the amount remitted to taxing authorities as costs. Other entities use a net presentation and do not report the taxes in revenues. The EITF did not take a position regarding which presentation is preferable, instead indicating, that the presentation is an accounting policy decision to be disclosed in accordance with APB Opinion No. 22, Disclosure of Accounting Policies (FASB ASC 2351050). However, entities that report sales and similar taxes on a gross basis are required to disclose the amount of those taxes if they are significant. Such disclosure may be done on an aggregate basis. Expenses The term matching" is sometimes used to describe the process of recognizing expenses in the same accounting period as the revenues associated with those costs. Statement of Financial Accounting Concepts No. 6 describes three broad expense recognition principles as follows:  Costs and revenues that result directly and jointly from the same transaction or event are recognized in the same accounting period, such as sales revenue, cost of goods sold, and certain selling expenses.  Costs that are incurred to obtain benefits that are exhausted in the period in which the costs are incurred are recognized in that period, for example, salesmen's monthly salaries and utilities. 208

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 Costs that provide benefits over several periods are allocated to those periods, for example, prepaid insurance and depreciation. Costs are generally allocated to accounting periods when no direct relationship between revenues and costs exists, and the costs cannot be identified with a particular accounting period. Accounting for particular types of expenses is discussed in Lesson 2. Gains and Losses Statement of Financial Accounting Concepts No. 6 indicates that gains and losses generally result from one of the following events or circumstances: a. Netting costs and proceeds of incidental transactions, such as sales of investments in marketable securities or equipment b. Nonreciprocal transfers other than those between the company and its owners, for example, donations, winning a lawsuit, or thefts c. Holding assets or liabilities while their values change, for example, causing inventory to be written down from cost to market d. Environmental factors, such as damage or destruction of property by fire or flood

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 1. FAD Corporation manufactures women's accessories as its ongoing central operation. These accessories are sold to department stores with the terms 2%/10, net/45. Which component of income would FAD record relating to the increase in accounts receivable resulting from the sale of the accessories? a. Revenue. b. Expense. c. Gain. d. Loss. 2. Which of the following items would be classified as an expense on FAD Corporation's statement of income? a. The increase in accounts payable resulting from the purchase of a new manufacturing machine. b. The use of raw materials in the manufacturing process for accessories sold in the current period. c. The outflow of cash resulting from the issuance of dividends to the corporation's stockholders. d. The total loss of a warehouse due to a tornado. 3. Which of the following is the most frequently used title for the income statement by nonpublic companies? a. Statement of Income. b. Statement of Operations. c. Income Statement. d. Statement of Earnings. 4. Captions within the income statement are not: a. Prescribed by authoritative literature. b. Determined by the income statement format. c. Based on the way revenues and expenses are recognized. 5. According to the additional guidelines provided in SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises: a. Magazine subscriptions may be recognized as revenue when cash is received. b. Revenues from precious metals may be recognized at completion of production. c. Revenue from selling an automobile is recognized on the date cash is received. d. Revenues from noncontracted construction may be recognized by a percentageofcompletion method.

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6. According to the AICPA's January 1999 nonauthoritative report, Audit Issues in Revenue Recognition," which of the following may be an indication of improperly recorded sales? a. Sales are recorded after goods are delivered. b. Sales are recorded after a service is rendered and completed. c. Sales are recorded based on purchase orders. 7. Generally, principals recognize as revenue the amount charged to the customer and agents recognize as revenue the portion of the amount charged to the customer that they retain. Which of the following provides guidance on whether to recognize revenue as a principal or agent? a. EITF Issue No. 9919. b. Staff Accounting Bulletin No. 101. c. EITF Issue No. 0010. d. Practice Alert 983. 8. The bookkeeper at Alberto's Roofing is preparing the financial statements for the month. According to the expense recognition principles in the Statement of Financial Accounting Concepts No. 6, which of the following expenses would be allocated over several accounting periods? a. Utilities for the office. b. Cost of goods sold for a small residential roofing job. c. Monthly payment for a local billboard advertisement. d. Depreciation on the work truck.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 1. FAD Corporation manufactures women's accessories as its ongoing central operation. These accessories are sold to department stores with the terms 2%/10, net/45. Which component of income would FAD record relating to the increase in accounts receivable resulting from the sales of the accessories? (Page 203) a. Revenue. [This answer is correct. Revenues are reported on the statement of income. Revenues include the expected cash inflows that will occur as a result of an entity's ongoing major or central operations. The increase in accounts receivable is properly classified as an expected cash inflow.] b. Expense. [This answer is incorrect. FAD Corporation will need to record the cost of goods sold for the accessories; however, the increase in accounts receivable does not result in an expense on the statement of income.] c. Gain. [This answer is incorrect. An increase in accounts receivable as a result of an entity's ongoing central operations is not recorded on the statement of income as a gain. A gain would be recorded in the event of a profitable sale of a machine used in the manufacture of the accessories.] d. Loss. [This answer is incorrect. The sale of accessories will not produce a component of income classified as a loss. A loss might occur upon the sale of a copy machine used in the business office of FAD Corporation.] 2. Which of the following items would be classified as an expense on FAD Corporation's statement of income? (Page 203) a. The increase in accounts payable resulting from the purchase of a new manufacturing machine. [This answer is incorrect. The purchase of a machine used in the manufacture of a product is recorded on the balance sheet.] b. The use of raw materials in the manufacturing process for accessories sold in the current period. [This answer is correct. Expenses are defined as the outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations.] c. The outflow of cash resulting from the issuance of dividends to the corporation's stockholders. [This answer is incorrect. The payment of dividends is not an item recorded on the statement of income. Distributions are recorded on the balance sheet.] d. The total loss of a warehouse due to a tornado. [This answer is incorrect. The casualty loss is not a result of an ongoing major or central operation. This event would be classified as a loss on the statement of income.] 3. Which of the following is the most frequently used title for the income statement by nonpublic companies? (Page 205) a. Statement of Income. [This answer is correct. The authoritative literature does not provide a specific title. However, Statement of Income" is the most frequently used title by nonpublic companies.] b. Statement of Operations. [This answer is incorrect. Statement of Operations" is an acceptable title for the income statement. Some companies use this title when the statement shows a net loss.] c. Income Statement. [This answer is incorrect. Income Statement" is not the most frequently used title by nonpublic companies. It is, however, one of the four most common.] d. Statement of Earnings. [This answer is incorrect. Statement of Earnings" is an acceptable title for the income statement, but it is not the most frequently used title by nonpublic companies.] 213

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4. Captions within the income statement are not: (Page 205) a. Prescribed by authoritative literature. [This answer is correct. Captions within the income statement will vary based on the nature of a company's operations, the way revenues and expenses are recognized, the detail presented, and the format of the income statement.] b. Determined by the income statement format. [This answer is incorrect. The captions within the income statement will vary based on whether the singlestep or multiplestep formats are used.] c. Based on the way revenues and expenses are recognized. [This answer is incorrect. The recognition of revenues and expenses will affect the captions within the income statement.] 5. According to the additional guidelines provided in SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises: (Page 206) a. Magazine subscriptions may be recognized as revenue when cash is received. [This answer is incorrect. Paragraph 84 of SFAC No. 5 provides that if sale or cash receipt precedes production and delivery, revenues may be recognized as earned by production and delivery.] b. Revenues from precious metals may be recognized at completion of production. [This answer is correct. Per paragraph 84 of SFAC No. 5, if products or other assets are readily realizable because they are salable at reliably determinable prices without significant effort, revenues and some gains or losses may be recognized at completion of production or when prices of the assets change.] c. Revenue from selling an automobile is recognized on the date cash is received. [This answer is incorrect. As a general rule, revenue from selling products is recognized at the date of sale.] d. Revenues from noncontracted construction may be recognized by a percentageofcompletion method. [This answer is incorrect. Paragraph 84 of SFAC No. 5 provides that if the product is contracted for before production, revenues may be recognized by a percentageofcompletion method as production takes place.] 6. According to the AICPA's January 1999 nonauthoritative report, Audit Issues in Revenue Recognition," which of the following may be an indication of improperly recorded sales? (Page 206) a. Sales are recorded after goods are delivered. [This answer is incorrect. Sales being recorded after goods are delivered is not a circumstance that may indicate improper revenue recognition per the AICPA's January 1999 guidance. Generally, if goods have been delivered, a sale has occurred.] b. Sales are recorded after a service is rendered and completed. [This answer is incorrect. Most improperly recorded sales involve physical goods rather than services.] c. Sales are recorded based on purchase orders. [This answer is correct. The AICPA issued the report to assist auditors on when revenue should be recognized in accordance with GAAP . If sales are recorded based on purchase orders, rather than delivery of the product, improper revenue recognition may be occurring.] 7. Generally, principals recognize as revenue the amount charged to the customer and agents recognize as revenue the portion of the amount charged to the customer that they retain. Which of the following provides guidance on whether to recognize revenue as a principal or agent? (Page 207) a. EITF Issue No. 9919. [This answer is correct. EITF Issue No. 9919 (FASB ASC 6054545) addresses the issue of whether the entity should recognize revenue as a principal or agent. The relative strength of each indicator should be evaluated. None of the indicators should be considered presumptive or determinative.] b. Staff Accounting Bulletin No. 101. [This answer is incorrect. Staff Accounting Bulletin No. 101 was issued by the SEC staff to provide additional guidance on revenue recognition in financial statements filed with 214

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the SEC. The SAB does not change any existing guidance on revenue recognition, but explains how the SEC staff applies that guidance to transactions not specifically addressed in the existing guidance.] c. EITF Issue No. 0010. [This answer is incorrect. EITF Issue No. 0010 addresses the issue of whether to recognize charges for shipping and handling as revenue. This guidance requires entities to record as revenue charges to customers for shipping and handling, without regard to whether those charges are designed solely as cost recovery or to generate a profit.] d. Practice Alert 983. [This answer is incorrect. Practice Alert 983, issued by the AICPA's Professional Issues Task Force, addresses revenue recognition issues. The practice alert is intended for auditors but may be useful to financial statement preparers.] 8. The bookkeeper at Alberto's Roofing is preparing the financial statements for the month. According to the expense recognition principles in the Statement of Financial Accounting Concepts No. 6, which of the following expenses would be allocated over several accounting periods? (Page 208) a. Utilities for the office. [This answer is incorrect. A monthly utility bill will be expensed in full each month. Costs that are incurred to obtain benefits that are exhausted in the period in which the costs are incurred are recognized in that period.] b. Cost of goods sold for a small residential roofing job. [This answer is incorrect. The expenses for the job will be recognized in the same period that the revenue was recognized. Costs and revenues that result directly and jointly from the same transaction or event are recognized in the same accounting period.] c. Monthly payment for a local billboard advertisement. [This answer is incorrect. The advertising expense would not be expensed each month as paid or allocated over several accounting periods. The advertising cost should be expensed the first time the advertising occurs.] d. Depreciation on the work truck. [This answer is correct. Costs that provide benefits over several periods are allocated to those periods, such as depreciation.]

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ELEMENTS OF NET INCOME THAT MUST BE PRESENTED SEPARATELY


As noted in the preceding section, there are few strict rules regarding the appropriate format for an income statement. Presenting a company's results of operations in a meaningful way that allows users to evaluate past performance and assess future performance should be the goal. Generally accepted accounting principles do require certain elements of net income to be presented separately, however. Those items are as follows: a. Extraordinary items b. Unusual or infrequent items c. Discontinued operations of a component of an entity d. Equity in operations of investees Generally accepted accounting principles historically haven not addressed the presentation of noncontrolling interests in the income statement. They have generally been shown as a separate line item, however. If more than one of the items in the preceding paragraph exists, the appropriate order of presentation is as follows: a. Income from continuing operations, including, if applicable, unusual or infrequently occurring items, and equity in operations of investees b. Discontinued operations of a component of an entity c. Extraordinary items The following paragraphs discuss accounting and presentation for the elements of net income that must be presented separately. Extraordinary Items Identifying Extraordinary Items. APB Opinion No. 30, Reporting the Results of Operations (FASB ASC 22520452), defines extraordinary items as events or transactions that meet both of the following criteria: a. Unusual Nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. [An event or transaction is not considered to be unusual merely because it is beyond the control of management.] b. Infrequency of Occurrence. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. A presumption underlying the definition of extraordinary items is that an event or transaction should be considered ordinary and usual unless the evidence clearly supports its classification as extraordinary. Thus, classifying an event or transaction as extraordinary would occur only in rare circumstances. In making that determination, the environment in which a company operates, including such factors as the characteristics of its industry, the geo graphical location of its operations, and the nature and extent of governmental regulation, should be a primary consideration. Thus, as a general rule, particular events or transactions do not, of themselves, require classification as extraordinary items. [However, there are exceptions to that rule, which will be discussed later in this lesson.] An event or transaction that may be considered an extraordinary item for one company may not be considered an extraordinary item for another. The materiality of an event or transaction should be considered in deciding whether to present it as an extraordinary item. Materiality should be considered as it relates to individual items, except that the effects of a series of related transactions from a single specific and identifiable event or plan of action should be considered in the aggregate. 216

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Examples of Items That Are Not Extraordinary Items. The following events or transactions generally should not be considered to be extraordinary items:  Writedown or writeoff of receivables, inventories, equipment leased to others, or intangible assets  Gains or losses from sale or abandonment of property, plant, or equipment used in the business  Gains or losses from exchange or translation of foreign currencies including those relating to major devaluations and revaluations  Effects of a strike, including those against competitors and major suppliers  Adjustments of accruals on longterm contracts  Disposals of a component of an entity  Proceeds from life insurance on an officer  Environmental remediation obligations The presentation of unusual or infrequent items that are not considered to be extraordinary items is discussed later in this lesson. Examples of Extraordinary Items. Catastrophic events and natural disasters, such as earthquakes and floods, continue at record levels. The frequency of those occurrences have brought into question whether they generally meet the criteria to be classified as extraordinary items in the income statement. It is believed that whether an event should be considered extraordinary depends on the facts and circumstances. Therefore, an event that is consid ered extraordinary in one set of facts and circumstances may not be considered extraordinary in others. An AICPA Technical Practice Aid at TPA 5400.05 discusses accounting and disclosures related to losses from natural disas ters. According to the TPA, a natural disaster is not considered unusual in nature or unlikely to recur because of the magnitude of the loss from the disaster. To illustrate, a catastrophic flash flood caused by rainfall of an unprecedented intensity that scientists say would likely occur only once in hundreds of years probably should be considered extraordinary. However, a flood caused by a river overflowing in a flood plain probably should not be considered extraordinary. It is also believed that there will be times when it is appropriate to classify the gains and losses that are a direct result of such events as extraordinary items. That treatment will usually be appropriate when the particular event is not reasonably expected to recur in the foreseeable future in the environment in which the entity operates. APB Opinion No. 30 (FASB ASC 22520455) prohibits any portion of such gains and losses that would have resulted from a valuation of the assets on a going concern basis to be included in the extraordinary item. For example, in the case of a fire that destroys a warehouse, any extraordinary loss should not include an adjustment to writedown inventory to market value. In addition, the net effect of the adjustments required when a company no longer meets the criteria for applying SFAS No. 71, Accounting for the Effects of Certain Types of Regulation (FASB ASC 9801015) [SFAS No. 101, Regulated EnterprisesAccounting for the Discontinuation of Application of FASB Statement No. 71 Paragraph6 (FASB ASC 98020402 through 404)], has been designated by authoritative pronouncements as an extraordinary item even though it may not meet the unusual nature or infrequency of occurrence criteria. Income Statement Presentation. Extraordinary items are presented in the following income statement. The APB Opinion No. 30 (FASB ASC 2252045) requirements are explained further in the notes to the following illustration.

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INCOME BEFORE INCOME TAXES AND EXTRAORDINARY ITEM INCOME TAXES INCOME BEFORE EXTRAORDINARY ITEM a EXTRAORDINARY ITEMSettlement of class action customer suit,b net of insurance proceeds (less applicable income taxes of $30,600)c NET INCOME Notes:
a

305,000 91,500 213,500

71,400 $ 142,100

A caption such as Income before extraordinary item" is to be used. If the income statement also shows the cumulative effect of an accounting change and discontinued operations, an appropriate caption is Income from continuing operations before extraordinary item and cumulative effect of a change in accounting principle." Descriptive captions for individual extraordinary items are to be used in the income statement or, if that is not practicable, extraordinary items are to be described in the notes to the financial statements. Income taxes applicable to the extraordinary item, if any, are to be disclosed, preferably on the face of the income statement. Disclosure in the notes to the financial statements is an acceptable alternative, in which case the appropriate caption would be ...(less applicable income taxes)."

Income Taxes Allocated to Extraordinary Items. The income tax allocated to an extraordinary item is a residual amount. In other words, income taxes for the tax effect of pretax income or loss from continuing operations that occurred during the year are allocated to continuing operations and the remainder is allocated to the extraordinary item. In the preceding illustration, assuming a tax rate of 30%, the amount of income taxes allocated to the extraordinary item is calculated as follows: Total Income Taxes Income from continuing operations and extraordinary item ($305,000 * $102,000) Income taxes at 30% Income Taxes Allocated to Continuing Operations Income from continuing operations Income taxes allocated to continuing operations Income Tax Benefit Allocated to Extraordinary Loss Total income taxes Income taxes allocated to continuing operations Income tax benefit allocated to extraordinary loss ($60,900 * $91,500)

$ $ $ $ $ $ $

203,000 60,900 305,000 91,500 60,900 91,500 30,600

This simple illustration assumes that a tax rate of 30% applies both to income before extraordinary items and to the extraordinary item. In practice, the calculation is frequently more complex because of the effect of the surtax exemptions and deferred taxes. 218

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Adjustment of Priorperiod Extraordinary Items. In many circumstances, amounts reported as extraordinary items are based on estimates and require adjustments in subsequent periods. In those cases, unless the adjust ments meet the criteria for priorperiod adjustments, they also should be reported as extraordinary items. Unusual or Infrequent Items APB Opinion No. 30 (FASB ASC 225204516) requires material events or transactions that are either unusual or infrequent, but not both (and therefore, do not meet the criteria for extraordinary items), to be presented in the income statement as separate elements of income from continuing operations. The income statement presentation should not imply that the amounts are extraordinary items; for example, they should not be presented net of tax as separate line items following income from continuing operations. The nature and effects of the events or transac tions should be disclosed on the face of the income statement or in the notes to the financial statements. Examples of items that may be considered as unusual or infrequent, but not both, were listed previously. The following income statement presentation is appropriate for unusual or infrequent items. NET SALES COSTS AND EXPENSES Cost of sales Selling and administrative Loss from foreign currency exchange INCOME BEFORE INCOME TAXES $ 350,000 165,000 95,000 83,000 343,000 7,000

Captions such as Nonrecurring items" or Unusual items" may be used if disclosure of the unusual or infrequent event or transaction is made in the notes to the financial statements. Discontinued Operations SFAS No. 144, Accounting for the Impairment or Disposal of LongLived Assets (FASB ASC 20520), provides guidance on accounting for and reporting discontinued operations. Generally, the standard provides that, an entity should present the results of discontinued operations of a component separate from continuing operations in the income statement. Identifying a Component. A component of an entity is a part of the entity for which operations and cash flows can be clearly distinguished from the rest of the entity, operationally and for financial reporting purposes. Any of the following may be a component of an entity: a. An operating segment, as defined by SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (FASB ASC 28010501) b. A reporting unit, under SFAS No. 142, Goodwill and Other Intangible Assets (FASB ASC 350203533 through 3538) c. A subsidiary d. A group of assets. As a practical matter, for most small and midsize entities, it is believed that a component is the smallest center the entity uses to accumulate components of financial position and results of operations. For example, it may be individual stores, divisions, or product lines. To illustrate considerations in identifying a component, assume that an entity manufactures men's and women's clothing and accessories through separate divisions and distributes them through manufacturers' representatives and directly through companyowned retail stores.  Closing all of the retail stores in a state probably would constitute disposal of a component. 219

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 Discontinuing the manufacture and sale of men's clothing most likely would constitute disposal of a component.  Discontinuing distribution through marketing representatives most likely would not constitute disposal of a component.  Downsizing operations would not constitute disposal of a component.  Shutting down the clothing division would most likely constitute disposal of a component. The results of operations of a component of an entity already disposed of or classified as held for sale are reported as discontinued operations if a. As a result of the disposal transaction, the operations and cash flows of the component have been, or will be, eliminated from the ongoing operations of the entity, and b. after the disposal transaction, the entity will not be significantly involved on an ongoing basis in the operations of the component. As with all accounting pronouncements, the provisions for accounting and reporting discontinued operations need not be applied to immaterial items. Accordingly, it is believed that the results of a component that meet the requirements for discontinued operations need not be presented as a discontinued operation if they are not material to the results of the entity's total operations. As a practical matter, however, the separate presentation of the results of a discontinued component provide the primary financial statement users with information helpful in assessing the entity's financial performance. As an illustration, assume that a distributor of beer and soft drinks finds that its soft drink sales have become considerably less profitable than its beer sales and decides to dispose of the division. Presenting results of the soft drink division as the results of discontinued operations shows the reader that management has identified and eliminated less profitable products and is concentrating on the more profitable ones. Presentation Considerations. In financial statements that include the period in which a component of the entity meets the criteria for its results of operations to be reported as discontinued operations under SFAS No. 144, the statement of income should report the results of the component's operations as discontinued operations for all periods presented. The results of discontinued operations should include impairment losses and subsequent recoveries recognized prior to realization, as well any additional gains and losses recognized on disposal. Any adjustments of amounts previously reported in discontinued operations should be classified separately in the results of discontinued operations in the period during which those adjustments were made. In addition, the financial statements should disclose the nature and amount of the adjustments. The results of operations, net of applicable income taxes, are required to be reported immediately after the results of continuing operations, and before extraordinary items and the cumulative effect of accounting changes (if any). According to SFAS No. 154, Accounting Changes and Error Corrections (FASB ASC 25010455), voluntary changes in accounting principle are no longer reported as a cumulativeeffect adjustment through the income statement of the period of change. The provision for income taxes related to the results of discontinued operations need not be allocated to components of the results of those operations. For example, there is no need to allocate the tax provision to the results of operating the component and the gain or loss on disposal of the component. The following is an example of presenting discontinued operations in the statement of results of operations:

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INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES INCOME TAXES INCOME FROM CONTINUING OPERATIONS DISCONTINUED OPERATIONS Loss from operations of discontinued component, including loss on disposal of $90,000 Provision for income tax benefit NET INCOME $

296,000 88,800 207,200

(42,000 ) 12,600 (29,400 ) 177,800

If the income statement also shows extraordinary items or the cumulative effect of an accounting change, appropri ate captions are Income from continuing operations before extraordinary item" or . . . before extraordinary item and cumulative effect of a change in accounting principle." Costs Associated with Exit or Disposal Activities The discussion earlier in this lesson provides accounting guidance when discontinuing an entire component of an entity. Historically, guidance on accounting for costs incurred to discontinue an activity that is less than an entire segment has been limited. As a result, the tendency by many companies was to take significant, onetime charges (often called restructuring charges) before management had a specific plan to alter a company's operations. Those charges often included writing off certain expenses that would otherwise reduce earnings over a longer period of time. The resulting effect was almost always dramatically improved earnings in a short period of time. Restructuring charges continue to be subjected to increased scrutiny, as many companies have accrued unsupported or undersupported reserves for planned exit activities and then charged operating expenses against the inflated restructuring reserves in subsequent periods. SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (FASB ASC 42010), applies to costs associated with disposal activities accounted for under SFAS No. 144 (FASB ASC 25020) and to exit activities, including restructuring costs, but not to activities associated with a business combination or to costs related to the retirement of longlived assets. Those issues are subject to the guidance in EITF Issue No. 953, Recognition of Liabilities in Connection with a Purchase Business Combination," and SFAS No. 143, Accounting for Asset Retire ment Obligations (FASB ASC 41020), respectively. The following are categories of costs associated with disposal or exit activities:  Onetime termination benefits  Termination of a contract, other than a capital lease  Other associated costs, including the consolidation of facilities or the relocation of employees The timing of the recognition and the measurement of exit or disposal costs differ depending on the type of costs associated with the activity. However, costs are accrued only when the definition of a liability is met. FASB Concepts Statement No. 6, Elements of Financial Statements, defines a liability as: . . . probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (FASB ASC 805), which applies prospectively to business combinations with an acquisition date on or after the beginning of the first annual 221

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reporting period beginning on or after December 15, 2008. Earlier application is not permitted. The new Standard revises SFAS No. 146 (FASB ASC 42010153) and nullifies the guidance in EITF Issue No. 953. Subsequent to the effective date of the new Standard, costs associated with exit activities including exit activities associated with an entity newly acquired in a business combination would be accounted for in accordance with SFAS No. 146 (FASB ASC 420). Onetime Termination Benefits. Onetime termination benefits represent benefits provided to involuntarily termi nated employees under an arrangement associated with a specified termination event or a specified future period. To be considered onetime," the benefits must not be provided according to an ongoing benefit arrangement or an individual deferred compensation contract. FASB Staff Position No. FAS 1461, Determining Whether a OneTime Termination Benefit Offered in Connection with an Exit or Disposal Activity Is, in Substance, an Enhancement to an Ongoing Benefit Arrangement, (FASB ASC 42010551; 71530604), clarifies this requirement by providing that if additional termination benefits represent a revision to an ongoing benefit arrangement that is not limited to a specified termination event or specified future period, the benefits should be accounted for according to the provisions of SFAS Nos. 87, 88, 106, or 112 (FASB ASC 71210 and 71510 through 60). A onetime benefit arrangement is deemed to exist when a termination plan has been communicated to employees and meets all of the following criteria (this event is referred to as the communication date"):  Management has committed to a plan of termination.  The plan establishes an expected completion date and identifies specific information regarding the employees to be terminated. The number of employees, their job classification, and their location should be included.  The plan includes sufficient information to allow employees to figure the benefits to which they will be entitled if they are terminated under the plan. This information should include the type and amount of benefits to be provided.  It is unlikely that the plan will be altered significantly or withdrawn altogether prior to execution. The requirements for recognizing and measuring a liability for onetime termination benefits differ depending on the level of continued service affected employees are required to provide to receive the benefits. If continued service is required, GAAP differentiates between plans that require continued service beyond a minimum retention period and those that do not. For purposes of this analysis, the minimum retention period must be less than or equal to any legal notification period applicable to the entity or 60 days if no legal requirement exists. A legal notification period may be established pursuant to an existing law or statute, or a contract between the entity and another party (such as a labor union). a. Future Service Is Required beyond the Minimum Retention Period. The initial liability should be measured at the communication date and should be recognized ratably over the future service period. It should be based on the fair value of the benefits as of the termination date. Subsequent changes to the plan should be recognized as follows: (1) Changes in the liability prior to the termination date due to revised expected cash flows should be measured using the same creditadjusted riskfree rate used in the initial measurement. The cumulative effect of the change should be recognized in the period of change. (2) Changes subsequent to the termination date resulting from the passage of time should be recorded as an expense (e.g., accretion expense) and an increase in the carrying amount of the liability. The charges should not be considered interest cost for purposes of capitalization or classification in the income statement. (3) Changes subsequent to the termination date due to revised expected cash flows should be recognized in the period of change. The cumulative effect should be reported in the same line on the income statement used to record the initial costs. 222

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b. Future Service Is Not Required or Is Required But the Service Period Is Less Than the Minimum Retention Period. The initial liability should be measured and recorded at the fair value of the benefits at the communication date. Subsequent changes to the plan should be recognized as follows: (1) If the plan is amended subsequent to the communication date resulting in the retention of employees beyond the minimum period, the initial liability should be recomputed using the same guidelines for plans that require continued employee service beyond the minimum retention period as discussed in item a. The cumulative effect of the change should be recognized in the period of the change. (2) Changes subsequent to the termination date resulting from the passage of time should be recorded as an expense (e.g., accretion expense) and an increase in the carrying amount of the liability. The charges should not be considered interest cost for purposes of capitalization or classification in the income statement. (3) Changes subsequent to the termination date due to revised expected cash flows should be recognized in the period of change. The cumulative effect should be reported in the same line on the income statement used to record the initial costs. Certain onetime termination benefit plans may also include termination benefits offered briefly to employees in exchange for their voluntary termination. Such voluntary termination benefits should be measured and accounted for in accordance with SFAS No. 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits (FASB ASC 71210251). In these cases, a liability should be recog nized when employees accept the offer for the termination benefits and the amount of the benefits can be reasonably estimated. Involuntary benefits offered under these plans should be measured as discussed previously. Contract Termination Costs. SFAS No. 146 (FASB ASC 42010) applies to costs associated with the termination of an operating lease and other contracts prior to the end of the contract's term. It also applies to costs under a contract that continue to be incurred until the end of the term without providing ongoing benefit to the entity, such as early termination penalties and remaining lease commitments. The guidance does not apply to costs associated with the termination of a capital lease. Those costs should be accounted for using the guidance provided by SFAS No. 13, Accounting for Leases (FASB ASC 8403040). The liability associated with contract termination costs should be measured at fair value. The timing of the recogni tion of the liability differs based on the timing of the termination as follows:  Contracts Terminated Prior to the End of a Contract. The liability should be measured at fair value and recognized at the date of termination when a contract is terminated in accordance with the provisions of the contract.  Contracts That Continue for the Remaining Term. The liability for costs that continue to be incurred should be recorded when an entity no longer has the right to the property, goods, or services to which the contract applies. The liability should be measured at fair value and should include consideration of remaining contract payments, prepaid or deferred costs recognized under a lease, and a reduction for estimated sublease rentals that could be obtained for the property under lease. The reduction for sublease rentals should be applied regardless of the entity's intention to sublease the property.  Changes Subsequent to Initial Measurement. For both types of contracts, changes to the liability subsequent to the initial determination date should be calculated using the same creditadjusted riskfree rate used in the initial measurement. The cumulative effect of any adjustment to the liability resulting from revisions to the timing or amount of benefits to be provided should be recognized in the period of change. The cumulative effect should be reported in the same line on the income statement used to record the initial costs. Changes resulting from the passage of time are to be recognized as an expense and an increase in the carrying amount of the liability. However, those costs should not be considered interest cost for purposes of capitalization of interest costs or for purposes of classification in the income statement. Costs to Consolidate or Close Facilities, Relocate Employees, and Other Associated Costs. Costs other than those related to onetime termination benefits and contract terminations should be measured at fair value only when incurred. Earlier recognition is not permitted. 223

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Presentation and Disclosure. Costs related to exit or disposal activities should be included in income from continuing operations unless the costs are associated with a discontinued operation. In that case, the costs should be included in the results of discontinued operations. If an entity's obligation for the liability is eliminated in a subsequent period, the liability should be removed from the entity's balance sheet. All previouslyrecognized costs should be reversed and presented in the same income statement line in which the costs were originally presented. SFAS No. 146 requires a number of disclosures relating to costs associated with exit or disposal activities. Exit Costs Resulting from a Business Combination. In many cases, a plan to terminate certain employees or exit certain business activities occurs as a result of a business combination. In those cases, the termination or exit plan is implemented only if the combination is consummated. EITF Issue No. 953, Recognition of Liabilities in Connection with a Purchase Business Combination," requires certain exit costs to be recognized as a liability in the purchase price allocation in a purchase business combination. EITF Issue No. 953 has been nullified by SFAS No. 141(R) (FASB ASC 805). EITF Issue No. 965, Recognition of Liabilities for Contractual Termination Benefits or Changing Benefit Plan Assumptions in Anticipation of a Business Combination," requires that liabilities for contrac tual termination benefits and curtailment losses under employee benefit plans that will be triggered by a business combination should be recognized when the combination is consummated. Equity in Operations of Investees The basic principles to be observed in recording an investor's share of earnings or losses of such an investee are: a. An investor's equity in the operating results of an investee should be based on the shares of common stock held. b. Intercompany profits and losses should be eliminated until realized. c. Dividends on the investee's cumulative preferred stock should be deducted in computing an investor's share of earnings whether or not such dividends are declared. d. The investor ordinarily should discontinue applying the equity method when accounting for its share of losses reduces the investment to zero and should not provide for additional losses unless the investor has guaranteed obligations of the investee or is otherwise committed to provide further financial support for the investee. If the investee subsequently reports net income, the investor should resume applying the equity method only after its share of that net income equals the share of net losses not recognized during the period the equity method was suspended. EITF Issue No. 9813, Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee" (FASB ASC 3231035 and 3231055), states that if previous losses have reduced an equity investment to zero and the investor is not required to advance additional funds to the investee, the investor should continue to report its share of equity method losses to the extent of any other investments in the investee. Other investments in the investee include (but are not limited to) preferred stock, debt securities, and loans to the investee. The equity method losses should reduce the adjusted basis in other invest ments in the order of their priority in liquidation. The basis of the other investments should be adjusted for the equity method losses before adjusting their basis for fair value adjustments required by other accounting pronounce ments (such as adjustments required by SFAS No. 114 (FASB ASC 3101035) for loans and SFAS No.115 (FASB ASC 3201035) for unrealized gains and losses on debt securities). Equity method losses should not be recorded after the adjusted basis of the other investments reaches zero. However, the investor should continue to track the amount of equity method losses so that if the investee subsequently reports net income, the investor can resume applying the equity method after its share of that net income equals the share of net losses not recognized during the period the equity method was suspended (as described in item d. above). The subsequent recording of equity method income should be applied to the adjusted basis of the other investments in reverse order of the application of the equity method losses. EITF Issue No. 9910, Percentage Used to Determine the Amount of Equity Method Losses" (FASB ASC 323103527 through 3528), addresses how the investor should calculate the amount of equity method losses when previous losses have reduced the equity investment to zero. In concluding that equity method losses should 224

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not be recognized based solely on the investor's percentage of common stock in the investee, the EITF discussed (but did not reach a consensus on) two possible methods investors could use to recognize equity method losses when previous losses have reduced the equity investment to zero. Those methods are: a. Using the Ownership Percentage of the Security or Loan That Is Being Reduced for the Equity Method Losses. For example, after reducing its common stock investment in an equity method investee to zero, an investor that owns 50% of an investee's preferred stock could reduce the preferred stock investment by 50% of the investee's losses. Similarly, after reducing its common stock investment (as well as any preferred stock investment) to zero, an investor that has made a loan to the investee that represents 60% of all loans extended to the investee could reduce the basis of the loan by 60% of the investee's losses. b. Using the Change in the Investor's Claim on the Investee's Book Value (Calculated as If the Investee Liquidated Its Assets and Liabilities at Book Value). After reducing its common stock investment in an equity method investee to zero, an investor would subtract its claim on the investee's book value from the amount the investor would receive if the investee liquidated its assets and liabilities at book value. The investor would recognize the difference as its share of the investee's losses and correspondingly reduce any preferred stock investment in the investee or the basis in any loan made to the investee. The EITF noted that other methods of calculating equity method losses after previous losses have reduced a common stock investment to zero also may be acceptable. However, the investor should apply only one method entitywide to determine the amounts of such equity method losses. Investors are required to disclose the selected method in the notes to the financial statements. Income Statement Presentation. APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (FASB ASC 32310451 through 452), states that an investor's share of earnings or losses of an investee should ordinarily be shown as a single amount except that the investor's share of extraordinary items reported in the investee's financial statements should be reported as an extraordinary item in the investor's financial statements. (APB Opinion No. 18 (FASB ASC 22520502) requires investors to record their share of priorperiod adjustments recognized by investees.) SFAS No. 130, Reporting Comprehensive Income (FASB ASC 323103518 and 453), states that an investor should record its proportionate share of an investee's equity adjustments for other comprehensive income (e.g., unrealized gains and losses on availableforsale marketable securities) as increases or decreases to the invest ment account with corresponding adjustments in equity. The investor may combine its own other comprehensive income with its proportionate share of the investee's other comprehensive income and display the aggregate amounts in a combined statement of income and comprehensive income, in a separate statement of comprehen sive income, or in a statement of changes in stockholders' equity. The format the investee uses to display other comprehensive income does not impact how the investor displays its proportionate share of those amounts. GAAP does not address whether the equity in the operating results of investees should be presented before or after the tax provision. Although practice varies, it is typically presented after the provision as illustrated below. As discussed previously, SFAS No. 109 (FASB ASC 740105011 through 5014) requires certain disclosures when ever the tax provision attributable to continuing operations varies from the amount that would be obtained by applying federal statutory rates to pretax income from continuing operations. For that purpose, it is believed that pretax income from continuing operations should be considered to include the equity in the operating results of investees, even if it is reported after the tax provision. The following income statement illustrates recording equity in earnings of investees as a separate item after the caption for income taxes:

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INCOME TAXES INCOME BEFORE EQUITY IN INCOME OF INVESTEE AND EXTRAORDINARY ITEM EQUITY IN INCOME OF INVESTEE, EXCLUSIVE OF EXTRAORDINARY ITEM INCOME BEFORE EXTRAORDINARY ITEM EQUITY IN EXTRAORDINARY ITEM OF INVESTEE NET INCOME Captions should describe the circumstances. For example,  Income before earnings of affiliates  Income before earnings of nonsubsidiary companies and  Equity in net income of ABC Company  Equity in earnings of affiliates  Equity in net earnings of XYZ Company Other affiliated companies $

186,000 279,000 103,000 382,000 (60,000 ) 322,000

Different Fiscal Year. In some cases, an investor and investee may have different fiscal years. APB Opinion No. 18 (FASB ASC 32310356), however, permits the investor's share of earnings to be recognized based on the most recent available" financial statements of the investee. While the Opinion does not indicate the time lag that is acceptable, ARB No. 51 (FASB ASC 810104512) states that a difference between fiscal years of a parent and a subsidiary of three months or less is acceptable for consolidations. With respect to investments accounted for by the equity method, it is believed that (a) the length of the time lag becomes more significant as the equity in the results of operations of the investee becomes more material to the investor's financial statements and (b) the threemonth provision should be used as a general guideline. When the year ends of an investor and an investee differ, the opinion does not address how to account for transactions that occur in the intervening period. Paragraph 4 of ARB No. 51 (FASB ASC 810104512) discusses a similar situation in the consolidated financial statements of a parent and a subsidiary, however, and states that recognition should be given by disclosure or otherwise to the effect of intervening events that materially affect the financial position or results of operations." While some accountants believe that disclosure of intervening events is sufficient, if a significant transaction occurs during the intervening period, this course takes the point of view that the transaction should be reflected in the financial statements. As an example, assume that a corporation issuing its annual financial statements at June 30, 20X1, owns a 30% interest in a real estate trust that reports on a calendar year basis. Historically, transactions in the trust have consisted primarily of interest income and interest expense and, since those amounts generally did not fluctuate significantly during the year, the company has reported its equity in the trust using the calendar year information provided by the trust. However, in March 20X1, the trust sold real estate at a substantial gain, and the corporation's equity in the gain is material to its financial statements. It is recommended that the equity pickup in the corporation's June 30, 20X1, financial statements reflect its 30% interest in the operations for the year ended December 30, 20X0, plus its 30% interest in the March 20X1 gain. (That same conclusion would apply if the real estate had been sold at a substantial loss.) 226

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EITF Issue No. 069, Reporting a Change in (or the Elimination of) a Previously Existing Difference between the Fiscal YearEnd of a Parent Company and That of a Consolidated Entity or between the Reporting Period of an Investor and That of an Equity Method Investee" (FASB ASC 810104513; 81010502), indicates a parent or an investor should report a change to or elimination of a previously existing difference between the parent's or investor's reporting period and the reporting period of a consolidated entity or equity method investee as a change in accounting principle in accordance with SFAS No. 154. (FASB ASC 2501045). Minority, or Noncontrolling, Interests Minority interests generally refer to the investment in the voting stock of a subsidiary that is not held by the parent company. Prior to the issuance of SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements (FASB ASC 81010), GAAP did not specifically address the presentation of minority interests in the income statement. When minority interests existed, consolidated net income was typically reduced by the minority inter ests' proportionate share of earnings or increased by the minority interests' proportionate share of losses. Minority interests were sometimes presented as a separate line item after the caption for income taxes (as illustrated below) or as a separate line item before Income before income taxes," either as an element of operating expenses or as an other" expense (as illustrated below). The following example presents minority interests as a separate item after the caption for income taxes: INCOME BEFORE INCOME TAXES AND MINORITY INTERESTS INCOME TAXES INCOME BEFORE MINORITY INTERESTS MINORITY INTERESTS IN SUBSIDIARIES' EARNINGS NET INCOME $ 143,000 43,000 100,000 16,600 83,400

The following examples present minority interests as an element of operating expenses and as an other" expense: COSTS AND EXPENSES Cost of sales Selling, general, and administrative expenses Minority interests in net income of consolidated subsidiaries or NET SALES COST OF SALES INCOME FROM OPERATIONS OTHER EXPENSES Minority interests in net income INCOME BEFORE INCOME TAXES $ 540,000 250,000 290,000 5,800 284,200 242,000 85,000 6,000 333,000

The FASB issued SFAS No. 160 (FASB ASC 81010) in December 2007 to, among other things, establish reporting standards for the presentation of noncontrolling interests in consolidated financial statements. The new Statement is effective for fiscal years beginning on or after December 15, 2008. Early adoption is prohibited. 227

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The new Statement replaces the term minority interest(s) with the term noncontrolling interest(s). Once effective, it will require net income or loss to be attributed to the parent and the noncontrolling interest. Further, it requires the amounts of consolidated net income and the consolidated net income attributable to the parent and the noncon trolling interest to be clearly identified and separately presented on the face of the consolidated statement of income. The revenues, expenses, gains, losses, and net income or loss are required to be reported at consolidated amounts. The following example illustrates the presentation of consolidated net income and the amounts attribut able to the parent and the noncontrolling interest on the face of a consolidated income statement: CONSOLIDATED NET INCOME LESS:NET INCOME ATTRIBUTABLE TO THE NONCONTROLLING INTEREST NET INCOME ATTRIBUTABLE TO THE COMPANY $ 160 (18 ) $ 142

If the consolidated financial statements report income from continuing operations, discontinued operations, or extraordinary items, the amounts attributable to the parent for each should be disclosed in the notes to the financial statements or on the face of the consolidated income statement.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 9. According to generally accepted accounting principles, all of the following items are required to be presented separately in the income statement except: a. Noncontrolling interest. b. Discontinued operations. c. Unusual items. d. Extraordinary items. 10. An extraordinary item is an event or transaction that is: a. Beyond the control of management. b. Unusual in nature and occurs infrequently. c. Unexpected by management. 11. Which of the following is considered an extraordinary item? a. Disposals of a component of an entity. b. Gains or losses from exchange or translation of foreign currencies including those relating to major devaluations and revaluations. c. The net effect of the adjustments required when a company no longer meets the criteria for applying SFAS No. 71. d. Writedown or writeoff of receivables. 12. SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (FASB ASC 42010), applies to which of the items below? a. Activities associated with a business combination. b. Costs related to the retirement of longlived assets. c. Costs associated with the termination of a capital lease. d. Costs associated with the termination of an operating lease.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 9. According to generally accepted accounting principles, all of the following items are required to be presented separately in the income statement except: (Page 216) a. Noncontrolling interest. [This answer is correct. Generally accepted accounting principles do not address presenting noncontrolling interest in the income statement. However, they have generally been shown as a separate line item.] b. Discontinued operations. [This answer is incorrect. Discontinued operations of a component of an entity are to be presented separately in the income statement. If all of the elements of net income are presented, discontinued operations of a component of an entity is presented second.] c. Unusual items. [This answer is incorrect. Generally accepted accounting principles require unusual or infrequent items to be presented separately in the income statement. If all of the elements of net income are presented, income from continuing operations, including unusual items, is presented first.] d. Extraordinary items. [This answer is incorrect. Extraordinary items are required to be presented separately in the income statement per generally accepted accounting principles. If all of the elements of net income are presented, extraordinary items are presented third.] 10. An extraordinary item is an event or transaction that is: (Page 216) a. Beyond the control of management. [This answer is incorrect. An event or transaction is not considered to be extraordinary just because it is beyond the control of management, such as union worker strikes.] b. Unusual in nature and occurs infrequently. [This answer is correct. An extraordinary item is an event or transaction that is both unusual in nature and occurs infrequently per APB Opinion No. 30 (FASB ASC 2252045). This permits the classification of an event or transaction as extraordinary only in rare circumstances.] c. Unexpected by management. [This answer is incorrect. Although many extraordinary items are not expected by management, some transactions such as the writedown of inventory, which may not have been expected is generally not an extraordinary item.] 11. Which of the following is considered an extraordinary item? (Page 217) a. Disposals of a component of an entity. [This answer is incorrect. The disposal of a component of an entity as well as proceeds from life insurance on an officer should not be classified as extraordinary items.] b. Gains or losses from exchange or translation of foreign currencies including those relating to major devaluations and revaluations. [This answer is incorrect. Extraordinary items generally should not include gains or losses from exchange or translation of foreign currencies including those relating to major devaluations and revaluations.] c. The net effect of the adjustments required when a company no longer meets the criteria for applying SFAS No. 71. [This answer is correct. This is an extraordinary item even though the transaction may not meet the unusual nature or infrequency of occurrence criteria.] d. Writedown or writeoff of receivables. [This answer is incorrect. Authoritative guidance states that the writedown or writeoff of receivables, inventories, equipment leased to others, or intangible assets should generally not be considered an extraordinary item.]

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12. SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (FASB ASC 42010), applies to which of the items below? (Page 223) a. Activities associated with a business combination. [This answer is incorrect. Activities associated with a business combination are not covered under SFAS No. 146 (FASB ASC 42010). They are subject to the guidance in EITF Issue No. 953, Recognition of Liabilities in Connection with a Purchase Business Combination."] b. Costs related to the retirement of longlived assets. [This answer is incorrect. SFAS No. 143, Accounting for Asset Retirement Obligations (FASB ASC 42010), covers costs related to the retirement of longlived assets. SFAS No. 146 (FASB ASC 42010) does not provide guidance on this subject.] c. Costs associated with the termination of a capital lease. [This answer is incorrect. The costs associated with the termination of a capital lease should be accounted for using the guidance provided by SFAS No.13, Accounting for Leases (FASB ASC 8403040). This subject is not covered under SFAS No. 146 (FASB ASC 42010).] d. Costs associated with the termination of an operating lease. [This answer is correct. SFAS No. 146 (FASB ASC 42010) applies to costs associated with the termination of an operating lease and other contracts prior to the end of the contract's term. SFAS No. 146 (FASB ASC 42010) does not apply to costs associated with a capital lease.]

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Lesson 2:The Accounting and Presentation of Certain Expenses Related to the Statement of Income
Introduction
This lesson will highlight particular types of expenses and the timing for recognition in the income statement. In addition, the required disclosures of these expenses will be covered. Learning Objectives: Completion of this lesson will enable you to:  Assess accounting and presentation issues related to depreciation, startup costs, research and development, and computer software.  Assess accounting and presentation issues related to rent expenses, advertising costs, and retroactive adjustment of workers' compensation and other expenses. Depreciation Paragraph 5 of APB Opinion No. 12, Omnibus Opinion1967 (FASB ASC 36010501), requires the following disclosures to be made about depreciable assets and depreciation: a. Depreciation expense for the period b. Balances of major classes of depreciable assets at the balance sheet date by nature or function c. Accumulated depreciation, either by major classes of depreciable assets or in total at the balance sheet date d. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets While determination of the amount of depreciation expense for a period is usually straightforward, it may be difficult if some depreciation is included in overhead and distributed to various inventory accounts and ultimately expensed through cost of sales. An AICPA technical practice aid at TIS 5210.02 indicates that, in those circumstances, it has become recognized practice to report the amount of depreciation charged to manufacturing costs and to expense accounts as the depreciation expense for the period even though depreciation included in inventories at the beginning and end of the period varies sufficiently to affect depreciation included in cost of sales. The amount of depreciation expense for the period may be disclosed: a. as a separate line item in the income statement; b. parenthetically in the income statement; c. in the notes to the financial statements; or d. in the statement of cash flows' reconciliation of net income to net cash flows from operating activities. Recording depreciation for financial accounting purposes in accordance with the (modified) Accelerated Cost Recovery System required for tax purposes is a departure from GAAP . Calculating depreciation for financial accounting purposes in accordance with one of the methods acceptable under GAAP would, if the differences are material, require the tax effects of the differences to be reflected in income tax expense. 232

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Startup Costs SOP 985, Reporting on the Costs of StartUp Activities (FASB ASC 7201515 and 7201525), requires the costs of startup activities (including organization costs) to be expensed as incurred. This guidance applies to all nongov ernmental entities, including development stage companies. The SOP broadly defines startup activities as activi ties related to organizing a new business, as well as onetime activities associated with:  Opening a new facility  Introducing new products or services  Conducting business with a new class of customers or in a new territory  Starting a new process in an existing facility or starting a new operation Organization costs, preopening costs, and preoperating costs are specifically identified as startup costs. Organi zation costs represent costs incurred in establishing a legal entity and include the costs of preparing such items as the company charter, a partnership agreement, bylaws, minutes of organizational meetings, and original stock certificate terms. The accounting requirements do not distinguish between organization costs and other startup costs; however, the SOP does not prohibit companies from separately reporting such costs in their income statements or separately disclosing such costs in the notes to the financial statements to emphasize the nature of the costs. Activities that are part of ongoing routine efforts to refine, enrich, or improve an existing product, service, process, or facility are not considered startup activities and are not within the scope of the SOP . Likewise, activities related to a merger or acquisition or to ongoing customer acquisition are not considered startup activities. In addition, the following costs are outside the scope of the SOP , even though such costs may be incurred in connection with a company's startup activities:  Costs of acquiring or constructing longlived assets and preparing them for their intended uses  Costs of acquiring or producing inventory  Costs of acquiring intangible assets  Costs related to internally developed assets (e.g., internaluse computer software costs)  Costs that are within the scope of SFAS No. 2, Accounting for Research and Development Costs (FASB ASC 7301015), and SFAS No. 71, Accounting for the Effects of Certain Types of Regulation (FASB ASC 980)  Costs of fund raising incurred by nonprofit organizations  Costs of raising capital  Costs of advertising  Costs incurred in connection with existing contracts as specified in paragraph 75d of SOP 811, Accounting for Performance of ConstructionTypeand Certain ProductionType Contracts, (FASB ASC 6053525) The preceding costs should be accounted for in accordance with other existing authoritative accounting literature and should not be capitalized unless they qualify for capitalization under those generally accepted accounting principles. The costs of using longlived assets (e.g., depreciation), intangible assets (e.g., amortization of a purchased patent), or internally developed assets that are allocated to startup activities are within the scope of the SOP . Although ongoing efforts to acquire customers are not considered startup activities, conducting business with a new class of customer is considered a startup activity. For example, a manufacturer that previously sold all of its 233

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products to retailers would be conducting a startup activity if the manufacturer attempted to sell its products directly to the public. In contrast, attempting to sell to new retailers would not be considered a startup activity. The appendix to the SOP includes several examples of startup costs that are subject to the provisions of the SOP , including the following:  Travel, salary, and consulting costs related to feasibility studies, accounting, legal, tax, and governmental affairs when opening a plant in a new market  Training costs for new employees when opening a new plant  Recruiting, organizing, and training costs when establishing a distribution network in a new market  Salary, training, and travel costs for new employees and management when opening new stores (in both existing and new markets) In addition, the appendix provides the following examples of costs that are outside the scope of the SOP:  Costs of a new plant and production equipment  Internaluse computer software development costs related to opening a new plant  Inventory costs  Advertising costs related to opening of a new store  Costs of furniture and equipment for a new store Research and Development Costs SFAS No. 2, Accounting for Research and Development Costs (FASB ASC 73010), generally requires all research and development costs to be charged to expense when incurred, rather than recording them as inventory, elements of overhead, or otherwise deferring them to future periods. Costs incurred for research and development contracts (e.g., government contracts with defense contractors) are generally recorded as inventory or a receivable until the related revenue is recorded. In addition, EITF Issue No. 073, Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities," requires certain advance payments for goods or services that will be used or rendered for future research and development activities and that are nonrefundable to be deferred and capitalized. This guidance should be applied prospectively to new contracts entered into in fiscal years beginning after December 15, 2007. Costs that should be expensed as research and development are as follows: a. Intangible assets purchased from others and materials, equipment, and facilities acquired or constructed for a particular research and development project that have no alternative future uses. Intangible assets purchased from others and materials, equipment, and facilities that have alternative future uses, including use in other research and development projects, should be capitalized. Reduction of capitalized costs should be considered research and development costs. b. Salaries and related costs of personnel engaged in research and development activities. c. Services performed by others in connection with research and development activities. d. Reasonable allocation of indirect costs (except general and administrative costs not clearly related to research and development activities). Total research and development costs charged to expense are required to be disclosed for each period for which an income statement is presented. Disclosure of total research and development costs may be made (a) by 234

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separate lineitem presentation in the income statement, (b) parenthetically in the income statement, or (c) in the notes to the financial statements. If research and development costs are a significant element of expense, they usually are disclosed as a separate line item in the income statement. The following are two methods of presenting research and development costs in the income statement: a. Costs and expenses Cost of sales Selling General and administrative Research and development Costs and expenses Cost of sales Selling General and administrative (including research and development expense of $25,000)

200,000 90,000 125,000 25,000

b.

200,000 90,000 150,000

SFAS No. 141 (revised 2007), Business Combinations (FASB ASC 805), which was issued in December 2007, amends SFAS No. 2 (FASB ASC 73010154) to exclude research and development assets acquired in a business combination from the scope of SFAS No. 2. Assets acquired in a business combination that are used in research and development activities should be recognized and measured at fair value regardless of whether the assets have an alternative future use. SFAS No. 141(R) (FASB ASC 805) applies prospectively to business combinations with an acquisition date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier application is not permitted. Computer Software Costs Computer Software to Be Sold, Leased, or Marketed. SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed (FASB ASC 985), requires companies to classify the costs of planning, designing, and establishing the technological feasibility of a computer software product as research and development costs and to charge those costs to expense when incurred. After the technological feasibility has been established, costs of producing product masters should be capitalized and amortized. (Capitalized costs should be evaluated at each balance sheet date and amounts that exceed net realizable value should be written off.) Costs incurred for duplicating the computer software, documentation, and training materials from the product masters and for physically packaging the product for distribution should be capitalized as inventory and charged to cost of sales when revenue is recognized. Costs of maintenance and customer support should be charged to expense when related revenue is recognized or when those costs are incurred, whichever occurs first. Neither SFAS No. 2 (FASB ASC 73010) nor SFAS No. 86 (FASB ASC 985) apply to computer software created for others under a contractual arrangement. For computer software created for internal use, SFAS No. 2 (FASB ASC 73010) applies, but SFAS No. 86 (FASB ASC 985) does not. SFAS No. 141 (revised 2007), Business Combinations (FASB ASC 805), which was issued in December 2007, amends SFAS No. 86 (FASB ASC 98520152 and 153) to exclude research and development assets acquired in a business combination from the scope of SFAS No. 86. Assets acquired in a business combination that are used in research and development activities should be recognized and measured at fair value. However, costs incurred after the date of a business combination related to computer software to be sold, leased, or otherwise marketed as a separate product or as part of a product or process, whether internally developed and produced or purchased, should be accounted for in accordance with SFAS No. 86 (FASB ASC 98520). SFAS No. 141(R) (FASB ASC 805) applies prospectively to business combina tions with an acquisition date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier application is not permitted. The following are required to be disclosed: a. Total research and development costs incurred for a computer software product to be sold, leased, or otherwise marketed, charged to expense for each period for which an income statement is presented 235

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b. Unamortized computer software costs included in each balance sheet presented c. Total amount charged to expense in each income statement presented for amortization of capitalized computer software costs and for amounts written down to net realizable value Guidance on disclosing total research and development costs is given previously in this lesson. The other disclo sures generally are made in the notes to the financial statements. Internaluse Computer Software. SOP 981, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (FASB ASC 35040), provides guidance on accounting for the costs of software that entities purchase or develop for their own use. (Costs related to software to be sold or leased to others as a product or part of a separate process are discussed above.) In addition, costs incurred for internaluse software used in research and development activities are discussed in a prior paragraph. Companies must properly classify applica ble software costs as part of research and development activities to meet GAAP's requirements to expense research and development costs and disclose the amount of such expense for each period. The SOP specifies that costs for the following internaluse software should be included as research and development expenses:  Software purchased or leased for use in research and development activities if the software has no alternative future uses.  Internaluse software developed as a pilot project or for use in a specific research and development project, regardless of whether the software has alternative future uses [the software may be internally developed or developed by third parties (such as programmer consultants)]. Software must meet both of the following criteria to fall under the scope of the SOP and be considered internaluse software: a. The software must be acquired, internally developed, or modified solely to meet the entity's needs. b. While the software is being developed or modified, no substantive plans can exist or be under development to market the software externally. A joint development arrangement with another entity for mutual internal use of the software is not considered a substantive plan to market the software. Likewise, routine market feasibility studies are not considered substantive plans to market software. Accounting for internaluse software depends on when the costs are incurred. The SOP defines the following stages of software development:  Preliminary Project Stage. Includes costs incurred for conceptualizing and evaluating software alternatives, determining existence of needed technology, and selecting final alternatives. Costs incurred during the preliminary project stage should be expensed as incurred.  Application Development Stage. Includes costs related to designing the chosen alternative (including software configuration and interfaces), coding, installing hardware, and testing. Costs incurred during the application development stage generally must be capitalized. However, training costs incurred during that stage should be expensed as incurred.  Postimplementation/Operation Stage. Includes costs related to training and software application maintenance. Postimplementation costs should be expensed as incurred. Costs incurred for the development or purchase of software necessary for access or conversion of old data by the new system may be capitalized. However, the actual costs of converting the data (for example, salaries of employees involved in performing data conversion duties such as reconciling data between the old and new systems) should be expensed as incurred. Even though the costs of bridging" software used to facilitate data conversion may be capitalized, the software may not have an alternative future use if it can only be used for a specific data conversion effort. In that case, the software's useful life may be so short that capitalization is effectively 236

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precluded. Consequently, when capitalizing bridging" software, companies should assess whether the software has an alternative future use. Entities must capitalize the following types of costs if they otherwise meet the criteria for capitalization discussed in the previous paragraph:  Direct external costs of materials and services used in developing or obtaining internaluse software (for example, fees paid to consultants for services provided to develop the software during the application development stage)  Payroll and related costs for employees who are directly involved with and devote time to the development of the internaluse software project (for example, salaries and benefits for programmers writing code during the application development stage)  Interest costs incurred during the development of internaluse software [in accordance with SFAS No. 34, Capitalization of Interest Cost (FASB ASC 83520)] The SOP specifically precludes capitalizing general and administrative costs and other overhead costs as costs of internaluse software. Additionally, how capitalized internaluse software should be classified on the balance sheet is not addressed, other than to state that such software is a longlived asset covered by SFAS No. 144 (FASB ASC 36010). Therefore, capitalized software could be presented with other longlived assets or with intangible assets. Capitalization should begin when the preliminary project stage is complete and management authorizes and commits to fund the project. In addition, it must be probable that the project will be completed and the software will perform its intended function. Capitalization should end when the project is substantially complete and ready for its intended use (i.e., testing and installation are complete). If it becomes probable that the project will not be completed and placed in service, no further costs should be capitalized and the guidance on impairment discussed later in this lesson should be followed. The following conditions may indicate that the software project is no longer expected to be completed and placed in service:  No expenditures are budgeted or incurred for the project.  Programming problems cannot be resolved in a timely manner.  Cost overruns are significant.  Information indicates that costs of the internally developed software will significantly exceed the cost of comparable thirdparty software.  New technologies in the marketplace indicate that management may decide to buy thirdparty software rather than authorize completion of the internally developed software.  The business segment to which the software is related is unprofitable or will be discontinued. The capitalized costs of internaluse software should be amortized on the straightline basis (unless another systematic and rational basis is more representative of the software's use) over the estimated useful life of the software. The amortization period depends on how long the company plans to use the software, considering technology and obsolescence. Amortization should begin for each module or component of a software project when the module or component is ready for its intended use (that is, after all substantial testing is completed for the module or component). Impairment of capitalized internaluse software should be determined and measured in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of LongLived Assets (FASB ASC 36010). The SOP states that impairment may be present when one of the following conditions exists related to internaluse software currently in use or under development:  The software is not expected to provide substantive service potential. 237

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 The extent or manner in which the software is used or expected to be used significantly changes.  The entity has made or intends to make a significant change in the software program.  The costs to develop or modify the software significantly exceed the amounts originally estimated. After internaluse software is placed into service, subsequent changes to the software should be capitalized or expensed depending on (a) whether the costs are incurred internally or externally, and (b)whether the costs are for maintenance or upgrades and enhancements.  Internal costs for upgrades and enhancements should be capitalized or expensed according to the criteria for the preliminary project, application development, and postimplementation/operation stages.  Internal maintenance costs should be expensed as incurred.  Internal costs for minor upgrades and enhancements that cannot be reasonably separated from maintenance costs should be expensed as incurred.  External costs incurred under agreements for specified upgrades and enhancements should be capitalized or expensed according to the criteria for the preliminary project, application development, and postimplementation/operation stages.  External costs for specified upgrades and enhancements that are combined with maintenance in a single contract should be allocated between the components, and the maintenance costs should be expensed over the contract period.  External costs for maintenance, unspecified upgrades and enhancements, and costs under agreements that combine the costs of maintenance and unspecified upgrades and enhancements should be expensed on a straightline basis over the contract period (unless another systematic and rational basis better represents the services received under the contract).  External costs for purchased software that includes multiple components (such as training, maintenance fees for routine maintenance, data conversion, or rights to future upgrades and enhancements) in the purchase price should be allocated to the various components, based on the fair value of each component (which may not be the stated contract price for each separate component). The allocated costs should be accounted for as discussed. Upgrades and enhancements are defined as modifications that increase the functionality of existing internaluse software. (That is, the modifications allow the software to perform new tasks.) Upgrades and enhancements must increase the software's functionality (rather than merely extend its useful life) to be considered for capitalization. If the software does not function significantly differently than it did before the upgrade or enhancement, the costs should be expensed as maintenance. New internaluse software that replaces previously existing internaluse software is considered a new purchase, not an upgrade or enhancement. Entities may decide to market internaluse software after it is developed. In such cases, the carrying amount of the capitalized software should be reduced by the proceeds from licensing the software (net of direct marketing costs, such as commissions, software reproduction costs, warranty costs, etc.). Revenue should not be recognized until the net carrying amount has been reduced to zero. If an entity decides to market the software during its develop ment, the provisions previously discussed apply. Distinguishing among Applicability of SOP 981 and SFAS Nos. 2 and 86. The accounting treatment for the costs of purchasing or developing software depends on its ultimate use. Further, costs for a software project cannot be accounted for under multiple standards. The flowchart at Exhibit 21 may be used to determine which account ing standards apply to software costs.

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Exhibit 21 Applying Accounting Standards to Software Costs

Yes

Is software to be sold, leased, or marketed?

No

Is software developeda as a pilot project or for use in a specific R&D project?

No

Is purchased or leased software to be used in R&D activities?

No

Yes

Yes

No

Does the software have alternative future uses?

Yes SFAS No. 86 applies. Note:


a

SFAS No. 2 applies.

SOP 981 applies.

The software may be internally developed or developed by third parties (such as programmer consultants).

*
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Software Developed as Part of a Reengineering Project. Many companies are entering into consulting contracts that combine software projects and business process reengineering. The costs for developing internaluse soft ware must be accounted for as discussed. However, reengineering activities (even though they are often associ ated with new or upgraded software applications) follow EITF Issue No. 9713, Accounting for Costs Incurred in Connection with a Consulting Contract or an Internal Project That Combines Business Process Reengineering and Information Technology Transformation." This guidance requires companies to expense the costs of business process reengineering activities, regardless of whether the activities are undertaken as separate projects or as part of projects to acquire, develop, or implement internaluse software. The requirement applies whether the company or a thirdparty consultant performs the reengineering. The following activities are typically associated with busi ness process reengineering:  Preparing a request for proposal.  Documenting the company's current business processes (except for the company's software structure).  Reengineering the company's processes to increase efficiency and effectiveness.  Restructuring the company's employees to operate the reengineered processes. If a thirdparty consultant performs the business process reengineering project, the total contract price must be allocated to each component of the contract based on the relative fair values of the separate activities. The portion of the costs relating to internaluse software must be accounted for under SOP 981 (FASB ASC 35040), while the portion relating to reengineering processes must be expensed as incurred.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 13. Which of the following is an inappropriate method of disclosing depreciation expense for the period covered in the financial statements? a. Disclosing depreciation in the notes to the financial statements. b. Disclosing depreciation in cost of sales. c. Disclosing depreciation in the statement of cash flow. d. Disclosing depreciation as a separate line item in the income statement. 14. The costs of startup activities should be: a. Amortized. b. Expensed up to $5,000 and the remainder must be amortized. c. Expensed as incurred. 15. Which of the following computer software costs should be capitalized and amortized according to SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, (FASB ASC 985)? a. Maintenance and customer support costs. b. Costs of producing product masters. c. Duplication costs. d. Planning costs. 16. Costs related to software developed by an organization for use solely by the organization can be classified as costs of one of three stages of software development. Testing falls within which stage? a. Preliminary project stage. b. Application development stage. c. Postimplementation/operation stage.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 13. Which of the following is an inappropriate method of disclosing depreciation expense for the period covered in the financial statements? (Page 232) a. Disclosing depreciation in the notes to the financial statements. [This answer is incorrect. Reporting depreciation in the notes to the financial statements or parenthetically in the income statement are appropriate methods of disclosing depreciation expense.] b. Disclosing depreciation in cost of sales. [This answer is correct. An AICPA technical practice aid states that it has become recognized practice to report the amount of depreciation charged to manufacturing costs and to expense accounts as the depreciation expense for the period even though depreciation included in inventories at the beginning and end of the period varies sufficiently to affect depreciation included in cost of sales.] c. Disclosing depreciation in the statement of cash flows. [This answer is incorrect. The amount of depreciation expense for the period may be disclosed in the statement of cash flows' reconciliation of net income to net cash flows from operating activities.] d. Disclosing depreciation as a separate line item in the income statement. [This answer is incorrect. Paragraph 5 of APB Opinion No. 12 (FASB ASC 36010501) requires depreciation expense to be disclosed. Depreciation expense may be disclosed as a separate line item in the income statement.] 14. The costs of startup activities should be: (Page 233) a. Amortized. [This answer is incorrect. SOP 985, Reporting on the Costs of StartUp Activities, (FASB ASC 7201515 and 7201525) does not allow for the amortization of the expenses associated with startup activities.] b. Expensed up to $5,000 and the remainder must be amortized. [This answer is incorrect. This is the current method of treating startup activities for tax purposes, it is not the correct method of accounting for and presenting startup costs in the statement of income.] c. Expensed as incurred. [This answer is correct. The costs associated with startup activities should be expensed as incurred per SOP 985, Reporting on the Costs of StartUp Activities, (FASB ASC 7201515 and 7201525).] 15. Which of the following computer software costs should be capitalized and amortized according to SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, (FASB ASC 985)? (Page 235) a. Maintenance and customer support costs. [This answer is incorrect. Costs of maintenance and customer support should be charged to expense when related revenue is recognized or when those costs are incurred, whichever occurs first.] b. Costs of producing product masters. [This answer is correct. The costs of producing product masters, after the technological feasibility has been established, should be capitalized and amortized.] c. Duplication costs. [This answer is incorrect. Duplication costs are a cost of producing the product. Costs incurred for duplicating the computer software, documentation, and training materials from the product masters and for physically packaging the product for distribution should be capitalized as inventory and charged to cost of sales when revenue is recognized.] 242

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d. Planning costs. [This answer is incorrect. Planning, designing, and establishing the technological feasibility of a computer software product should be expensed as incurred.] 16. Costs related to software developed by an organization for use solely by the organization can be classified as costs of one of three stages of software development. Testing falls within which stage? (Page 236) a. Preliminary project stage. [This answer is incorrect. The preliminary project stage includes costs incurred for conceptualizing and evaluating software alternatives, determining existence of needed technology, and selecting final alternatives.] b. Application development stage. [This answer is correct. The application development stage includes costs related to designing the chosen alternative, coding, installing hardware, and testing.] c. Postimplementation/operation stage. [This answer is incorrect. The postimplementation/operation stage includes costs related to training and software application maintenance.]

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Rent Expense under Operating Leases SFAS No. 13 (FASB ASC 8401020) generally requires rent expense under operating leases to be recognized on a straightline basis. Paragraph 15 of SFAS No. 13 (FASB ASC 84020251) states: Normally, rental on an operating lease shall be charged to expense over the lease term as it becomes payable. If rental payments are not made on a straightline basis, rental expense nevertheless shall be recognized on a straightline basis unless another systematic and rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis shall be used. (Emphasis added.) In many cases, rent payments under operating leases are made on a straightline basis and are charged to expense in the period they are payable to the lessor. However, the lease payments in some operating leases vary either because the lessor offers a rentfree period or a period of reduced rent as an incentive for the lessee to sign the agreement or because the lease provides for scheduled rent increases. GAAP generally requires rent expense to be recognized on a straightline basis over the lease term as shown in the following example: Lease term: 5 years Monthly rent: First year free; $550 per month thereafter Total rent expense during lease term: $550 48 months Monthly rent expense per financial statements: $26,400 B 60 months $ $ 26,400 440

The excess of expense over payments during the rentfree period ($440 12) should be credited to an accrued liability. The liability should be reduced in each subsequent month by the excess of the monthly payments over the expense ($550 * $440). In recent years, a number of public companies restated their financial statements to correct errors relating to lease accounting. As a result of those restatements, the chairman of the AICPA Center for Public Company Audit Firms requested the Office of the Chief Accountant of the Securities and Exchange Commission (SEC) to clarify the SEC staff's interpretation of certain accounting issues and their application relating to operating leases. One area of clarification related to the proper recognition of rent expense when the term of an operating lease includes periods of free or reduced rents, often referred to as rent holidays. In February 2005, the Chief Accountant of the SEC issued a letter in response to the request indicating that the positions expressed within the letter are based on existing accounting literature. The letter indicates, according to FASB Technical Bulletin 853 (FASB ASC 84020252), Accounting for Operating Leases with Scheduled Rent Increases, a lessee in a operating lease with rent holidays should recognize the rent holidays on a straightline basis over the term of the lease, including any rent holiday period, unless another allocation method is more representative of the time pattern in which the property is used. Although the letter was intended for SEC registrants, the issues discussed are relevant to nonpublic entities as well. The positions expressed in the letter are consistent with the accounting treatment discussed in the previous paragraph. The SEC letter is discussed further later in this lesson. Accounting for leases with scheduled annual increases is similar to accounting for leases with rentfree periods or reduced rents. To illustrate, assume a threeyear lease provides for an annual base rent of $10,000 with increases during the second two years of at least 5% (that is, to at least $10,500 in the second year and $11,025 in the third year). Since minimum payments of $31,525 are scheduled over the lease term, GAAP requires recognizing rent of $10,508 (or $31,525 B 3) on a straightline basis during each of the three years. (Since the lessor and lessee would report different amounts of rent each year for tax purposes, deferred taxes should be provided for the temporary differences between rent recognized for financial statement and income tax reporting.) GAAP emphasizes that to use a method other than straightline, it must be more representative of the time pattern in which the property is used. Using factors such as the time value of money, anticipated inflation, or expected 244

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future revenues to allocate scheduled rent increases to expense is not appropriate because those factors do not relate to the time pattern of actually using the leased property. FASB Technical Bulletin (TB) No. 881, Issues Relating to Accounting for Leases (FASB ASC 84020252), provides additional guidance on using the straightline method to account for rental expense in the following circumstances: a. The lessee has the right to control the use of the leased property. b. Incentive payments are made by the lessor. c. The lessor assumes the lessee's preexisting lease. The FASB is currently working with the International Accounting Standards Board (IASB) on a joint project related to accounting for leases by lessees. The project will not address accounting by lessors. The goal of the project is to develop a new model for recognizing assets and liabilities arising under lease contracts. Lessee Controls Use of Property. The right to control the use of the leased property should be considered as the equivalent of physical use. In other words, when the lessee controls the use of the leased property, recognition of rental expense or rental revenue is not affected by the extent to which the lessee uses the leased property. An AICPA Technical Practice Aid at TPA 5600.08 reinforces this concept and indicates a lease term for accounting purposes may begin before the initial fixed noncancelable term stated in a lease agreement. The TPA references the guidance that indicates for accounting purposes the lease term includes all periods in which the lessee has access to and control over the leased space even if those periods are prior to the fixed noncancelable term included in the lease agreement. Thus, for example, if a manufacturing building having excess capacity is leased, and the lessor provides for escalating rental payments in contemplation of the lessee's expected expansion and physical use of the excess capacity, the aggregate lease payments should be recognized on a straightline basis over the lease term as discussed previously. (Since rent is includable in taxable income by lessors and lessees when due, conforming with GAAP causes a temporary difference between income for financial and income tax reporting.) On the other hand, if rents escalate as the lessee gains control of the additional leased property, GAAP requires rental expense and rental revenue to be recognized as due, provided rental amounts are based on the relative fair value of the additional leased property at the inception of the lease. If escalating rental payments are not based on fair value, however, they should be reallocated between the original leased space and the additional leased space based on the relative fair value of the property at the inception of the lease. After the reallocation, the amount of rental expense or rental revenue attributable to the additional leased property should be proportionate to the relative fair value of the additional property, as determined at the inception of the lease, in the periods during which the lessee controls its use. To illustrate a situation in which rental payments are not based on relative fair value, assume the owner of a twostory office building has separate leases for each floor. The first floor lease expires, and the lessee decides not to renew. The lease on the second floor is scheduled to expire in five years. The lessor signs a 10year master lease agreement with a new tenant. During the first five years, the lessee only leases the first floor of the building, but during the last five years, the lessee leases both the first and second floors. Rent for the first year is $50,000 with scheduled annual increases of 5% during the second through the fifth year. Rent for the sixth year is $90,000 with scheduled annual increases of 6%. At the inception of the lease, the market rental is $50,000 for the first floor and $80,000 for the entire building, resulting in a fair value for the first floor lease equal to 62.5% of the total fair value of the lease.

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The following summarizes approximate rental payments under the agreement reallocated based on the fair values. First Floor Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 $ $ 50,000 52,500 55,100 57,900 60,800 276,300 56,300 59,600 63,200 67,000 71,000 593,400 $ Second Floor 33,700 35,800 37,900 40,200 42,600 190,200 $ Total 50,000 52,500 55,100 57,900 60,800 276,300 90,000 95,400 101,100 107,200 113,600 783,600

Annual rent recognized on the first floor space would be $59,340 (that is, total rentals of $593,400 B the 10year lease term), and $38,040 would be recognized annually on the second floor space while it is leased (that is, total rentals of $190,200 B the fiveyear lease term). As a result, the lessee would recognize annual rent expense of $59,340 during the first five years and $97,380 during the last five years (that is $59,340 for the first floor plus $38,040 for the second floor). The lessor would recognize the same amounts of rental income. Operating leases sometimes provide the lessee with the right of first refusal on additional space as other leases expire. The Technical Bulletin guidance does not apply to that type of arrangement. In some situations, a lessee may enter into a leasing arrangement under which the lessee is given control of a leased asset for the purpose of constructing leasehold improvements and preparing the property for operations. According to FSP No. FAS 131, Accounting for Rental Costs Incurred during a Construction Period" (FASB ASC 840202510 and 2511; 84020451), rental costs related to ground or building operating leases incurred during a construction period should not be capitalized as a cost of construction but should be recognized as rental expense. Lessees should allocate the rental costs over the term of the lease. Incentive Payments by Lessors. Incentive payments include items such as upfront cash payments to the lessee to sign the lease and payments to reimburse the lessee for specific costs such as moving costs or abandoned leasehold improvements. The lessor and lessee are required to amortize incentive payments against rental income or expense over the term of the lease. The lessee should record receipt of the payment through a debit to cash and a credit to a deferred lease incentive account. The deferred lease incentive account should be amortized through a credit to rent expense over the lease term using the straightline method. The lessor should record the payment as a debit to a deferred lease incentive account and a credit to cash. The deferred lease incentive account should be amortized by the lessor against rent income over the lease term using the straightline method. (The required accounting will create a temporary difference between income for financial and income tax reporting, since the lessor would deduct the incentive payment when paid and the lessor and lessee would recognize rent for tax purposes when it is due.) To illustrate, assume that the lessor reimburses the lessee for $10,000 of its moving costs as an incentive to enter into a fiveyear noncancelable lease requiring annual rentals of $50,000. The lessee would record receipt of the payment as a debit to cash and a credit to deferred lease incentive for $10,000. (Receipt of the payment has no effect on the lessee's accounting for the moving costs. Expenses or losses such as moving expenses, losses on subleases, or the writeoff of abandoned leasehold improvements are charged to expense as incurred.) The $10,000 deferred lease incentive should be amortized over the fiveyear lease term through annual credits to rent expense of $2,000 calculated using the straightline method. As a result, the lessee would make the following entry each year to record payment of the annual rentals:

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Rent expense Deferred lease incentive Cash

48,000 2,000

50,000

The lessor should record payment of the $10,000 through a debit to deferred lease incentive and a credit to cash. The deferred lease incentive should be amortized over the lease term through annual charges to rental income of $2,000 calculated using the straightline method. As a result, the lessor would make the following entry each year to record receipt of the annual rentals: Cash Deferred lease incentive Rent income 50,000

2,000 48,000

Over the lease term, both the lessor and lessee would recognize rent of $240,000 (that is, annual rent of $48,000 five years), which represents total minimum lease payments of $250,000 (that is, annual payments of $50,000 five years) less the $10,000 incentive payment. The guidance also applies when an incentive arises from payments by the lessor to third parties on behalf of the lessee, such as payments for leasehold improvements or moving costs. A common example relating to leasehold improvements is an agreement under which the lessor makes all leasehold improvements requested by the lessee and bills the lessee for its cost less an allowance. In that situation, it is believed that the lessee should record the full cost as leasehold improvements. (Since the tax basis of the leasehold improvements is the amount paid, a temporary difference will result because the basis of leasehold improvements for financial reporting will exceed their tax basis.) To illustrate, assume that, as an incentive for a lessee to enter into a fiveyear lease for annual rentals of $50,000, the lessor agrees to make leasehold improvements for a total cost of $35,000 and to bill the lessee for $25,000. The $10,000 leasehold improvements allowance would be considered a rent incentive. The lessee would record the incentive through the following entry: Leasehold improvements Deferred lease incentive Cash 35,000

10,000 25,000

The lessee would amortize the leasehold improvements over the shorter of their estimated useful life or the lease term, and the $10,000 deferred lease incentive would be amortized against rent expense over the fiveyear lease term using the straightline method. As a result, $48,000 of the annual rent payments would be charged to rent expense, and the remaining $2,000 would be charged to the deferred lease incentive. If the lessor initially charged the $35,000 payment to leasehold improvements, it would record the $25,000 receipt from the lessee as follows: Cash Deferred lease incentive Leasehold improvements 25,000 10,000

35,000

The lessor would amortize the deferred lease incentive over a fiveyear period using the straightline method. In February 2005, the Chief Accountant of the SEC issued a letter to the chairman of the AICPA Center for Public Company Audit Firms regarding the SEC staff's interpretation of certain accounting issues and their application relating to operating leases. One issue addressed in the letter relates to landlord and tenant incentives. The SEC letter indicates if a lessee makes leasehold improvements that are funded by landlord incentives or allowances under an operating lease, the lessee should capitalize the leasehold improvement assets and amortize them over an appropriate term. The SEC letter also indicates landlord incentives should be recorded as deferred rent and amortized as reductions of rent expense over the term of the lease. The SEC staff believes it is not appropriate to net 247

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deferred rent against leasehold improvements. Although the letter was intended for SEC registrants, the issues discussed are relevant to nonpublic entities as well. The positions expressed in the letter are consistent with the accounting treatment discussed in this lesson. Lessor Assumes Lessee's Lease. If a lessor assumes a lessee's preexisting lease with a third party, the related loss incurred by the lessor is considered a rent incentive. The lessor and the lessee should independently estimate the loss incurred by the lessor. While the lessee may not have access to the same information as the lessor, it still must estimate the loss to decide whether to accept the offer. The lessor should estimate its loss based on the total remaining costs reduced by the expected benefits from the sublease or use of the assumed leased property. The method the lessee should use is not prescribed, but it may be appropriate for the lessee to base its estimate on a comparison of the new lease with the market rental rate available for similar lease property or the market rental rate from the same lessor without the lease assumption. [This accounting will create a temporary difference between financial and taxable income, since, for tax reporting, the lessor would deduct the loss as incurred (that is, as payments under the assumed lease and rentals under the sublease are due), and the lessor and lessee would include rent in taxable income when it is due.] To illustrate, assume that the lessee presently pays annual rent of $32,000 on its office facilities and three years remain under that lease. The lessee enters into a lease for new facilities that requires annual rentals of $50,000 over a noncancelable term of five years and the assumption of its existing lease. The lessor believes it can sublease the space under the lessee's old lease for annual rentals of $24,000 but, because of current market conditions, believes that it will need to grant a rentfree period of six months. The lessor should compute its loss on assuming the lease as follows: Total rental commitment remaining under the lease assumedthree years at $32,000 per year Total sublease income2.5 years at $24,000 per year Loss on assumption of the lease

$ $

96,000 60,000 36,000

The lessee, on the other hand, believes the annual market rental for similar property is $45,000. Thus, the lessee calculates the value of the incentive as the $5,000 ($50,000 * $45,000) excess annual rental over the fiveyear term for a total of $25,000. The lessee would record a loss of $25,000 at inception. As lease payments are made, the $25,000 would be amortized as a reduction of rent expense. The entries would be as follows: At inception Loss on sublease assumed by lessor Deferred lease incentive Annually thereafter Rent expense Deferred lease incentive Cash 45,000 5,000 25,000 25,000

50,000

The lessor would record the loss of $36,000 as a debit to deferred lease incentive and a credit to accrued loss on lease assumed. Both the asset and liability should be amortized using the straightline method, but the asset should be amortized over the fiveyear term of the new lease because it is considered to be a cost of obtaining the new lease, and the liability should be amortized over the threeyear term of the old lease because the accrued loss relates to the old lease. Sublease income of $20,000 would be recognized annually over the threeyear sublease term under the straightline method (that is, total sublease rentals of $60,000 B three years). The difference in each year between sublease income and rent collected would be debited or credited to accrued rent receivable as discussed previously.

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The lessor would record the following entries in the first year: a. Deferred lease incentive Accrued loss on assumed lease To record deferred lease incentive resulting from estimated loss on assumed sublease. b. Accrued loss on assumed lease ($36,000 B 3) Lease expense Cash To record expense relating to assumed lease. c. Cash Accrued rent receivable Lease income ($60,000 B 3) To record income relating to assumed lease. d. Cash Deferred lease incentive ($36,000 B 5) Rental income To record entries relating to new lease. 50,000 7,200 42,800 12,000 8,000 12,000 20,000 36,000 36,000

32,000

20,000

Contingent Rentals. In contrast to the lease incentives discussed in the preceding paragraphs, contingent rentals are dependent on future changes in the factors on which the lease payments are based, such as future sales volume, future inflation, or future property taxes. If contingent rentals under operating leases are based on an existing index or rate, they would be included in the minimum lease payments based on the index or rate existing at the inception of the lease. (They would, therefore, be subject to the accounting treatment described previously.) Subsequent changes in the index or rate and other contingent rentals under operating leases should be charged to expense when they are incurred. If contingent rentals are based on factors that do not exist or are not measurable at the inception of the lease, for example future sales volume, no amount for those factors should be included in the minimum lease payments. The entire amount based on those factors should be expensed as it is incurred. (Contingent rentals under capital leases should be excluded from minimum lease payments and also should be charged to expense when incurred. EITF Issue No. 989, Accounting for Contingent Rent" (FASB ASC 840102535; 84010401; 84010505; 8404056), requires lessees to recognize contingent rental expense in annual and interim periods prior to achieving a specified target that triggers the contingent rent if it is probable that the target will be achieved. Previously recorded contingent rental expense should be reversed into income if it later appears probable that the specified target will not be met. The EITF also reached a consensus that lessors should not recognize contingent rental income in interim periods before achieving the specified target that triggers the contingent rent. However, in subsequent discussions, the EITF withdrew that consensus. Lessors that changed their accounting for contingent rental income due to the initial consensus (reached at the EITF's May 21, 1998 meeting) can continue to follow that consensus or account for contingent rental income using the accounting policy they followed before that consen sus. Lessors that did not change their accounting policy for contingent rental income because their existing accounting policy was consistent with the initial consensus should continue to use that policy. Regardless of the policy used, lessors should disclose their accounting policy for contingent rental income. In addition, a lessor that accrues contingent rental income before a lessee achieves a specified target (because achieving the target was considered probable) must disclose the impact on rental income as if the lessor had deferred recognizing contin gent rental income until the specified target had been met. The SEC's Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, prohibits lessors from recognizing contingent rental income before the target that triggers the contingent lease payments actually 249

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occurs. Consequently, lessors that are SEC registrants should not record contingent rental income until the period in which the contingency is resolved. Disclosures. Disclosures are required for all operating leases that have noncancelable lease terms in excess of one year. The AICPA recently released a series of Technical Practice Aids (TPAs) that address accounting for leases. The following TPAs, which are nonauthoritative, are consistent with the accounting guidance discussed in this course and are available on the AICPA website at www.aicpa.org:  TPA 5600.07, Determining a lease term for accounting purposes"  TPA 5600.08, Lease term for accounting purposes differs from term stated in lease (part 1)"  TPA 5600.09, Lease term for accounting purposes differs from term stated in lease (part 2)"  TPA 5600.10, Rent expense and rent revenue in an operating leasegeneral"  TPA 5600.11, Rent expense and rent revenue in an operating leasescheduled increase in rental space"  TPA 5600.12, Rent expense and rent revenue in an operating leaserent holiday"  TPA 5600.13, Rent expense and rent revenue in an operating leasescheduled rent increases"  TPA 5600.14, Amortization/Depreciation of leasehold improvements in an operating lease (part 1)"  TPA 5600.15, Leasehold improvements and lease term in an operating lease (part 2)"  TPA 5600.16, Landlord incentive allowance in an operating lease"  TPA 5600.17, Cash flows statement presentation of landlord incentive allowance in an operating lease" Advertising Costs Statement of Position 937, Reporting on Advertising Costs (FASB ASC 34020; 72035), requires advertising costs to be capitalized in some situations and applies to commercial businesses as well as nonprofit organizations. It covers most types of advertising, such as TV or radio commercials, business or consumer publications, and directmail advertising. However, fundraising activities for nonprofit organizations are not considered advertising within the scope of the SOP . In addition, the costs of premiums, contest prizes, gifts and similar promotions, as well as discounts or rebates (including those resulting from the redemption of coupons) are specifically excluded from its requirements. Other costs of coupons and similar items (such as the costs of magazine or newspaper advertis ing space) are considered advertising costs and are subject to the requirements of the SOP . When Should Advertising Costs Be Expensed? For many companies, there is no significant change in account ing for advertising other than directresponse advertising. Production costs incurred in advertising (for example, writing advertising copy, artwork, printing) can either be expensed as incurred or expensed the first time the advertising occurs. However, the company may need to disclose its policy for reporting advertising expenses in its financial statements. Communication costs should not be expensed until the first time the advertising occurs (for example, the first time a television commercial is shown). Even if the advertisement will run for an extended time period (for example, Yellow Page ads or bill boards), the advertisement typically cannot be withdrawn once the publication or other communication is released. Accordingly, it is believed that the company has incurred a liability to pay for the advertising once the communication is released; therefore, the related expense should be recognized at that time. Even if a publication bills the company monthly for an advertisement that will run for a year (for example, Yellow Page ads), the expense should still be recognized when the advertisement first appears. If a company trades products or services for advertising, the advertising expense and the revenue from the sale" should be recorded at the fair value of either the advertisement or the sale, whichever is more objectively determin able. As a practical matter, such transactions would not have to be recorded if their effect is not material to the company's results of operations. 250

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When Should Advertising Costs Be Capitalized? Special rules may apply to advertising considered direct response advertising" when: a. it can be shown that customers responded to a specific advertisement, and b. there is a probable future economic benefit. Some ways that a company can show that customers responded to a specific advertisement are:  using coded order forms, coupons, or response cards.  linking telephone calls to a unique phone number only included in a specific advertisement.  maintaining files that indicate a customer's name and the related directresponse advertisement. To demonstrate that the directresponse advertising will result in a future benefit, the entity should consider its response experience with similar directresponse advertising used in the past. Considerations of likely response should include (a) the audience demographics, (b) the advertising method, (c) the product, and (d) economic conditions. The evidence should include a verifiable historical pattern of results for that entity. General industry statistics on advertising methods are not adequate to show that there will be a probable future benefit. Also, retroactive capitalization of advertising costs (based on results in subsequent periods supporting a probable future benefit) is not permitted. Practice Bulletin No. 13, Directresponse Advertising and Probable Future Benefits (FASB ASC 340202517 and 2518; 34020357), indicates that a company should only consider primary revenues associated with direct response advertising when determining whether probable future benefits exist. Primary revenues are those derived from sales to customers receiving and responding to the directresponse ads. A company can also obtain secon dary benefits from directresponse advertising. For example, if a publisher's subscription base increases as a result of directresponse advertising, the publisher will likely receive higher advertising fees for space sold in the publica tion. Those increased advertising fees are secondary revenues and should not be considered when determining whether probable future benefits exist or when amortizing and assessing the realizability of any advertising reported as assets. Directresponse Advertising Costs to Capitalize and Amortize. Not all costs attributable to directresponse advertising can be capitalized. Generally, only the following two types of costs should be included in amounts reported as assets: a. Direct, incremental costs incurred in transactions with third parties (such as artwork or written advertising copy) b. The portion of employee payroll (and payrollrelated costs) directly associated with directresponse advertising activities Items such as administrative costs, rent, depreciation, etc. should not be included in the capitalized advertising asset. Tangible assets used in advertising, such as billboards, should be capitalized and depreciated over their expected useful lives. Printed sales materials, such as catalogs or brochures, can be accounted for as prepaid supplies until they are distributed or no longer expected to be used. A company should amortize the capitalized costs over the period that it believes it will obtain sales (or a benefit) as a result of that specific advertisement. Often the period will be fairly short (e.g., less than six months). In addition, the amortization for a given period should be in proportion to the amount of benefits received during that period. That means that the amortization will usually decline over time, with more amortization in earlier periods following distribution and less in later periods. A company should also periodically assess the realizability of the advertising costs that remain capitalized. That is done by comparing the carrying amounts of the capitalized advertising (on a costpoolbycostpool basis") to the estimated remaining future net revenues expected to result from that specific advertisement. If the carrying 251

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amounts exceed the remaining future net revenues, the excess should be reported as advertising expense in the period that the evaluation occurs. Applying the SOP to advertising costs can be reduced to a few simple decisions as outlined in Exhibit 22. Required Disclosures. Certain disclosures are required, even if advertising costs are not capitalized. For many small to mediumsized companies, expenditures for directresponse advertising will not be capitalized. In those cases, disclosure of advertising expense for each income statement period presented is required. In addition, the notes to the financial statements should disclose whether advertising costs are expensed as incurred for the first time the advertising takes place. Depending on the facts and circumstances, the financial results under the two alternatives may or may not differ materially. For example, the results may differ materially when significant production costs are incurred over a long period or when communication costs are incurred significantly in advance of when the advertising takes place. An example of when the results may not differ materially is a distributor that incurs material amounts of costs in communicating advertising through programs produced by the manufacturer, and the manufacturer a. Arranges with local advertising agencies to bill the distributor for advertising communicated using print media when it appears and for advertising communicated using radio and television spots when they air. Since the costs of those forms of advertising are incurred when the advertising takes place, the results under the SOP's two alternatives are the same. b. Bills the distributor for pointofsale advertising in connection with a national campaign, and the pointofsale material is received shortly before the campaign is to begin and therefore is quickly moved to the retail outlets. While the SOP clearly requires disclosure of the company's advertising policy when the results of the two methods differ materially, some accountants have questioned whether disclosure is required when the results do not differ materially. Disclosure of the alternative selected is consistent with APB OpinionNo.22 (FASB ASC 23510501 through 506; 2351053 and 54)'s requirement to disclose a selection of an accounting policy from existing acceptable alternatives. However, the guidance indicates the accounting policies disclosed are those that materi ally affect financial position, cash flows, or results of operations. Under that presumption, a selection from existing acceptable alternatives that does not materially affect the financial statements need not be disclosed. To illustrate applying that presumption to accounting for advertising costs, a reader would not be able to better understand the financial statements knowing that the cost of communicating advertising through various media is expensed when incurred if those costs are not incurred until the communication occurs. Accordingly, best practices indicate that the financial statements are not required to disclose the alternative selected when the financial results under the two alternatives do not differ materially. Advertising Barter Transactions. Advertising barter transactions involve an exchange of advertising services for other services or products. Such transactions are not new; for example, small radio stations historically have provided airtime for advertisements in exchange for other services. However, the transactions are gaining new prominence with the increasing number of Internet companies that enter into transactions in which they exchange rights to place advertisements on each other's websites. In some transactions, no cash is exchanged, while in others similar amounts of cash are exchanged (frequently referred to as swapping checks"). Many Internet companies have tended to report net losses and net operating cash outflows, and their market capitalization often is based on revenues. Since no net cash is exchanged, two Internet companies conceptually could agree on a grossly inflated amount at which to report advertising, with each one reporting that same amount of advertising revenue and expense. To avoid the artificial inflation of market capitalization from such a practice, the EITF addressed such transactions in Issue No. 9917, Accounting for Advertising Barter Transactions" (FASB ASC 605202514 through 2518; 60520501). While the Issue was addressed specifically in response to concern about exchanges of Internet advertising, the guidance applies to all transactions in which advertising services are exchanged.

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Exhibit 22 Applying SOP 937 to Advertising costs

Cost Specifically Excluded by SOP 937?

Yes

SOP 937 Does Not Apply.

No

Direct Response Advertising Cost?

No

Expense As Incurred (Production Costs) or the First Time the Advertising Occurs (Production or Communication Costs).

Yes Can It Be Shown That Response Was to Specific Advertise ment? Yes Do Not Capitalize Cost. Expense as Incurred (Production Costs) or the First Time Advertising Occurs (Pro duction or Communication Costs).

No

Probable Future Economic Benefit?

No

Yes Direct Incremental Cost Paid to Outside Party or Employee Payroll (or Pay rollrelated) Cost Associ ated with Directresponse Advertising?

No

Yes

Capitalize Cost. Amortize over Benefit Period. Periodically Assess Realizability of Unamortized Portion.

*
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The EITF consensus was that revenue and expense should be recognized at the carrying amount of the advertising surrendered, which likely will be zero, unless the strict guidelines prescribed by the Issue for determining fair value are met. Essentially, revenue and expense should be recognized at fair value only if the fair value of the advertising surrendered can be determined based on historical, cashbased similar experience with entities unrelated to the counterparty of the barter transaction. In determining whether an advertising barter transaction should be recog nized at fair value, the following criteria must be met: a. The Experience Must Be Prior to the Transaction. The historical experience considered must be for a period not more than six months before the date of the barter transaction.  If economic circumstances have changed such that transactions within that sixmonth period do not represent current fair value, then a shorter, more representative period should be used.  Look backs are not permissible. In other words, the historical cashbased experience must occur before the barter transaction. If the cashbased experience occurs after the barter transaction but before issuance of the entity's financial statements, the cashbased experience cannot be used to recognize the barter transaction in the entity's financial statements. b. The Experience Must Be Cashbased. The entity may consider only historical transactions in which it received cash, marketable securities, or other consideration that is readily convertible to a known amount of cash. c. The Experience Must Be Similar. For advertising to be considered similar  It must have been in the same media and within the same website or other advertising vehicle as the advertising in the barter transaction.  Its characteristics must be reasonably similar with respect to circulation, exposure, or saturation within an intended market; timing (such as daily or weekly); prominence (such as a page on a website); demographics of readers, viewers, or customers; and length of time the advertising is displayed. d. The Volume or Quantity of Advertising Surrendered in a Prior Cashbased Transaction Only Can Evidence the Fair Value of an Equivalent Volume or Quantity of Advertising Surrendered in Subsequent Barter Transactions. The amount of revenue recognized in an advertising barter transaction cannot exceed the amount of the prior cashbased transaction used to provide evidence of fair value. After a prior transaction is used to support recognition of an equal amount of barter revenue, that transaction cannot provide evidence of fair value for another barter transaction. Required disclosures include a. the amount of revenue and expense recognized from advertising barter transactions for each income statement period presented. b. information about the volume and type of advertising surrendered and received for each income statement period presented if the fair value of advertising barter transactions is not determinable within the Issue's guidelines. Retroactive Adjustment of Workers' Compensation and Other Expenses Workers' compensation carriers often charge annual premiums based on what they think the experience rate will be for the year and adjust the premium later based on the actual rate. Sometimes the adjustment is settled in cash, but it may also be settled prospectively through an adjustment of the next year's premium. The expense recognized for the year should equal the adjusted premium for that period. That requires estimating the retroactive adjustment, regardless of whether it is a refund, an additional payment, or a prospective adjustment. Considering the need for an adjustment requires some practical considerations: a. If workers' compensation expense is not material to the financial statements, a retroactive adjustment is not likely to be material. 254

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b. If the expense is material, often the most efficient approach is to talk with the agent about the likelihood of a significant premium adjustment. Agents for the carriers often can estimate the amount of the adjustment within an acceptable range. c. If there is a reasonable possibility that the estimate will change with a material effect on next year's financial statements, the requirements of SOP 946, Disclosure of Certain Significant Risks and Uncertainties (FASB ASC 27510), apply. This guidance also applies to other expenses incurred under similar arrangements.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 17. PIP Company signed an operating lease agreement with Leases R Us. The lessor offered PIP a rent free period of one year. For the remaining three years of the lease, PIP's monthly rent will be $1,000. How much rent expense will PIP recognize in month twelve? a. $0. b. $750. c. $1,000. 18. Assume the same facts as in the previous example. What will be the accrued liability on PIP's books at the end of the thirteenth month of the operating lease? a. $0. b. $250. c. $8,750. d. $9,000. 19. Up & Up signed a tenyear operating lease agreement with Ascending Company with an annual base rent of $10,000. Each succeeding year, the rent will increase by $1,000 over the previous year. How much rent expense will Up & Up recognize in year five? a. $10,000. b. $14,000. c. $14,500. d. $15,000. 20. Bows & Bells was offered a $4,000 upfront cash lease incentive to sign a fouryear noncancelable lease requiring annual rentals of $40,000. How will Bows & Bells account for the incentive payment by the lessor? a. Record the $4,000 receipt as income when received. b. Record the $4,000 as a reduction in rent expense when received. c. Record the $4,000 as a deferred lease incentive when received. d. Record the $4,000 receipt as a reduction in moving costs when received. 21. When a lessor assumes a lessee's preexisting lease with a third party: a. The lessor and lessee should independently estimate the loss incurred by the lessor. b. The lessor and lessee should agree on the calculation of the loss incurred by the lessor. c. The lessee must use the lessor's calculation of the loss. d. The lessor must use the lessee's calculation of the loss. 257

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22. Which advertising cost below is subject to the requirements in SOP 937, Reporting on Advertising Costs? a. Contest prizes. b. Coupons printed in the newspaper. c. Gifts and promotions. d. Discounts or rebates.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 17. PIP Company signed an operating lease agreement with Leases R Us. The lessor offered PIP a rent free period of one year. For the remaining three years of the lease, PIP's monthly rent will be $1,000. How much rent expense will PIP recognize in month twelve? (Page 244) a. $0. [This answer is incorrect. A rentfree period does not mean that no rent expense is recorded on the financial statements. SFAS No. 13, Accounting for Leases (FASB ASC 8401020), provides guidance on expense recognition.] b. $750. [This answer is correct. A total of $36,000 will be paid during the contract period. The contract term is for four years, which is fortyeight months. Therefore, $36,000 B 48 months = $750.] c. $1,000. [This answer is incorrect. PIP's lease expense is not $1,000 per month during the twelfth month because rent expense is recognized on a straightline basis.] 18. Assume the same facts as in the previous example. What will be the accrued liability on PIP's books at the end of the thirteenth month of the operating lease? (Page 244) a. $0. [This answer is incorrect. The excess of expense over payments during the rentfree period should be credited to an accrued liability.] b. $250. [This answer is incorrect. This is the excess of the monthly payment over the expense in months thirteen through fortyeight.] c. $8,750. [This answer is correct. The excess expense over payments during the rentfree period was $9,000 ($750 12). The liability should be reduced in each subsequent month (months thirteen through fortyeight) by the excess of the monthly payments over the expense ($1,000 * $750 = $250). Therefore, $9,000 * $250 = $8,750.] d. $9,000. [This answer is incorrect. This is the amount of the accrued liability at the end of month twelve. The excess expense over payments during the rentfree period was $9,000 ($750 12).] 19. Up & Up signed a tenyear operating lease agreement with Ascending Company with an annual base rent of $10,000. Each succeeding year, the rent will increase by $1,000 over the previous year. How much rent expense will Up & Up recognize in year five? (Page 244) a. $10,000. [This answer is incorrect. $10,000 is the annual base rent. The rent increases each year by $1,000.] b. $14,000. [This answer is incorrect. This is the amount of rent paid in year five. This is not the correct amount of rent expense for the year when applying SFAS No. 13, Accounting for Leases (FASB ASC 8401020).] c. $14,500. [This answer is correct. The rent paid for the first year is $10,000. The rent payments increase by $1,000 each year. The total rent paid over the ten year lease is $145,000. $145,000 recognized on a straightline basis over the term of the lease is $14,500 per year.] d. $15,000. [This answer is incorrect. $15,000 is the amount of rent paid in year six. This calculation does not follow the guidance in SFAS No. 13 (FASB ASC 8401020).]

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20. Bows & Bells was offered a $4,000 upfront cash lease incentive to sign a fouryear noncancelable lease requiring annual rentals of $40,000. How will Bows & Bells account for the incentive payment by the lessor? (Page 246) a. Record the $4,000 receipt as income when received. [This answer is incorrect. The lease incentive should not be recorded as revenue to Bows & Bells because the payments are amortized over the term of the lease.] b. Record the $4,000 as a reduction in rent expense when received. [This answer is incorrect. Rent expense is reduced when the incentive is amortized.] c. Record the $4,000 as a deferred lease incentive when received. [This answer is correct. The lessee should record receipt of the payment through a debit to cash and a credit to a deferred lease incentive account. The deferred lease incentive account should be amortized through a credit to rent expense over the lease term using the straightline method.] d. Record the $4,000 receipt as a reduction in moving costs when received. [This answer is incorrect. Receipt of the payment has no effect on the lessee's accounting for specific costs such as moving costs or abandoned leasehold improvements. Expenses such as moving expenses, losses on subleases, or the writeoff of abandoned leasehold improvements are charged to expense as incurred.] 21. When a lessor assumes a lessee's preexisting lease with a third party: (Page 248) a. The lessor and lessee should independently estimate the loss incurred by the lessor. [This answer is correct. If a lessor assumes a lessee's preexisting lease with a third party, the related loss incurred by the lessor is considered a rent incentive. The lessor and the lessee should independently estimate the loss incurred by the lessor.] b. The lessor and lessee should agree on the calculation of the loss incurred by the lessor. [This answer is incorrect. The lessee may not have access to the same information as the lessor. They are not required to agree on the calculation.] c. The lessee must use the lessor's calculation of the loss. [This answer is incorrect. The lessee is not required to use the lessor's calculation of the loss. It may be appropriate for the lessee to loose its estimate on a comparison of the new lease using market rental rates.] d. The lessor must use the lessee's calculation of the loss. [This answer is incorrect. The lessee may not have access to the same information as the lessor. The lessor is not required to use the lessee's calculation.] 22. Which advertising cost below is subject to the requirements in SOP 937, Reporting on Advertising Costs, (FASB ASC 34020; 72015)? (Page 250) a. Contest prizes. [This answer is incorrect. Contest prizes are specifically excluded from the requirements of SOP 937 (FASB ASC 34020; 72035).] b. Coupons printed in the newspaper. [This answer is correct. Costs of coupons such as the costs of magazine or newspaper advertising space are considered advertising costs and are subject to the requirements of the SOP . However, costs resulting from the redemption of coupons are excluded.] c. Gifts and promotions. [This answer is incorrect. SOP 937 does not apply to gifts and promotions or to the costs of premiums.] d. Discounts or rebates. [This answer is incorrect. SOP 937 (FASB ASC 34020; 72035) does not apply to discounts or rebates (including those resulting from the redemption of coupons.)]

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Lesson 3:Income Tax Accounting


Introduction
SFAS No. 109, Accounting for Income Taxes (FASB ASC 74010; 74020; 74030), provides requirements for accounting for income taxes in annual financial statements. It is a comprehensive standard that provides the principal guidance on all aspects of accounting for income taxes including the following: a. Calculating deferred tax assets and liabilities b. Classifying deferred tax assets and liabilities in the balance sheet c. Presenting income tax expense in the income statement d. Disclosing information about income taxes e. Recognizing the effects of operating loss carrybacks and carryforwards f. Accounting for changes in tax rates g. Accounting for changes in a company's tax status FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes" (FASB ASC 74010), was issued in June 2006 as an interpretation of SFAS No. 109 (FASB ASC 74010; 74020; 74030). The Interpretation provides guidance on accounting for uncertainty in incomes taxes recognized in accordance with the standard. Learning Objectives: Completion of this lesson will enable you to:  Assess issues related to accounting for income taxes.  Implement various income tax calculations, including deferred taxes, loss carryforwards, and others. Overview of the Rules The standards on accounting for and reporting on income taxes on the balance sheet and on calculating deferred tax assets and liabilities. Under the asset and liability approach, the tax effects of transactions are reported in the year that the underlying transactions are recorded in the financial statements, but the tax effects are based on tax rates expected to be in effect in the period that the differences reverse. Changes in tax rates are recognized in the period that they are enacted (i.e., signed into law by the President). Deferred income tax provisions are the differences between deferred tax balance sheet accounts from period to period. The basic calculation of income taxes consists of the following elements: a. Calculate the current tax provision for the period. (The current tax provision is the amount expected to be reported on the tax return. The current income tax expense or benefit represents the income taxes payable or refundable for the year determined by applying the provisions of enacted tax law to taxable income.) b. Calculate the deferred tax effects at the end of the period of (1) differences between transactions recorded in the financial statements and those recorded in the tax return and (2) operating loss and tax credit carryforwards. c. Provide a valuation allowance for the portion of deferred tax assets for which there is not more than a 50% chance of realization. d. Subtract the deferred tax asset and liability at the beginning of the year from the amounts at the end of the year in steps b. and c. e. Total the amounts calculated in steps a. and d. to obtain the total tax provision or benefit for the year. 261

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Differences between Financial and Income Tax Reporting Permanent Differences. Not all differences between financial and income tax reporting are included in calculating income taxes as outlined in the preceding paragraph. Some differences have no tax consequences and accoun tants sometimes use the term permanent differences to describe income and expenses that are reported in the financial statements but never will be reported in the tax returns. Some common examples are taxexempt interest on municipal bonds, the dividends received deduction, penalties, and certain premiums on life insurance. Although SFAS No. 109 (FASB ASC 74010; 74020; 74030) retains the concept of permanent differences from earlier authoritative standards, it does not use that specific term. This course, however, continues to use the term permanent differences to describe differences that have no tax consequences. Temporary Differences. Temporary differences are differences between financial and income tax reporting that have future tax consequences. Temporary differences are defined as differences between the financial and tax basis of assets and liabilities that will result in future taxable or deductible amounts. The term deductible temporary differences (or deductible differences) is used to refer to temporary differences that will result in deferred tax assets. Deductible differences generally represent expenses that have been recognized in the financial statements but will be deducted in future tax returns, such as a provision for warranty costs. They also may represent income recognized in the tax returns but deferred for financial statement reporting, such as subscriptions received in advance. The term deductible reversals refers to reversals of deductible differences. Term taxable temporary differences (or taxable differences) is used to refer to temporary differences that will result in deferred tax liabilities. Taxable differences generally represent expenses that have been deducted in the tax returns but will be expensed in future financial statements, such as depreciation deducted over shorter lives for tax purposes than permitted by GAAP . They also may represent income recognized in the financial statements that will be taxable in future tax returns, such as use of thepercentageofcompletion method of accounting by a small contractor for financial reporting and the completedcontract method for tax reporting. The term taxable reversals refers to reversals of taxable differences. Which Rates to Use Deferred taxes are calculated using tax rates that are expected to be in effect when temporary differences reverse. Companies are required to consider sources of future taxable income other than reversals of temporary differences when calculating deferred taxes. Thus, the rate used to measure deferred taxes is the rate that is expected to apply to estimated taxable income (which includes reversing temporary differences) in the period that the temporary differences are expected to reverse. Under current federal tax law, corporations with taxable income between $335,000 and $10,000,000 are taxed at a flat rate of 34%. Personal service corporations and corporations with taxable income over $18,333,333 are taxed at a flat rate of 35%. Other corporations are subject to a graduated rate structure that imposes rates ranging from 15% to 39% on various levels of taxable income. Companies are required to measure deferred federal taxes using the flat tax rate (currently 34% or 35%) unless: (a) the effect of the graduated rate structure is significant or (b) special rates apply to the temporary difference. Since the 34% tax rate applies to taxable income between $335,000 and $10,000,000, the highest flat tax rate that many corporations will be subject to is 34%. In that instance, it is recommended that corporations base deferred tax calculations on the 34% flat tax rate (unless a significantly lower average graduated tax rate applies or special rates apply to the temporary difference). Companies need only consider tax rates under the regular tax system. It is not necessary to consider temporary differences under the alternative minimum tax system or to calculate the effects of the alternative minimum tax system on the annual reversals. Selecting a Tax Rate When Graduated Rates Are a Significant Factor. In some situations, using a flat rate to measure deferred taxes may produce significantly different results than if graduated tax rates had been used. In those situations, deferred taxes should be computed using the average tax rate applicable to taxable income of the year in which the temporary difference is expected to reverse. The average graduated tax rate is calculated by dividing the tax on taxable income by taxable income. To illustrate, assume that a company expects taxable income in year 2 to be $100,000. Under currently enacted tax laws, the first $50,000 of that income will be taxed at 15%, the next $25,000 will be taxed at 25%, and the next $25,000 will be taxed at 34%. Thus, the company expects to pay 262

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taxes of $22,250 in year 2. The expected average graduated tax rate is 22.25% ($22,250 B $100,000). The following are the average graduated tax rates for various levels of income based on current federal tax laws: Taxable Income $ 50,000 75,000 100,000 125,000 150,000 200,000 250,000 335,000 $ Average Graduated Tax Rate 15 % 18 22 26 28 31 32 34

Tax 7,500 13,750 22,250 32,000 41,750 61,250 80,750 113,900

Different average graduated tax rates may apply in different years. Should a different average graduated tax rate be computed for each year in which temporary differences are expected to reverse? In most cases, no. Because the calculation is based on expected taxable income, which is no more than an estimate, SFAS No. 109, Paragraph 236 (FASB ASC 7401055138), states that determining a different average graduated tax rate for each future year in the reversal period is usually not necessary. In most cases, using a single average graduated tax rate based on average estimated annual taxable income during the reversal period will provide sufficient precision. For companies with expected future taxable income of $10 million or less, it is believed that the effect of the current federal graduated rate structure could potentially be significant if future taxable income is expected to be under $150,000 (depending on the magnitude of temporary differences and carryforwards). The maximum effect of using a flat tax rate of 34% instead of an average graduated tax rate would be to overstate the deferred tax asset or liability by 19% of the related temporary difference or carryforward (the flat tax rate of 34% less the lowest graduated tax rate of 15%). In other words, if a deferred tax asset were measured using a 34% rate instead of a 15% rate, the deferred tax asset would be overstated by 56% (19% divided by 34%). The following table illustrates the effect of the potential overstatement on pretax financial income of $50,000 for various changes in temporary differences: Change in Temporary Difference $ 5,000 10,000 20,000 30,000 40,000 50,000 19% Overstate ment $ 950 1,900 3,800 5,700 7,600 9,500 Percentage of Income 1.9 % 3.8 7.6 11.4 15.2 19.0

The effect of using a 34% tax rate instead of an average graduated tax rate based on the current federal graduated rate structure is believed to generally not be significant if future taxable income is expected to be between $150,000 and $10 million. In that situation, the maximum effect of using the flat 34% tax rate instead of an average graduated tax rate would be to overstate the deferred tax asset or liability by 6% of the related temporary difference or carryforward (the flat tax rate of 34% less the average graduated tax rate of 28% for taxable income of $150,000). Such an overstatement is normally acceptable for the following reasons:  Overstating the deferred tax asset or liability by 6% of the related temporary difference or carryforward is not likely to be significant to the balance sheet, particularly considering the subjective nature of the estimate.  Consistent use of the flat tax rate instead of an average graduated tax rate is not likely to have a significant effect on the statements of income or cash flows. 263

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If future taxable income is expected to exceed $10 million, the effect of using a flat tax rate of 35% instead of an average graduated tax rate generally will be insignificant. Selecting a Tax Rate When Special Rates Apply. Certain types of taxable income may be taxed at different rates. For example, prior to the Tax Reform Act of 1986, federal tax law imposed a maximum tax rate of 28% on excess net longterm capital gains. Currently, the federal regular tax system for domestic corporations does not impose any special tax rates. Some tax jurisdictions may, however, and federal tax law may be changed to impose such rates in the future. If special tax rates apply and they differ significantly from the regular tax rate, companies should measure the deferred tax effect of temporary differences that will not be taxed as ordinary income using the special rates. In addition, enacted rate changes are used in the calculation, but other rate changes are not, regardless of their probability. Tax rate changes are considered to be enacted when the President signs the underlying law. For example, the Job Creation and Worker Assistance Act of 2002 was signed by the President on March 9, 2002. Although the Act changed tax rates effective January 1, 2002, only deferred tax calculations in balance sheets as of March 9, 2002, or later should have been based on the new tax rates. Balance sheets prior to March 9, 2002, should have reflected deferred tax calculations based on the tax rates that were in effect at the balance sheet date. Calculating the Deferred Tax Provision The deferred tax provision is the change between the deferred tax asset or liability during the period. The deferred tax asset or liability is calculated by determining the deductible and taxable temporary differences at the balance sheet date and calculating the deferred tax effect. A tax liability always should be recognized for taxable temporary differences. A tax asset for deductible reversals should be reduced by a valuation allowance if it is more likely than not that all or a portion of the asset will not be realized. The steps in calculating the deferred tax provision are as follows: a. Identify the taxable and deductible temporary differences and loss carryforwards available for tax reporting at the end of the year. b. Calculate the deferred tax liability by multiplying total taxable differences by the applicable tax rate. c. Calculate the deferred tax asset by multiplying total deductible differences and loss carryforwards by the applicable tax rate. d. Identify tax credit carryforwards available for tax reporting at the end of the year and record a deferred tax asset for the total carryforwards. e. Provide a valuation allowance for the portion of the deferred tax asset for which there is not more than a 50% chance that the benefit of the deductible differences and carryforwards of losses and tax credits will be realized. f. Subtract the net deferred tax asset or liability at the end of the year from the net amount at the beginning of the year to determine the deferred tax benefit or expense for the year. The net deferred tax asset or liability is the difference between the deferred tax liability and the deferred tax asset net of the related valuation allowance. Each of the preceding steps is discussed in the remainder of this section. Illustrations of the Basic Calculation The four illustrations presented below show how to calculate deferred taxes under the following scenarios: a. Illustration 1 uses a flat tax rate of 34% to calculate deferred taxes when there are taxable or deductible temporary differences. 264

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b. Illustration 2 uses a flat tax rate of 34% to calculate deferred taxes when there are both deductible and taxable temporary differences. c. Illustration 3 uses a flat tax rate of 34% to calculate deferred taxes when there is an enacted tax rate increase. d. Illustration 4 uses an average graduated tax rate to calculate deferred taxes. All of the illustrations assume that there are no operating loss or tax credit carryforwards. Illustration 1Using a Flat Tax Rate of 34% to Calculate Deferred Taxes When There Are Taxable Temporary Differences or Deductible Temporary Differences. To illustrate, assume the following facts: a. At the end of 20X0, a company had taxable temporary differences of $40,000 and recorded a deferred tax liability of $13,600 based on a flat tax rate of 34% ($40,000 34% = $13,600). b. During 20X1, the taxable temporary differences increased by $50,000 to $90,000. c. Based on taxable income expected in future years, the effect of the graduated tax rates is not considered significant. There are no enacted changes to the 34% tax rate. The deferred tax liability at the end of 20X1 would be $30,600 ($90,000 would be calculated as follows: Ending deferred tax liability Beginning deferred tax liability Deferred tax expense 34%). The deferred tax expense for 20X1 $ $ 30,600 13,600 17,000

If the assumptions in this illustration were the same except that the temporary differences were deductible rather than taxable temporary differences, the calculation would be the same except that the deferred tax liabilities would be deferred tax assets and the deferred tax expense would be a deferred tax benefit. The deferred tax assets would be reduced, if necessary, by a valuation allowance as explained later in this lesson. Illustration 2Using a Flat Tax Rate of 34% to Calculate Deferred Taxes When There Are Both Deductible and Taxable Temporary Differences. To illustrate, assume the following facts: a. At the end of 20X0 and 20X1, a company has deductible and taxable temporary differences as follows: 20X0 Deductible Taxable $ 40,000 55,000 $ 20X1 60,000 70,000

b. At the end of 20X0, deferred tax liabilities amount to $18,700 (taxable temporary differences of $55,000 34%) and deferred tax assets total $13,600 (deductible temporary differences of $40,000 34%). A valuation allowance was not considered necessary for the deferred tax assets. The company recorded a net deferred tax liability of $5,100 (deferred tax liabilities of $18,700 * deferred tax assets of $13,600). c. Based on pretax income in previous years and the amount expected in future years, the effect of the graduated tax rates is not considered significant. There are no enacted changes to the 34% tax rate. Deferred tax liabilities and assets at the end of 20X1 would be calculated as follows (assuming that a valuation allowance is not considered necessary for the deferred tax assets): Deferred tax liability ($70,000 34%) Deferred tax asset ($60,000 34%) Net deferred tax liability 265 $ $ 23,800 20,400 3,400

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The deferred tax benefit for 20X1 would be as follows: Ending deferred tax liability Beginning deferred tax liability Deferred tax expense $ $ 3,400 5,100 (1,700 )

Illustration 3Using a Flat Tax Rate of 34% to Calculate Deferred Taxes When There Is an Enacted Tax Rate Increase. If currently enacted tax law requires changes in future tax rates, companies will need a knowledge of when temporary differences will reverse. Thus, companies will need to estimate the reversals of temporary differ ences to some extent. The amount of scheduling can be reduced by using estimates or aggregate calculations. Companies may group several years together and, thus, schedule reversals based on only a few periods (for example, the period before the rate change and the period after the rate change). To illustrate, assume the same facts as in Illustration 1 except that during 20X1, tax rate changes were enacted that increased tax rates to 37% for 20X2 and to 40% for 20X3 and thereafter. Assume the taxable temporary differences totaling $90,000 are expected to reverse $50,000 in 20X2 and $40,000 in 20X3. As discussed previously, enacted future tax rates are used to calculate deferred taxes. Based on the assumed facts, the deferred tax liability at the end of 20X1 would be calculated as follows: Temporary Differences Expected To Reverse in 20X2 20X3 $ $ Amount 50,000 40,000 Tax Rate 37% 40% $ $ $ The deferred tax expense for 20X1 would be determined as follows: Ending deferred tax liability Beginning deferred tax liability Deferred tax expense $ $ 34,500 13,600 20,900 Deferred Tax Liability 18,500 16,000 34,500

Illustration 4Using an Average Graduated Tax Rate to Calculate Deferred Taxes. The preceding illustrations have each assumed the use of a flat tax rate. That not only simplified the illustrations but also reflects the belief that flat tax rates will often be used. However, an average graduated rate may be used in some situations, and the following illustrates how deferred taxes would be calculated assuming the following facts: a. At the end of 20X0, a company recorded a deferred tax liability of $3,300. b. At the end of 20X1, the company has deductible and taxable temporary differences as follows: 20X1 Deductible Taxable $ 60,000 70,000

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c. Enacted tax rates at the end of 20X1 are as follows: Taxable Income First $50,000 $50,001 to $75,000 $75,001 to $100,000 $100,001 to $335,000 Over $335,000 Tax 15% of taxable income $7,500 plus 25% of the amount over $50,000 $13,750 plus 34% of the amount over $75,000 $22,250 plus 39% of the amount over $100,000 34% of taxable income

d. Taxable income for 20X0 and 20X1 is $100,000 and $110,000, respectively. It is expected that income will remain at approximately that level throughout the reversal period of the temporary differences. No significant income at special tax rates (such as the capital gain rate in effect prior to the Tax Reform Act of 1986) is expected. The average graduated tax rate would be calculated as follows: Tax on $110,000 [($110,000*$100,000) 39% + $22,250] $ 26,150 24 %

Average graduated tax rate ($26,150 B $110,000)

The deferred tax liability at the end of 20X1 would be calculated as follows (assuming that a valuation allowance is not considered necessary for the deferred tax assets): Deferred tax liability ($70,000 24%) Deferred tax asset ($60,000 24%) Net deferred tax liability The deferred tax benefit for 20X1 would be determined as follows: Ending deferred tax liability Beginning deferred tax liability Deferred tax benefit Accounting for Loss Carryforwards GAAP requires a deferred tax asset to always be recognized for the tax benefits of loss carryforwards, but it also requires a valuation allowance to be provided if it is more likely than not that all or a portion of the deferred tax asset will not be realized. Furthermore, only loss carryforwards available for income tax purposes are considered. Thus, the necessary information can be easily obtained from the income tax returns or from tax files. There is no need for a separate calculation to convert that information to carryforwards for financial reporting. To illustrate accounting for operating loss carryforwards assume the following: a. A company has a net operating loss carryforward for tax purposes of $25,000. b. The company has determined that a flat tax rate of 34% will be used to compute deferred taxes. A deferred tax asset for the operating loss carryforward in the amount of $8,500 ($25,000 recorded. Evaluating the need for a valuation allowance is discussed later in this lesson. The Alternative Minimum Tax System Perhaps the most significant provision of the Tax Reform Act of 1986 is the corporate alternative minimum tax rules, which were conceived to ensure that all companies pay at least a minimum amount of tax. Under the rules, a 267 34%) would be $ $ 2,400 3,300 (900 ) $ $ 16,800 14,400 2,400

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company's tax liability is the greater of taxes calculated using either the regular tax system or the alternative minimum tax system. In reality, the AMT rules are structured so that many companies calculate two tax amounts: one based on the regular tax rules and a tentative minimum tax (TMT) based on the AMT rules. If the TMT exceeds the regular tax, an additional tax equal to the excess, referred to as the alternative minimum tax (AMT), also must be paid. For tax years beginning after 1997, certain small corporations" are exempt from AMT if their threeyear average annual gross receipts do not exceed $5 million for the first tax year beginning after 1996 and do not exceed $7.5 million for later tax years. Corporations that qualify for the AMT exemption for tax years beginning in 1998 remain exempt from AMT as long as their average gross receipts for the preceding three years do not exceed $7.5 million. Corporations that initially qualify for the small corporation exemption from AMT but subsequently fail the $7.5 million average gross receipts test become subject to AMT on a prospective basis (for certain AMT preferences and adjustments relating to transactions occurring in and after the year the corporation fails the test). A new corporation receives an automatic AMT exemption, regardless of its receipts, in its first year of existence. The corporation remains exempt in its second year if gross receipts for the first year do not exceed $5 million (on an annualized basis, if the first year was less than 12 months). The corporation remains exempt in its third year if average gross receipts for the first two years do not exceed $7.5 million (after annualizing the first year's receipts, if necessary). The corporation remains exempt from AMT in subsequent years as long as its average gross receipts for the three prior years do not exceed $7.5 million (after any necessary annualizing). Once a corporation ceases to qualify for the exemption, the exemption cannot be regained in a future year. Income taxable under the AMT system is referred to as AMT income (or AMTI). It consists of taxable income adjusted as follows: a. Items designated as preference items are added to taxable income in determining AMTI. The items that are currently designated as preference items include percentage depletion, intangible drilling costs, taxexempt interest on certain private activity bonds, charitable contributions of certain appreciated capital gain property, and accelerated depreciation on certain property placed in service before 1987. b. Items designated as adjustments are either added to or subtracted from taxable income in determining AMTI. The items that are currently designated as adjustments include methods used to account for longterm contracts other than the percentageofcompletion method, adjusted gain or loss on dispositions, alternative tax net operating loss deductions, mining exploration and development costs, amortization of certified pollution control facilities, merchant marine capital construction funds, special deductions for Blue Cross/Blue Shield organizations, and alcohol fuel credits. In addition, the AMT system imposes a depreciation method that adjusts depreciation for purposes of calculating AMTI. For property placed in service after December 31, 1998, the Taxpayer Relief Act of 1997 repealed the AMT depreciation adjustment resulting from the use of ADS recovery periods. In addition, the Internal Revenue Service Restructuring and Reform Act of 1998 allows taxpayers the option of completely eliminating the AMT depreciation adjustment by electing the 150% declining balance method (using regular tax depreciation lives) on property otherwise eligible for the 200% declining balance method. The AMT depreciation adjustment must continue to be made for property placed in service on or before December 31, 1998, for as long as the property is owned. ACE Adjustment. For tax years beginning in 1990, taxable income also is increased or decreased by an adjust ment for adjusted current earnings (ACE adjustment). The ACE adjustment increases or decreases AMTI by 75% of the difference between ACE and AMTI (computed without regard to NOL deductions and the ACE adjustment itself). The ACE adjustment may not decrease AMTI by more than the net cumulative amount by which it has increased AMTI in prior years, however. The AMT rate (currently 20%) is applied to the excess of the AMTI over a prescribed exemption to determine the AMT. The exemption is $40,000, but it is phased out so that there is no exemption when AMTI is $310,000 or more. The phaseout is accomplished by reducing the exemption by 25% of the excess of AMTI over $150,000. To illustrate, assume that AMTI is $200,000, which exceeds the $150,000 starting point for the phaseout by $50,000. Accordingly, the exemption is reduced by $12,500 (or 25% of the $50,000 excess) and would equal $27,500 ($40,000 less $12,500). The AMT rate would be applied to the $172,500 excess of AMTI over the available exemption (or $200,000 less $27,500), and the AMT would be $34,500 (or $172,500 20%). 268

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With certain limitations, an excess of AMT over regular tax may be carried forward indefinitely to offset the excess of the regular tax over the AMT in future years. It may never reduce the tax for a year below the AMT, however. The carryforward is referred to as the AMT credit. There are no limits on the amount of excess AMT that can be carried forward as a credit for tax years beginning after 1989. However, the Taxpayer Relief Act of 1997 requires small corporations" that are exempt from AMT for tax years beginning after December 31, 1997, to reduce the regular tax by 25% of the amount over $25,000 when calculating how much of the AMT credit carryforward related to prior years may be used. Determining Deferred Taxes under the AMT System. The current income tax provision should be the higher of income taxes determined under the regular and AMT systems. Deferred taxes, however, should only be computed using tax rates and temporary differences determined under the regular tax system; tax rates and temporary differences under the AMT system should not be considered. However, similar to other types of tax credit carryfor wards, deferred tax assets should be recorded for the tax benefits attributable to the AMT credit carryforwards. The deferred tax asset should be reduced by a valuation allowance if it is more likely than not that some portion or all of the asset will not be realized.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 23. Frilly Girlz Boutique is depreciating select assets over a shorter time frame for tax purposes than permitted by GAAP . What type of a difference will the boutique have between financial and income tax reporting? a. A permanent difference. b. A deductible temporary difference. c. A taxable temporary difference. d. A deductible reversal. 24. What should companies consider when calculating deferred taxes under SFAS No. 109, Accounting for Income Taxes? a. Tax rates under the regular tax system. b. Tax rates under the regular tax system and temporary differences under the alternative minimum tax system. c. Tax rates under the regular tax system and the effects of the alternative minimum tax system on the annual reversals. 25. Pet Couture is subject to a flat tax rate of 34%, has taxable temporary differences of $120,000, and deductible temporary differences of $50,000. A valuation allowance is not considered necessary. How much is the net deferred tax liability? a. $17,000. b. $23,800. c. $40,800. d. $50,000. 26. Busy Bees Service Company is subject to a flat tax rate of 34%, has miscellaneous taxable temporary differences of $20,000, and deductible temporary differences of $5,000. In addition, Busy Bees has a net operating loss carryforward for tax purposes of $7,000. The company believes that all of the deferred tax asset will be realized. Therefore, a valuation allowance is not considered necessary. How much is the net deferred tax liability? a. $1,700. b. $2,380. c. $2,720. d. $6,800.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 23. Frilly Girlz Boutique is depreciating select assets over a shorter time frame for tax purposes than permitted by GAAP . What type of a difference will the boutique have between financial and income tax reporting? (Page 262) a. A permanent difference. [This answer is incorrect. Permanent differences refer to income and expenses that are reported in the financial statements but will never be reported in the tax return. An example of a permanent difference is federal income tax. FIT is reported as an expense in the financial statements but is never recorded as an expense on the federal tax return.] b. A deductible temporary difference. [This answer is incorrect. Deductible temporary differences are expenses that have been recognized in the financial statements but will be deducted in future tax returns or income recognized in the tax returns but deferred for financial statement reporting.] c. A taxable temporary difference. [This answer is correct. Taxable temporary differences generally represent expenses that have been deducted in the tax returns but will be expensed in future financial statements or income recognized in the financial statements that will be taxable in future tax returns.] d. A deductible reversal. [This answer is incorrect. Deductible reversals refer to reversals of deductible differences.] 24. What should companies consider when calculating deferred taxes? (Page 262) a. Tax rates under the regular tax system. [This answer is correct. Companies need only consider tax rates under the regular tax system per SFAS No. 109.] b. Tax rates under the regular tax system and temporary differences under the alternative minimum tax system. [This answer is incorrect. Temporary differences under the alternative minimum tax system are not required to be considered when calculating temporary differences. However, deferred tax assets should be recorded for the tax benefits attributable to any AMT credit carryforwards.] c. Tax rates under the regular tax system and the effects of the alternative minimum tax system on the annual reversals. [This answer is incorrect. The effects of the alternative minimum tax system on the annual reversals are not required to be considered when calculating temporary differences. However, any deferred tax asset that has been recorded with benefits attributable to AMT credit carryforwards should be reduced by a valuation allowance if it is more likely than not that some portion or all of the asset will not be realized.] 25. Pet Couture is subject to a flat tax rate of 34%, has taxable temporary differences of $120,000, and deductible temporary differences of $50,000. A valuation allowance is not considered necessary. How much is the net deferred tax liability? (Page 265) a. $17,000. [This answer is incorrect. This amount is the deferred tax asset ($50,000 34%).]

b. $23,800. [This answer is correct. The deferred tax liability is $40,800 ($120,000 34%). The deferred tax asset is $17,000 ($50,000 34%). The net of these two numbers is the net deferred tax liability.] c. $40,800. [This answer is incorrect. This amount is the deferred tax liability ($120,000 34%).]

d. $50,000. [This answer is incorrect. This amount is the deductible temporary differences.]

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26. Busy Bees Service Company is subject to a flat tax rate of 34%, has miscellaneous taxable temporary differences of $20,000, and deductible temporary differences of $5,000. In addition, Busy Bees has a net operating loss carryforward for tax purposes of $7,000. The company believes that all of the deferred tax asset will be realized. Therefore, a valuation allowance is not considered necessary. How much is the net deferred tax liability? (Page 267) a. $1,700. [This answer is incorrect. This amount is the deferred tax asset ($5,000 34%).]

b. $2,380. [This answer is incorrect. This amount is the deferred tax asset for the operating loss carryforward ($7,000 34%).] c. $2,720. [This answer is correct. The deferred tax liability from the miscellaneous taxable temporary differences is $6,800 ($20,000 34%). The deferred tax asset is $1,700 ($5,000 34%). The deferred tax asset for the operating loss carryforward is $2,380 ($7,000 34%). The net of these numbers is the net deferred tax liability.] d. $6,800. [This answer is incorrect. This amount is the deferred tax liability ($20,000 34%).]

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Considering the Need for a Deferred Tax Asset Valuation Allowance The deferred tax asset should be reduced by a valuation allowance if it is more likely than not that all or a portion of it will not be realized. In other words, a deferred tax asset should only be recognized if there is more than a 50% chance that it will be realized. Whether a deferred tax asset will be realized requires considerable judgment. Companies should weigh the potential effects of both positive and negative evidence. If negative evidence exists, it may be difficult to conclude that a valuation allowance is not needed for at least a portion of the deferred tax asset. The existence of negative evidence does not always indicate that a valuation allowance is needed, however. In some cases, positive evidence may exist that outweighs the negative evidence, and a conclusion can be reached that a valuation allowance is not necessary. SFAS No. 109, Paragraphs 2324 (FASB ASC 740103021 and 3022), lists the following examples of negative and positive evidence that should be considered (the list is not allinclu sive): Negative evidence  Cumulative losses in recent years  A history of operating loss or tax credit carryforwards expiring unused  Losses expected in early future years by a presently profitable entity  Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years  A carryback, carryforward period that is so brief that it would limit realization of tax benefits if (a) a significant deductible temporary difference is expected to reverse in a single year or (b) the enterprise operates in a traditionally cyclical business Positive evidence  Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures  An excess of appreciated asset value over the tax basis of the entity's net assets in an amount sufficient to realize the deferred tax asset  A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual, infrequent, or extraordinary item) is an aberration rather than a continuing condition Whether a deferred tax asset will be realized ultimately depends on whether there will be sufficient taxable income available during the carryback, carryforward period available under the tax law. SFAS No.109 (FASB ASC 740103018) lists the following sources of taxable income that should be considered when determining the need for a valuation allowance: a. Future reversals of existing taxable temporary differences b. Future taxable income exclusive of reversing temporary differences and carryforwards c. Taxable income in prior carryback years if carryback is permitted under the tax law d. Taxplanning strategies The following paragraphs provide guidance for estimating future taxable income from each of the four sources. Estimating Future Reversals of Existing Taxable Temporary Differences. Companies may conclude that all or a portion of their deferred tax assets will be realized if future reversals of existing deductible differences can be 274

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offset by future reversals of existing taxable differences. In some cases, considering future reversals of taxable differences may be the easiest way to determine that no valuation allowance is needed. For example, assume that a company has a $20,000 taxable temporary difference at the end of 20X1 that is expected to reverse in even amounts over the next four years. The company also has a $15,000 deductible temporary difference that is expected to reverse in 20X3. A valuation allowance would not be necessary since the reversal of the deductible temporary difference will be offset by reversals of existing taxable temporary differences through carryback and carryforward provisions under the tax law. When considering future reversals of taxable differences, it may be necessary to schedule the reversals (that is, identify the future years in which each temporary difference is expected to reverse) to some extent. The amount of scheduling, however, will depend on the facts and circumstances of each case. It is believed that scheduling often will not be necessary, or the amount of scheduling can often be reduced by using estimates or approximate calculations. For example, in the preceding paragraph, it is apparent, without scheduling, that the reversal of the deductible temporary differences will be offset by reversal of existing taxable temporary differences within the carryback, carryforward period available under the tax law. Deductible differences can only be offset by taxable differences of the appropriate character. For example, under current federal tax laws, capital losses may only be deducted if they offset capital gains. Thus, the tax effects of an existing deductible difference related to unrealized capital losses will not be realized if the only source of future taxable income is reversals of existing taxable differences that will produce ordinary income. Considering Future Taxable Income. Companies may conclude that no deferred tax valuation allowance is needed if there is more than a 50% probability that future taxable income will be sufficient to realize the deferred tax asset. For example, assume (a) a company has recorded a $10,000 deferred tax asset for a tax credit carryforward that will expire in 10 years, (b) the company expects its taxable income next year to be approximately $50,000, and (c) the currently enacted tax rate that is expected to be in effect next year is 34%. Based on those assumptions, the company's expected income tax before using the tax credit carryforward is $17,000 ($50,000 34%). Thus, the company expects sufficient taxable income next year to realize its $10,000 tax credit carryforward and a deferred tax valuation allowance is not necessary. One source of future taxable income that should be considered when determining whether a valuation allowance is necessary is future taxable income exclusive of reversals of existing temporary differences. Reversals of existing temporary differences are implicit in estimates of future taxable income, however. Taxable income consists of GAAP income adjusted for permanent differences and originating temporary differences and reversing temporary differ ences. Thus, to conclude that no valuation allowance is needed for deductible temporary differences, companies need only determine that there is more than a 50% chance that taxable income will exist in the year that the deductible differences are expected to reverse. The fact that taxable income is expected to exist in that year indicates that the deductible reversals will be offset by other sources of taxable income. Future taxable income does not include the effects of operating loss or tax credit carryforwards, however. Therefore, when considering the need for a valuation allowance for those items, the mere existence of taxable income during the carryforward period does not indicate that a valuation allowance is not needed. In those cases, companies must determine that there is more than a 50% chance that future taxable income will be sufficient to absorb the loss carryforward or that taxes on future taxable income will be sufficient to offset the tax credit carryforward. When determining whether a valuation allowance is needed, companies should consider not only whether suffi cient future taxable income will exist but whether the appropriate character of taxable income will exist. For example, assume the following: a. Current federal income tax law allows corporations to deduct capital losses only if they offset capital gains. Unused capital losses may be carried back three years and carried forward five years. b. At the end of 20X4, a company has a $15,000 deductible difference related to an unrealized loss on marketable securities.

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c. The company expects to realize the loss in 20X5; however, no capital gains are expected in that year. Thus, the company will be able to carry back the capital loss three years (20X220X4) and carry forward any remaining capital loss five years (20X620Y0). d. The company's taxable income during 20X320X4 totaled $85,000. None of that taxable income resulted from capital gains. e. The company expects approximately $35,000 of taxable income each year during the next six years. The company expects that $5,000 of the 20X6 taxable income will result from capital gains. f. The currently enacted tax rate is 34%. In this example, taxable income during the carryback, carryforward period is expected to total $295,000. Only $5,000 of that taxable income will result from capital gains, however. Therefore, only $5,000 of the $15,000 deductible difference will be deducted on the company's tax returns. A valuation allowance of $3,400 [($15,000 * $5,000) 34%] is needed at the end of 20X4. Taxable Income in Prior Carryback Years. Many tax jurisdictions allow unused losses and deductions to be carried back to offset taxable income of prior tax years. For example, current federal tax law allows most companies to carry back operating losses two years. To the extent that carrybacks are allowed by tax law, taxable income in prior carryback years may be considered when determining the need for a valuation allowance. The carryback period is measured from the year that the deductible difference reverses, not originates. For example, in the illustration in item c. listed previously, the deductible difference originated in 20X4 but was expected to reverse in 20X5. Thus, the deduction was carried back beginning with the third year preceding 20X5, not 20X4. Taxplanning Strategies. Taxplanning strategies are required to be considered only when determining the amount of the deferred tax asset valuation allowance, not when otherwise calculating deferred tax assets or liabilities. Taxplanning strategies must meet the following three criteria to be considered qualifying strategies:  The Strategy Must Be Prudent and Feasible. A strategy is prudent and feasible if management has the ability to implement the strategy and expects to do so if necessary in future years. For example, the sale of an asset that is essential to operations would not be prudent because the asset would need to be replaced; but a strategy to sell the asset and lease it back may be considered prudent. The strategy would only be feasible, however, if the company is likely to find a party that would enter into the saleleaseback transaction. The overriding consideration is that management is able to apply and intends to apply the strategy unless conditions change.  The Strategy Is One That Management Ordinarily Might Not Take, But Would Take to Prevent an Operating Loss or Tax Credit Carryforward from Expiring Unused. Thus, management must actually intend to implement the strategy if necessary to realize the tax benefits of operating loss or tax credit carryforwards. For example, a company that uses accelerated depreciation methods for tax reporting may decide to use the straightline method for future acquisitions if the additional income from reduced depreciation would enable the company to use a loss carryforward.  The Strategy Would Result in the Realization of Deferred Tax Assets. Taxplanning strategies are only considered when determining the need for a deferred tax asset valuation allowance. Since taxplanning strategies are designed to enable realization of deferred tax benefits, they can be viewed as methods of increasing future taxable income by (a) changing the tax treatment of recurring transactions or (b) initiating future transactions that will generate taxable income of the appropriate character. Strategies may involve elections to treat recurring transactions differently, either retroactively or prospectively. The following are examples of such strategies:  A strategy to retroactively change from accelerated depreciation methods to straightline methods would accelerate the reversal of the underlying taxable difference. The additional taxable income would be available for the offset of deductible differences or loss carryforwards. 276

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 Companies may change the tax treatment of recurring future transactions to shift estimated future taxable income between future years. For example, a company that uses accelerated depreciation methods for tax reporting purposes may elect to begin using straightline methods for future acquisitions. Such an election would reduce future depreciation expense and, as a result, increase future taxable income. Similarly, a company may elect to terminate its LIFO election so that the cumulative effect of the reserve will generate future taxable income. (That strategy would be prudent if the company expects prices to remain stable so that LIFO will not provide the advantages it provided in earlier years.) Initiating future transactions to generate taxable income involves selling or reducing an existing asset or liquidating or reducing an existing liability. Examples include the following:  Selling investments in securities to generate capital gains so that capital loss carryforwards may be used  Selling a building that is essential to continuing operations through a saleleaseback agreement so that the gain on the sale generates taxable income of the appropriate character (i.e., capital gains or ordinary income through recapture provisions)  Retiring longterm debt at a discounted amount to generate ordinary taxable income that will allow a loss carryforward to be used (If longterm interest rates are currently higher than the stated rate of longterm debt, the lender may be willing to accept early payoff at a discounted amount. If so, the excess of the outstanding principal over the settlement amount would be taxed as ordinary income. The strategy would only be feasible if the lender agrees to the early payoff. It would only be prudent if the company could raise the required cash to retire the debt without hurting its operations.)  If trade accounts receivable are sold, the receivable balance may exceed the sales price because of potential collection problems. The loss on sale is deductible in the year of the sale. Such a strategy effectively accelerates the reversal of deductible differences related to bad debts, perhaps to a year with sufficient taxable income to offset the deductible differences. Several taxplanning strategies may be available to a company that would reduce or eliminate the need for a valuation allowance. For example, assume that using one strategy would reduce a company's valuation allowance by $4,000, using another would reduce the company's valuation allowance by $9,000, and using both strategies would reduce the company's valuation allowance by $13,000. In that situation, the company should recognize the effect of both strategies and reduce the valuation allowance by $13,000. The company may not recognize the effect of one strategy and postpone the effect of the other until a later year. Since all known taxplanning strategies should be considered, how extensive an effort should management make to identify all taxplanning strategies? The FASB indicates that companies should make a reasonable effort to identify all significant taxplanning strategies. The company's obligation to consider taxplanning strategies to reduce the valuation allowance required is the same as its obligation to apply the requirements of other accounting pronouncements. (Asearch for taxplanning strategies is not necessary, however, if it can be concluded that taxable income from other sources will be adequate to eliminate the need for a valuation allowance.) Considering the Costs of Implementing the Strategies. The valuation allowance should reflect the costs of implementing taxplanning strategies. Those costs not only include the direct costs of implementing the strategies, such as legal costs and commissions, but their related tax effects as well (i.e., the tax benefit of the additional expenses incurred to implement the strategy). Only costs that would not otherwise be incurred should be consid ered, and they should be considered net of the tax benefit of their deduction. To illustrate, assume that a strategy is available to accelerate the reversal of a taxable difference of $12,000, enabling a net operating loss carryforward of $9,000 to be used before it expires. If there are no other sources of taxable income, a 30% tax rate applies, and costs of $1,500 would be incurred to implement the strategy, deferred tax balance sheet accounts would be as follows: (a) deferred tax liability of $3,600 ($12,000 taxable difference 30%), (b) a deferred tax asset of $2,700 ($9,000 carryforward 30%), and (c)a valuation allowance of $1,050 (costs of $1,500 less tax benefit of $450 from deducting those costs). In the year the loss carryforward arises, a tax benefit of $1,650 should be recognized for the excess of the $2,700 asset over the $1,050 allowance. When the strategy is implemented and the costs are incurred, theremaining benefit of $1,050 is recognized. In that year, there 277

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would be a pretax loss of $1,500 equal to the implementation costs incurred and a tax benefit of $1,500 equal to the $450 tax benefit of deducting those costs plus the $1,050 benefit from eliminating the valuation allowance. The deferral of a part of the benefit is required although realization of all of it is more likely than not because of the strategy that accelerates the reversal of existing taxable differences. Deciding Which Sources of Taxable Income to Consider. SFAS No. 109, Paragraph 21 (FASB ASC 740103018), states, To the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered." Thus, companies do not always have to consider each source of future taxable income to determine whether a valuation allowance is needed. If a valuation allowance is needed, however, all four sources of future taxable income must be consid ered to determine the amount of the valuation allowance. The Standard does not establish an order of preference for the four sources of future taxable income. Thus, the sources should be considered in the order that is most efficient. It is believed that taxable income will often be the most efficient source to consider for the following reasons: a. Taxable income of many small to mediumsized companies remains relatively constant. Thus, estimating taxable income in those cases may not be difficult. (When there are significant loss carryforwards that expire in the near future or significant carryforwards that require a certain character of income, however, other sources of future taxable income may also need to be considered.) b. When determining the need for a valuation allowance, precise estimates of taxable income are not always needed. For example, assume that a company has a net operating loss carryforward of $100,000 that expires in 10years. To conclude that no valuation allowance is necessary, the company need only determine that there is more than a 50% probability that it will generate taxable income of $100,000 during the next 10 years. Precise estimates of the amount of taxable income during each of the next 10 years are not needed. c. Future taxable income includes future reversals of existing taxable and deductible differences. Thus, a valuation allowance will not be needed for the tax benefits of deductible differences so long as a taxable loss is not estimated for a year during the reversal period. To illustrate, if a deductible difference of $10,000 is expected to reverse next year and breakeven operations are expected, a valuation allowance would not be needed. The deductible reversal would be offset by $10,000 of other sources of taxable income. (That does not apply when considering the need for a valuation allowance for loss carryforwards, however.) Because the most efficient approach varies depending on the company and its circumstances, however, there will be instances in which each of the four sources will be most efficient. In some cases, considering taxable reversals may be the easiest and least subjective method of determining whether a valuation allowance is necessary. Reversals of existing temporary differences are implicit in estimates of future taxable income. As a result, consider ing future taxable income views two of the four sources of future taxable income (i.e., reversals of existing taxable differences and future taxable income exclusive of reversals of existing temporary differences) as a single source. Thus, companies should not consider reversals of existing taxable temporary differences in addition to future taxable income unless future taxable income specifically excludes those reversals. Companies may conclude that a valuation allowance is not needed if future reversals of existing deductible differences can be offset by future reversals of existing taxable differences. Although some scheduling may be required to reach that conclusion, detailed scheduling of the reversals of taxable and deductible differences for each year may not be necessary. Question 2 of the FASB Special Report on SFAS No. 109 (FASB ASC 740105517) states, . . . if existing taxable temporary differences that will reverse over a long number of future years greatly exceed deductible differences that are expected to reverse over a short number of future years, it may be appropriate to conclude, in view of the [20year] carryforward period for net operating losses, that realization of future tax benefits for the deductible differences is thereby more likely than not without the need for scheduling." If deductible reversals exceed taxable reversals, the likelihood of taxable income from other sources should be assessed. In other cases, considering taxable income in prior carryback years may be the most efficient method of determin ing whether a valuation allowance is necessary. If the carryback period includes the current year and one or more 278

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years prior to the current year, the taxable income in carryback years will be based, at least in part, on actual taxable income. Therefore, considering taxable income in carryback years is less subjective than estimating taxable income from other sources. In still other cases, considering taxplanning strategies may be the most efficient method of concluding that no valuation allowance is needed. For example, a company may have tax exempt investment securities. A taxplanning strategy to sell the assets could result in additional future taxable income that would allow deferred tax assets to be realized. Considering More Than One Source of Future Taxable Income. In some situations, it may be necessary to consider more than one source of future taxable income to determine whether a valuation allowance is necessary. To illustrate, assume that a company has a net operating loss carryforward of $200,000 that expires in three years. The loss carryforward arose primarily due to significant losses during the first few years after the company was formed. Since that time, taxable income has ranged from $25,000 to $50,000. The company expects future taxable income from the following sources:  Future Taxable Income (i.e., Reversals of Existing Taxable Differences and Taxable Income Exclusive of Reversals of Existing Taxable Differences). Based on past trends, the company believes that $100,000 of taxable income will be generated during the next three years.  Taxable Income in Prior Carryback Years. The existence of operating loss carryforwards indicate that there is no available taxable income in prior carryback years. Either (a) the taxable income in prior carryback years has already been used to offset the operating loss carryforwards or (b) an election was made to forego carryback and carry the losses forward.  Taxplanning Strategies. The company has a note receivable from the sale of real estate in a prior year. The sale is accounted for under the installment method, and gross profit of $50,000 has been deferred. Management would pledge the note for collateral for new debt in an arrangement that would trigger recognition of all of the deferred taxable income. Costs of implementing the strategy are expected to be insignificant. Considering those sources of future taxable income, the loss carryforward would be realized as follows: Loss carryforward Sources of future taxable income: Taxable income during the next three years Taxplanning strategies: Gross profit recognized upon sale of note receivable Unused loss carryforward Assumed average tax rate Valuation allowance needed $ $ 200,000 (100,000 ) (50,000 ) 50,000 15 % 7,500

To record the deferred tax benefits of the loss carryforward, the company would record a deferred tax asset of $30,000 ($200,000 15%) and a valuation allowance of $7,500. Income Statement Presentation Captions. Income tax expense generally is presented as a separate line item in the income statement immediately preceding net income (or income before extraordinary items and cumulative accounting adjustments, if applica ble). Many companies use the caption Income Taxes," although Federal Income Taxes" frequently is used if a company is not subject to taxes of other jurisdictions. Other captions that may be used include the following: a. Provision for Income Taxes (or Provision for Taxes on Income) 279

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b. Taxes on Income (or Taxes on Earnings) c. Income Tax Expense d. Federal and State Income Taxes Captions for income tax benefits are illustrated later in this lesson. Disclosing Components of Income Tax Expense. Paragraph 45 of SFAS No. 109 (FASB ASC 74010509) requires the following components of income tax expense attributable to continuing operations to be disclosed either on the face of the financial statements or in the related notes for each period presented: a. Current tax expense or benefit b. Deferred income tax expense or benefit, exclusive of any adjustments for the components listed in c. through h. c. Investment tax credits d. Government grants (to the extent recognized as a reduction of income tax expense) e. The benefits of operating loss carryforwards f. Tax expense that results from allocating certain tax benefits either directly to contributed capital or to reduce goodwill or other noncurrent intangible assets of an acquired entity. SFAS No. 141 (revised 2007), Business Combinations (FASB ASC 805), which was issued in December 2007, revises this disclosure requirement. Subsequent to the effective date of the new Statement, this disclosure would be limited to the disclosure of the tax expense that results from allocating certain tax benefits directly to contributed capital. SFAS No. 141(R) (FASB ASC 805) applies prospectively to business combinations with an acquisition date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier application is not permitted. g. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or for a change in a company's tax status h. Adjustments of the beginningoftheyear balance of a valuation allowance because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years. SFAS No. 141(R) (FASB ASC 805) revises SFAS No. 109 (FASB ASC 74010509) to include any acquisitiondate income tax benefits or expenses recognized from changes in the acquirer's valuation allowance for its previously existing deferred tax assets due to a business combination as an example of this disclosure. Note that the standard only requires the components of income tax expense related to continuing operations to be disclosed. Thus, total tax expense allocated to items other than continuing operations (for example, extraordinary items and discontinued operations) should be disclosed, but the financial statements need not disclose the components of income tax expense allocated to other elements of net income. SFAS No. 130, Reporting Compre hensive Income, (FASB ASC 220104512) requires disclosure of the income tax expense or benefit allocated to each component of other comprehensive income.

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If the components of tax expense include only current and deferred taxes or current taxes, deferred taxes, and ITC, some companies disclose the components on the face of the income statement. For example: INCOME BEFORE INCOME TAXES INCOME TAXES Current Deferred NET INCOME or INCOME BEFORE INCOME TAXES INCOME TAXES Current, net of investment tax credit of $10,000 Deferred NET INCOME $ 174,400 34,300 12,100 46,400 128,000 $ 378,000 98,000 30,000 128,000 250,000

Note that although the current and deferred components of income tax expense include taxes from all applicable tax jurisdictions (for example, federal, foreign, state, and local), taxes from each jurisdiction typically are not shown separately on the income statement. Even though the components of income tax expense are permitted to be disclosed on the face of the income statement, many companies show income tax expense as a net amount, as illustrated below, and disclose the components in the notes to the financial statements. INCOME BEFORE INCOME TAXES INCOME TAXES NET INCOME $ 213,600 48,500 165,100

Net Operating Losses. Paragraph 37 of SFAS No.109 (FASB ASC 74020453) states that, in most circumstances, the tax benefits of loss carryforwards or carrybacks . . . shall be reported in the same manner as the source of the income or loss in the current year and not in the same manner as (a) the source of the operating loss carryforward or taxes paid in a prior year or (b) the source of expected future income that will result in realization of a deferred tax asset for an operating loss carryforward from the current year." Thus, tax benefits of operating losses may be classified as either (a) a reduction of the currentperiod income tax expense (or a tax benefit), (b) an extraordinary item, or (c)anelement of discontinued operations. As a general rule, the tax benefits of a currentyear loss are characterized in the same manner as the loss, regardless of whether the loss is carried back or forward. For example, the tax benefits of a loss from continuing operations would be allocated to continuing operations, and the tax benefits of an extraordinary loss would be allocated to the extraordinary item. However, if no tax benefits were recognized in the current year for a currentyear loss because the related deferred tax asset was offset by a valuation allowance, the tax benefits of the loss generally are characterized in the same manner as the income in the subsequent year that enables the tax benefits of the loss carryforward to be realized. For example, assume that no tax benefit was recognized in the current year for an extraordinary loss because the related deferred tax asset was offset by a valuation allowance. If the loss carryforward was realized next year because the company had income from continuing operations, the tax benefits would be allocated to continuing operations. (However, adjustments of the beginningoftheyear balance of a valuation allowance because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset ordinarily should be allocated to continuing operations.) 281

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For most small businesses, it is believed that realization of tax benefits of both loss carrybacks and loss carryfor wards generally will be attributable to income from continuing operations, since the criteria for reporting a transac tion as an extraordinary item are rarely met and discontinued operations are not encountered frequently. Accordingly, the tax benefits of operating losses generally will be shown as a reduction of income tax expense (or as a tax benefit). Special rules apply to the tax effects of deductible differences and operating losses that are recognized in a purchase business combination after the acquisition date (SFAS No. 109, Paragraph 30) (FASB ASC 805740253 and 254)]; prior to the effective date of SFAS No. 141(R); the tax effects of deductible differences and carryforwards related to (a) contributed capital, (b) expenses for employee stock options, (c)dividends paid on unallocated shares held by an ESOP that are charged to retained earnings, and (d) deductible differences and operating losses as of the date of a quasireorganization [SFAS No. 109, Paragraphs 36 (FASB ASC 740204511) and 39 (FASB ASC 852740453)]. The tax effects of deductible differences and carryforwards related to items (a) through (d) should be charged or credited directly to other comprehensive income or to the related components of stockhold ers' equity. SFAS No. 141(R) (FASB ASC 805) applies prospectively to business combinations with an acquisition date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Loss Carrybacks. If operating losses are carried back to earlier periods under provisions of the tax law, the Standard requires an asset to be recognized for the amount of refundable taxes. If there are no temporary differences, either in the period of loss or the carryback periods, the claim for refund of income taxes also should be reported as a tax benefit in the statement of income. The following income statement presentation would be appropriate assuming that the tax benefit is attributable to continuing operations: LOSS BEFORE INCOME TAX BENEFIT INCOME TAX BENEFIT NET LOSS $ (41,500 ) (8,300 ) (33,200 )

If the income statement shows a tax benefit, appropriate captions would include Income Tax Benefit," Federal Income Tax Benefit," and Federal and State Income Tax Benefit." If there are temporary differences, either in the period of the loss or the carryback periods, the claim for refund of income taxes still should be recognized as the current tax benefit. However, because deferred taxes reported in the income statement are based on the change in deferred tax assets and liabilities at the beginning and end of the period, the income statement might report either a deferred tax benefit or a deferred tax expense. If the total of current and deferred taxes results in a net tax benefit, reporting the benefit as a single amount is recommended. Similarly, if a net tax expense results, it is believed that the expense should be reported as a single amount using a caption such as Income Taxes," as illustrated previously. (In either case, the components of income tax expense should be disclosed in the notes to the financial statements.) The following presentation, however, also would be acceptable: INCOME BEFORE INCOME TAXES INCOME TAXES Current tax benefit Deferred tax expense NET INCOME $ 25,000 (2,000 ) 12,000 10,000 15,000

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If the tax loss for the year is carried back and there is an extraordinary loss, the extraordinary item is reported net of the related tax benefits as illustrated below. INCOME BEFORE EXTRAORDINARY ITEM EXTRAORDINARY ITEMsettlement of class action customer suit, net of insurance proceeds (less applicable income taxes of $9,400) NET LOSS $ 8,000 (36,600 ) (28,600 )

Loss Carryforwards. The tax benefit of operating losses that are carried forward should be recognized in the income statement in the year the losses occur but should be reduced by a valuation allowance when it is more likely than not that all or a portion of the assets will not be realized. If no valuation allowance is considered necessary, the tax benefits of the loss are characterized the same as the currentyear loss. If no tax benefits were recognized in the current year for a currentyear loss because the related deferred tax asset was offset by a valuation allowance, the tax benefits of the loss generally are characterized in the same manner as the income in the subsequent year in which the tax benefits of the loss carryforward are realized. Thus, for example, SFAS No. 109, Paragraph 245 (FASB ASC 740105538), indicates that the tax benefit of an operating loss carryforward that (a) is first recognized in a company's financial statements during the current year and (b) resulted from an extraordinary loss in a prior year would be allocated to a. continuing operations if it offsets the current or deferred tax consequences of income from continuing operations, or b. an extraordinary gain if it offsets the current or deferred tax consequences of the extraordinary gain. An exception to the preceding rule exists when tax benefits are recognized in a subsequent year as a result of changes in judgment about the future realization of the tax benefits. In those circumstances, the tax benefits are required to be allocated to continuing operations. Thus, the effects of the change in the valuation allowance should be allocated to continuing operations if the adjustment relates to the tax benefits of items that arose in a prior year and are expected to be realized in a future year. The effects of other changes in the balance of a valuation allowanceincreases in the allowance for deductible differences and carryforwards arising in the current year and decreases in the allowance for realization in the current year of the benefits of items that arose in prior yearsare allocated among continuing operations and items other than continuing operations following the method illustrated items a. and item b. above. To illustrate allocating the tax benefits of loss carryforwards, assume that a company has a loss carryforward at the end of last year in the amount of $30,000. A deferred tax asset of $12,000 ($30,000 40% assumed tax rate) was recorded at that time. The asset was reduced by a $6,000 valuation allowance, however, because the company determined that there was less than a 50% probability that $15,000 of the loss carryforward would be realized in future years. During the current year, the company incurs a loss from continuing operations of $20,000 and a gain from restructuring debt of $60,000. The company carries the $30,000 loss forward to the current year, resulting in a current tax liability of $4,000 on taxable income of $10,000 (taxable income before the loss carryforward of $40,000 * $30,000 loss carryforward 40% tax rate). Although the entire loss carryforward is realized for tax purposes in the current year as a result of the extraordinary gain, $6,000 of it is recognized for financial statement purposes last year and $6,000 of it is recognized this year. The tax benefits of the loss carryforward recognized in the current year financial statements should be allocated to extraordinary items since it offsets the current tax consequences of the extraordinary gain. Income taxes would be allocated between pretax income from continuing operations and the extraordinary gain as follows:

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Current tax expense Deferred tax expense Deferred tax assetbeginning of the year ($12,000 * $6,000) Deferred tax assetend of the year Total income tax expense Allocation Continuing operations: Income tax benefit of loss from continuing operations ($20,000 40%) Extraordinary gain Consisting of: Tax benefit of change in prioryear valuation allowance Tax on gain ($60,000 40%)

$ $ 6,000 $

4,000

6,000 10,000

(8,000 ) $ $ (6,000 ) 24,000 $ 18,000 18,000

The company's income statement would be presented as follows: LOSS BEFORE INCOME TAX BENEFIT AND EXTRAORDINARY ITEM INCOME TAX BENEFIT LOSS BEFORE EXTRAORDINARY ITEM EXTRAORDINARY ITEMgain from restructuring debt, net of related income taxes of $18,000 NET INCOME $ (20,000 ) (8,000 ) (12,000 ) 42,000 30,000

In the preceding illustration, the tax benefits of the prioryear loss carryforward are allocated to the extraordinary gain. They are not allocated to continuing operations because there is no income from continuing operations in the subsequent year; thus, they do not meet the criteria in item a. of the Loss Carryforwards" paragraph. Furthermore, they do not relate to the tax benefits of items that arose in a prior year and are expected to be realized in a future year, and, thus, they do not meet the exception in the previous paragraph. Rather, they relate to the tax benefits of items that arose in a prior year and are realized in the current year. Those adjustments of the balance of a valuation allowance are allocated following the method illustrated in items a. and b. of the Loss Carryforwards" paragraph. Tax Credit Carrybacks and Carryforwards. Certain tax credits that arise but cannot be used in the current year may be carried back for a refund of taxes paid in prior years or carried forward to reduce taxes due in subsequent years. The tax benefits of tax credit carrybacks and carryforwards should be recognized in the income statement in the year they arise, unless they are offset by a valuation allowance. GAAP does not address presenting the tax benefit of tax credit carrybacks or carryforwards. However, it is believed that the guidance provided in the preceding paragraphs for carrybacks and carryforwards of operating losses should be followed. Accordingly, the tax benefit of a tax credit may be classified as either (a)a reduction of the currentperiod income tax expense, (b) an extraordinary item, or (c) an element of discontinued operations, depending on the source of the tax credit in the current year, or, if a valuation allowance is provided, the income in a subsequent year that allows the tax credit to be realized.

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For most small businesses, it is believed that realization of tax benefits of both carrybacks and carryforwards of tax credits generally will be attributable to income taxes related to continuing operations, since the criteria for reporting a transaction as an extraordinary item are strict, and discontinued operations are not encountered frequently. In addition, it is believed that as a result of the Tax Reform Act of 1986, the benefit of tax credits usually will not be material to small businesses, so that all of the benefits generally could be allocated to income taxes related to continuing operations, even if there are components other than continuing operations. Intraperiod Tax Allocation Definition. GAAP requires intraperiod tax allocation, which refers to the mechanics of allocating income taxes within a period to income from continuing operations and to various other components of net income and equity. GAAP requires income taxes to be allocated to the following components: a. Continuing operations b. Discontinued operations: c. Extraordinary items d. Other comprehensive income, for example, unrealized holding gains and losses on availableforsale marketable securities e. Items charged or credited directly to stockholders' equity, such as: (1) Priorperiod adjustments (2) An increase or decrease in contributed capital (for example, stock issue costs that are reported as a reduction of the related proceeds on the financial statements and are deducted for tax purposes) (3) Expenses for employee stock options recognized differently for financial reporting and for tax purposes (4) Dividends that are paid on unallocated shares held by an ESOP and that are charged to retained earnings (5) Deductible temporary differences and carryforwards that existed at the date of a quasireorganization accounted for as a direct addition to contributed capital and recognized for tax purposes in a later period Allocation Method. GAAP prescribes an allocation method that focuses on continuing operations. The difference between income tax expense on income from continuing operations and the total income tax expense or benefit is the tax to be allocated to income from sources other than continuing operations. The basic allocation procedures are as follows: a. Calculate income tax expense or benefit for the year (including current and deferred taxes) b. Determine income taxes on continuing operations, which include the tax effect of: (1) Pretax income or loss from continuing operations (2) Change in tax laws or rates (3) Change in tax status (4) Changes in circumstances that cause a change in judgment about the realization of deferred tax assets in future years 285

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(5) Tax deductible dividends paid to shareholders (except those paid on unallocated shares held by an ESOP and charged to retained earnings) c. The difference between a. and b. is the amount allocated to sources other than continuing operations d. When there is only one source other than continuing operations, the difference in c. is allocated to that source e. When there are two or more sources other than continuing operations, the difference in c. is allocated to each of the sources in proportion to the tax effect of each source Allocation Involving a Single Gain Element. To illustrate allocating tax expense to the components of net income when there is income from continuing operations and an extraordinary gain, assume that a company had no temporary differences and its pretax income included the following components: Income from continuing operations Extraordinary gain GAAP pretax income and taxable income $ $ 60,000 30,000 90,000

Assuming that ordinary income and capital gains are taxed at 40%, income taxes would be allocated as follows: Tax on GAAP pretax income ($90,000 Tax on continuing operations ($60,000 Tax to be allocated to extraordinary gain 40%) 40%) $ $ 36,000 24,000 12,000

Allocation Involving Item Charged to Other Comprehensive Income. Under current GAAP , certain items are charged or credited to other comprehensive income rather than net income. Generally, the tax effects of those items are also charged or credited directly to other comprehensive income. There are a number of situations when that treatment is appropriate. Although many of the situations are uncommon, some, such as changes in unrealized gains and losses on marketable securities classified as availableforsale securities, can be quite common. To illustrate allocating tax expense when there are items charged to other comprehensive income, assume that a company has the following temporary differences: Beginning of Year Unrealized losses on marketable equity securities that are available for sale Accrued expenses Total deductible temporary differences $ $ 23,000 53,000 76,000 $ $ End of Year 37,000 64,000 101,000

Its results of operations for the year (all of which relate to continuing operations) are summarized below: GAAP pretax income Temporary difference related to accrued expenses Taxable income $ $ 360,000 11,000 371,000

Assuming that the tax rate for the current and future years is 40%, the company's total income tax provision would be computed as follows:

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Current taxes ($371,000

40%) $ 40,400 30,400

148,400

Deferred taxes: Ending deferred tax asset ($101,000 40%) Beginning deferred tax asset ($76,000 40%) Total tax provision

(10,000 ) $ 138,400

The company would allocate its income tax provision to continuing operations and other comprehensive income as follows: Current taxes on income from continuing operations ($371,000 40%) Ending deferred tax asset related to accrued expenses ($64,000 40%) Beginning deferred tax asset related to accrued expenses ($53,000 40%) Taxes attributable to income from continuing operations Total tax provision Tax benefit allocated to other comprehensive income $ 25,600 21,200 (4,400 ) 144,000 138,400 $ (5,600 ) $ 148,400

The tax provision allocated to income would be presented in the company's income statement as follows: INCOME BEFORE INCOME TAXES INCOME TAXES NET INCOME $ 360,000 144,000 216,000

The tax benefit allocated to other comprehensive income would be added to the deferred tax amounts allocated to other comprehensive income in previous years (assumed to be $9,200) and the accumulated other comprehensive income would be presented in the company's balance sheet as follows: STOCKHOLDERS' EQUITY Common stock Retained earnings Unrealized loss on marketable equity securities (net of deferred income taxes of $14,800) 1,000 553,800 (22,200 ) 532,600

SFAS No. 130 (FASB ASC 220) also requires disclosure of the income tax benefit or expense allocated to each component of other comprehensive income. Consequently, the notes to the financial statements (or the face of the financial statement that displays the components of other comprehensive income) must disclose the current year tax benefit of $5,600 allocated to other comprehensive income resulting from the $14,000 of unrealized losses on marketable equity securities in the current year. The preceding illustration assumes that a deferred tax asset valuation allowance is not needed. But, what if a valuation allowance were needed because the company did not expect sufficient future capital gains to allow it to deduct the unrealized losses on marketable equity securities? How would the effects of the valuation allowance be allocated between income from continuing operations and other comprehensive income? The tax provision is required to be allocated based on the effects of each category on the total tax provision for the year. Consequently, if the company recorded a valuation allowance at the beginning and end of the year for the full amount of the deferred tax asset related to the unrealized losses, the tax provision would be computed and allocated to income from continuing operations and other comprehensive income as follows: 287

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Total tax provision Current taxes ($371,000 40%) Deferred taxes: Ending deferred tax asset [($101,000 40%) * $14,800 valuation allowance] Beginning deferred tax asset [($76,000 40%) * $9,200 valuation allowance] Total tax provision Allocation to income from continuing operations and other comprehensive income Current taxes on income from continuing operations ($371,000 40%) Ending deferred tax asset related to accrued expenses ($64,000 40%) Beginning deferred tax asset related to accrued expenses ($53,000 40%) Taxes attributable to income from continuing operations Total tax provision (calculated above) Tax benefit allocated to other comprehensive income $ $ 25,600 21,200 (4,400 ) 144,000 144,000 $ 0 148,400 $ $ 25,600 21,200 $ (4,400 ) 144,000 148,400

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 27. Which of the following items is positive evidence in considering the need for a deferred tax asset valuation allowance? a. A brief carryback or carryforward period. b. A history of expired tax credit carryforwards. c. An unsettled circumstance that could adversely affect future operations. d. A sufficient amount of appreciated asset value over the tax basis of the entity's net assets. 28. Which of the following is not one of the three criteria to be considered qualifying taxplanning strategies? a. Management must be willing to implement the strategy. b. The realization of deferred tax assets would be a result of the strategy. c. The strategy must be retroactive. d. The strategy must be prudent and feasible. 29. Which of the following is not a source of future taxable income to consider when determining whether a valuation allowance is necessary? a. A capital contribution. b. Taxable income exclusive of reversals of existing taxable differences. c. Taxable income in prior carryback years. d. Taxplanning strategies. 30. Devine Winery has income from continuing operations of $520,000 and an extraordinary gain of $30,000. The entity did not have any temporary differences. Assume that ordinary income and capital gains are taxed at 30%. What amount of income taxes would be allocated to extraordinary gain? a. $0. b. $9,000. c. $156,000. d. $165,000.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 27. Which of the following items is positive evidence in considering the need for a deferred tax asset valuation allowance? (Page 274) a. A brief carryback or carryforward period. [This answer is incorrect. A carryback, carryforward period that is so brief that it would limit realization of tax benefits if a significant deductible temporary difference is expected to reverse in a single year or the enterprise operates in a traditionally cyclical business is negative evidence that a deferred tax asset will be realized.] b. A history of expired tax credit carryforwards. [This answer is incorrect. A history of tax credit carryforwards expiring unused is negative evidence that a deferred tax asset will be realized.] c. An unsettled circumstance that could adversely affect future operations. [This answer is incorrect. Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years is negative evidence that a deferred tax asset will be realized.] d. A sufficient amount of appreciated asset value over the tax basis of the entity's net assets. [This answer is correct. An excess of appreciated asset value over the tax basis of the entity's net assets in an amount sufficient to realize the deferred tax asset is positive evidence that a deferred tax asset will be realized.] 28. Which of the following is not one of the three criteria to be considered qualifying taxplanning strategies? (Page 276) a. Management must be willing to implement the strategy. [This answer is incorrect. Management must be willing to implement the strategy if necessary to realize the tax benefits of operating loss or tax credit carryforwards to be considered a qualifying strategy.] b. The realization of deferred tax assets would be a result of the strategy. [This answer is incorrect. Taxplanning strategies are only considered when determining the need for a deferred tax asset valuation allowance. Therefore, this is one of the three criteria.] c. The strategy must be retroactive. [This answer is correct. The strategy does not have to be retroactive to qualify. However, some strategies may involve elections to treat recurring transactions differently, either retroactively or prospectively.] d. The strategy must be prudent and feasible. [This answer is incorrect. This answer is a requirement for the tax strategy to be considered qualifying. Management must have the ability to implement the strategy and expect to do so if necessary in future years.] 29. Which of the following is not a source of future taxable income to consider when determining whether a valuation allowance is necessary? (Page 279) a. A capital contribution. [This answer is correct. A capital contribution is not income; it is an increase in equity.] b. Taxable income exclusive of reversals of existing taxable differences. [This answer is incorrect. Future taxable income (i.e., reversals of existing taxable differences and taxable income exclusive of reversals of existing taxable differences) should be considered.]

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c. Taxable income in prior carryback years. [This answer is incorrect. Taxable income in prior carryback years could be considered. The existence of operating loss carryforwards indicate that there is no available taxable income in prior carryback years.] d. Taxplanning strategies. [This answer is incorrect. Taxplanning strategies could be considered as a source of future taxable income, and are required to be considered only when determining whether a valuation allowance is necessary.] 30. Devine Winery has income from continuing operations of $520,000 and an extraordinary gain of $30,000. The entity did not have any temporary differences. Assume that ordinary income and capital gains are taxed at 30%. What amount of income taxes would be allocated to extraordinary gain? (Page 286) a. $0. [This answer is incorrect. The tax allocated to extraordinary gain is not $0. Devine Winery has an extraordinary gain of $30,000. Tax must be allocated to this gain.] b. $9,000. [This answer is correct. The tax on GAAP pretax income is $165,000 ($550,000 30%). Tax on continuing operations is $156,000 ($520,000 30%). The tax to be allocated to extraordinary gain is $9,000 ($165,000 * $156,000).] c. $156,000. [This answer is incorrect. $156,000 is the tax on continuing operations.] d. $165,000. [This answer is incorrect. $165,000 is the tax on GAAP pretax income.]

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EXAMINATION FOR CPE CREDIT


Companion to PPC's Guide to Preparing Financial StatementsCourse 3 The Statement of Income (PFSTG083)
Test Instructions 1. Following these instructions is an examination consisting of multiple choice questions. You may complete the exam by logging on to our online grading system at OnlineGrading.Thomson.com. Click the purchase link and list of exams will appear. You may search for the exam using wildcards. Payment for the exam is accepted over a secure site using your credit card. Once you purchase an exam, you may take the exam three times. On the third unsuccessful attempt, the system will request another payment. Once you successfully score 70% on an exam, you may print your completion certificate from the site. The site will retain your exam completion history. If you lose your certificate, you may return to the site and reprint your certificate. If you prefer, you may continue to mail your completed answer sheet to the address below. In the print product, the answer sheets are bound with the course materials. For the CDROM product, answer sheets may be printed. The answer sheets are identified with the course acronym. Please ensure you use the correct answer sheet. Indicate the best answer to the following exam questions by completely filling in the circle for the correct answer. The bubbled answer should correspond with the correct answer letter at the top of the circle's column and with the question number. 2. If you change your answer, remove your previous mark completely. Any stray marks on the answer sheet may be misinterpreted. 3. Copies of the answer sheet are acceptable. However, each answer sheet must be accompanied by a payment of $75. If you complete all three courses, the price for grading all three is $214 (a 5% discount on all three courses). In order to receive the discounted fees, all courses must be submitted for grading at the same time. OR the price for grading all four is $270 (a 10% discount on all four courses). 4. To receive CPE credit, completed answer sheets must be postmarked by December 31, 2009. Send the completed Examination for CPE Credit Answer Sheet along with your payment to the following address. CPE credit will be given for examination scores of 70% or higher. An express grading service is available for an additional $24.95 per examination. Course results will be faxed to you by 5 p.m. CST of the business day following receipt of your examination for CPE Credit Answer Sheet. 5. Only the Examination for CPE Credit Answer Sheet should be submitted for grading. DO NOT SEND YOUR SELFSTUDY COURSE MATERIALS. Be sure to keep a completed copy for your records. 6. Please allow a minimum of three weeks for grading. 7. Please direct any questions or comments to our Customer Service department at (800) 3238724. Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to: Thomson Reuters Tax & AccountingR&G PFSTG083 Selfstudy CPE P .O. Box 966 Fort Worth, TX 76101 If you are paying by credit card, you may fax your completed Examination for CPE Credit Answer Sheet and Course Evaluation to the Tax & Accounting business of Thomson Reuters at (817) 2524021.

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EXAMINATION FOR CPE CREDIT 1. Which one of the following choices is a characteristic of gains and losses? a. They are a result of rendering services. b. They are usually recorded at their gross amounts. c. They are a result of peripheral events. d. They are a result of producing goods. 2. In which of the following scenarios would revenue be recorded on the statement of income? a. The Coffee Cup Caf sold old restaurant equipment while remodeling. b. Pet Paradise, a retail pet store, sold a luxurious pet bed. c. Ink Jet City, a printer cartridge store, sold used store fixtures. d. Dr. Hurt, a dentist, sold two filing cabinets. 3. An income statement may be presented in which of the following formats? a. Direct format. b. Indirect format. c. Singlestep format. d. Twostep format. 4. Which of the following captions is used in the singlestep format? a. Revenues. b. Gross profit. c. Income from operations. d. Other income and expenses. 5. According to Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, what is(are) the requirements for recording revenue in the financial statements? a. When the amounts are possible and reasonably estimated. b. When the amounts are probable and reasonably estimated. c. When the amounts are billable. d. When the amounts are realized or realizable and are earned.

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6. According to the AICPA nonauthoritative report, Audit Issues in Revenue Recognition," revenue may be improperly recognized due to all of the following except: a. The buyer and seller do not have a firm agreement. b. Customers cannot cancel the sale. c. The product has not been delivered. d. The earnings process is not complete. 7. According to EITF Issue No. 9919 (FASB ASC 6054545), which of the following is a possible indicator that the entity should recognize revenue as a principal? a. The supplier has the credit risk. b. The primary obligor in the arrangement is the supplier. c. The entity has discretion in supplier selection. d. The entity earns a fixed amount. 8. How are taxes, such as sales taxes, required to be reported on the financial statements? a. Recorded as revenue received from the customer and as an expense paid to the taxing authority (gross presentation). b. Recorded as a payable to the taxing authority when collected from the customer, not recorded as revenue (net presentation). c. Recorded using either gross or net presentation. d. Recorded according to the rules of the state/local collection authority. 9. Which of the following elements of net income will be presented last in the income statement? a. Extraordinary items. b. Unusual or infrequent items. c. Discontinued operations of a component of an entity. d. Equity in operations of investees. 10. What should be considered in deciding whether to present an event or transaction as extraordinary? a. The effect of the event or transaction. b. The materiality of the event or transaction. c. The classification of the event by other companies. d. The size of the event or transaction.

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11. Which of the following would not be a component of an entity? a. A subsidiary. b. An operating segment defined by SFAS No. 131 (FASB ASC 28010501). c. A reporting unit defined by SFAS No. 142 (FASB ASC 350203533 through 3538). d. A group of assets dependent on the cash flows from other assets. 12. XYZ Company is in the process of restructuring and will be involuntarily terminating employees. Which of the following sources of accounting guidance should be followed? a. SFAS No. 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits (FASB ASC 71210251). b. SFAS No. 112, Employers' Accounting for Postemployment Benefitsan amendment of FASB Statements No. 5 and 43 (FASB ASC 71210 and 71510 through 60). c. SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (FASB ASC 42010). d. SFAS No. 154, Accounting Changes and Error Corrections (FASB ASC 25010455). 13. Which of the following costs associated with startup activities is expensed as incurred as required by SOP 985, Reporting on the Costs of StartUp Activities, (FASB ASC 7201515 and 7201525)? a. Costs related to opening a new facility. b. Costs of raising capital. c. Costs of advertising. d. Costs of acquiring longlived assets. 14. ABC Manufacturing Company spent $100,000 in the current period for research and development. How will ABC present these costs in the financial statements? a. The costs will be reported on the balance sheet as inventory. b. The costs will be reported as overhead on the statement of income. c. The costs will be expensed as incurred on the statement of income. d. The costs will be deferred to future periods. 15. Which of the following statements correctly describes the amortization of internaluse software? a. The software should be amortized over a three year period. b. The determination of the amortization period should consider obsolescence. c. Amortization should begin when the software is placed into service. d. The software should be amortized as a whole, not as individual modules.

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16. For internaluse software, external costs for unspecified upgrades and enhancements incurred under agreements should be: a. Expensed as incurred. b. Expensed on a straightline basis over the contract period. c. Capitalized or expensed. d. Capitalized and amortized. 17. Austin Company signed a threeyear operating lease agreement with Houston Company. The lessor offered Austin a rent free period of the first nine months. For the remaining months of the lease, Austin's monthly rent will be $4,000. How much rent expense will Austin recognize in month sixteen? a. $0. b. $2,000. c. $3,000. d. $4,000. 18. Assume the same facts as in the previous example. What will be the accrued liability on Austin's books at the end of the thirtyfifth month of the operating lease? a. $0. b. $1,000. c. $4,000. d. $27,000. 19. Fantasy Cakes signed a twoyear operating lease agreement with Space Company. The rent for months one through nine is $450 each month. In month ten, the rent will increase to $550 and remain at that level through the remainder of the lease period. How much rent expense will Fantasy Cakes recognize in month nine? a. $450. b. $500. c. $513. d. $550. 20. According to FSP No. FAS 131, Accounting for Rental Costs Incurred during a Construction Period," (FASB ASC 840202510 and 2511; 84020451) how should rental costs related to building operating leases be accounted for during the construction period? a. Expensed as incurred. b. Capitalized. c. Allocated over the term of the lease. d. Deferred. 297

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21. Noncancelable operating leases with lease terms in excess of what period require disclosures? a. One year. b. Two years. c. Three years. d. Five years. 22. Which of the following directresponse advertising costs is not capitalized? a. Thirdparty artwork. b. Thirdparty written advertising copy. c. Directly associated payroll costs. d. Rent. 23. Travel Around Company's meal expenses for the year per the statement of income were $6,564. Since only fifty percent of that amount is deductible for income tax purposes, what type of a difference is this classified as? a. A permanent difference. b. A deductible temporary difference. c. A taxable temporary difference. d. A temporary difference. 24. If using a flat rate to measure deferred taxes may produce significantly different results than if graduated tax rates had been used, deferred taxes should be calculated using the average tax rate applicable to taxable income of the year in which the temporary difference is expected to reverse. What would be the average graduated tax rate for an expected taxable income of $150,000 under currently enacted tax laws? a. 22%. b. 26%. c. 28%. d. 31%. 25. A valuation allowance should reduce a tax asset for deductible reversals if it is that all or a portion of the asset will not be realized. a. Likely. b. Probable. c. Possible. d. More likely than not.

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26. The Grain Bin is subject to a flat tax rate of 34%, has taxable temporary differences of $100,000, and deductible temporary differences of $20,000. A valuation allowance is not considered necessary. How much is the net deferred tax liability? a. $6,800. b. $21,200. c. $27,200. d. $34,000. 27. Carry On Corporation has a $4,000 deductible difference related to an unrealized loss on marketable securities. Federal income tax law allows corporations to deduct capital losses only if they offset capital gains. Unused capital losses may be carried back three years and carried forward five years. Total income during the carryback, carryforward period is expected to total $289,000, but only $3,000 of that taxable income will result from capital gains. Based on the tax rate of 34%, how much valuation allowance is needed? a. $0. b. $340. c. $1,020. d. $1,360. 28. When must taxplanning strategies be considered? a. When calculating deferred tax assets. b. When calculating deferred tax liabilities. c. When determining the amount of the deferred tax asset valuation allowance. d. When the strategy is prudent. 29. Which of the following is not a permitted classification of tax benefits of operating losses when disclosing components of income tax expense under SFAS No. 109 (FASB ASC 74020453)? a. An unusual or infrequent item. b. An extraordinary item. c. An element of discontinued operations. d. A reduction of the current period income tax expense. 30. Lifeline Company's tax rate is 40%. Current taxes were calculated as $85,000. The total deductible temporary differences at the beginning of the year were $2,600 and at the end of the year were $5,500. How much is the total tax provision? a. $82,800. b. $83,840. c. $86,040. d. $85,000. 299

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GLOSSARY
Agent. An agent has general or specific authority, as determined by the principal, to bind the principal as regards third parties (i.e., an agent works for and under the control of another (the principal) and has the power to impose liability to third parties on the principal). A general agent," however, is not an independent contractor, trustee, or employee (servant). Duties of an agent include acting with loyalty and good faith (fiduciary" relationship); obedience; necessary skill, care, and diligence; and duty to account. An agent's duties do not include making delegation or substitution. An agent is generally not personally liable to third parties unless the agent does any of the following: acts for a nonexistent, incompetent, or undisclosed principal, signs a negotiable instrument in his own name, misrepresents his authority, or personally guarantees certain acts. Agents are liable for their own torts. Capital lease. A capital lease is a lease that meets one or more of the following criteria for capitalization. For both the lessee and the lessor: the lease transfers ownership of the property to the lessee by the end of the lease term, the lease contains a bargain purchase option, the lease term is equal to 75% or more of the estimated economic life of the lease property, and the present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90% of the excess of the fair market value of the leased property at that time. Component. A component may be a reportable segment or an operating segment (per SFAS 131), a reporting unit (per SFAS 142), a subsidiary, or a qualifying asset group (per SFAS 144). Deductible temporary differences. Temporary differences that will result in deferred tax assets. Deductible differences generally represent expenses that have been recognized in the financial statements but will be deducted in future tax returns, such as a provision for warranty costs. They also may represent income recognized in the tax returns but deferred for financial statement reporting, such as subscriptions received in advance. The term deductible reversals refers to reversals of deductible differences. Deferred tax provision. The deferred tax provision is the change between the deferred tax asset or liability during the period. The deferred tax asset or liability is calculated by determining the deductible and taxable temporary differences at the balance sheet date and calculating the deferred tax effect. A tax liability always should be recognized for taxable temporary differences. A tax asset for deductible reversals should be reduced by a valuation allowance if it is more likely than not that all or a portion of the asset will not be realized. Depreciation. Depreciation is the process of systematic, rational allocation of the cost of operational assets to the accounting periods benefited. Depreciation is not a process of valuation, does not represent a reserve to replace the asset, and does not mean that cash will be available to replace the asset. Depreciation allowed for tax purposes often differs from depreciation allowed for accounting. Accounting depreciation attempts to match the cost of the asset to the revenues generated over the life of the asset. It represents accrual accounting and has no effect on cash flows (a noncash expense). Depreciation expense must be added back to accounting income when reconciling to cash from operations. Expenses. Outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. Extraordinary item. Extraordinary items are events or transactions that meet both of the following criteria: unusual nature and infrequency of occurrence. (see unusual item and infrequent item) Gains. Increases in equity (net assets) from peripheral or incidental transaction of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners. Infrequent item. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. Losses. Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners. 300

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Minority interest. A minority interest is ownership of less than 50% of outstanding voting stock (i.e., the net assets) of another corporation. It may be accounted for by the equity or cost method. It is a subset of stockholders' equity, disclosed as a separate item of equity on the consolidated financial statements of the parent of the subsidiary that is less than wholly (100%) owned by the parent. Net income. Each item presented in the statement of income may be categorized according to one of the four components of net income. According to Statement of Financial Accounting Concepts No. 6, the components of net income are revenues, expenses, gains, and losses. Operating lease. An operating lease is a lease that does not meet one of the criteria for capitalization, specifically, a lease that does not transfer a material ownership interest in the leased asset from the lessor to the lessee. Rental on an operating lease is charged to expense over the lease term as it becomes payable; a nonrefundable down payment is capitalized and recognized on a straightline basis over the lease term. Permanent differences. Income and expenses that are reported in the financial statements but never will be reported in the tax returns. Some common examples are taxexempt interest on municipal bonds, the dividends received deduction, penalties, and certain premiums on life insurance. Principal. A principal is one with the legal capacity to contract, who agrees with another (the agent) that the agent should act on the principal's behalf. A principal is the person with control over an agent in an agency relationship. Revenues. Actual or expected cash inflows (or the equivalent) that have occurred or will eventuate as a result of an entity's ongoing major or central operations. Temporary differences. Temporary differences are differences between financial and income tax reporting that have future tax consequences. Taxable temporary differences. Temporary differences that will result in deferred tax liabilities. Taxable differences generally represent expenses that have been deducted in the tax returns but will be expensed in future financial statements, such as depreciation deducted over shorter lives for tax purposes than permitted by GAAP . They also may represent income recognized in the financial statements that will be taxable in future tax returns, such as use of the percentageofcompletion method of accounting by a small contractor for financial reporting and the completedcontract method for tax reporting. The term taxable reversals refers to reversals of taxable differences. Unusual item. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates.

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INDEX
B
BUSINESS COMBINATIONS   Sale of assets following pooling of interests . . . . . . . . . . . . . . 217 EXPENSES  Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250  Captions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205  Classification in income statement . . . . . . . . . . . . . . . . . . . . . . 204  Computer software costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235  Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203  Exit or disposal activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223  Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208  Research and development costs . . . . . . . . . . . . . . . . . . 234, 238  Retroactive adjustment of workers' compensation . . . . . . . . 254 EXTRAORDINARY ITEMS  Adjustment of previously reported amounts . . . . . . . . . . . . . . 219  Captions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217  Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216, 217  Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217  Income statement presentation . . . . . . . . . . . . . . . . . . . . . 216, 217  Income taxes . . . . . . . . . . . . . . . . . . . . . . . 218, 280, 281, 283, 286  Intraperiod tax allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218  Materiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216  Receipt of Federal Home Loan Mortgage Corporation stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217  Recognized by equity investee . . . . . . . . . . . . . . . . . . . . . . . . . 225  Sale of assets following pooling of interests . . . . . . . . . . . . . . 217  Tax benefits of loss carryforward . . . . . . . . . . . . . . . . . . . . . . . . 283

C
CAPTIONS  Equity in earnings of investee . . . . . . . . . . . . . . . . . . . . . . . . . .  Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Income statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Unusual or infrequent items . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226 217 205 279 219

CODE OF PROFESSIONAL CONDUCT, AICPA  Rule 203 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 COMPREHENSIVE INCOME  Equity method investees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225  Income tax allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285, 286 COMPUTER SOFTWARE COSTS  Computer software to be sold, leased, or marketed . . . 235, 238  Internaluse computer software . . . . . . . . . . . . . . . . . . . . . . . . . 236  Software developed as part of a reengineering project . . . . . 240 CONSTRUCTION CONTRACTORS  Income recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206

I
INCOME STATEMENT  Authoritative basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203  Basic financial statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203  Captions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205  Classifying items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203, 204  Components of net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203  Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216  Expense recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208  Form and style . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204  Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203, 209  Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203, 209  Multiplestep format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204  Order of presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216  Revenue recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205  Singlestep format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204  Title . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 INCOME TAXES  Alternative minimum tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267  Authoritative literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261  Captions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279, 282  Deferred, liability method  Alternative minimum tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267  Calculating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261, 264  Deferred vs. liability method . . . . . . . . . . . . . . . . . . . . . . . . 261  Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267  Permanent differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262  Taxplanning strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276  Tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262  Temporary differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262  Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . 261, 264, 265, 274, 281, 283  Deferred tax asset valuation allowance . . . . . . . . . . . . . . 261, 274  Disclosures  Allocation of income tax to other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285  Composition of tax provision . . . . . . . . . . . . . . . . . . . . . . . . 280  Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Income statement presentation . . . . . . . . . . . . . . . . . . . . . . . . . 279  Intraperiod tax allocation  Authoritative requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . 285

D
DEFERRED CHARGES  Lease incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 DEPRECIATION  ACRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232  Departures from GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 DISCLOSURES  Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252, 254  Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232  Income taxes  Allocation of income tax to other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280, 285  Change in tax status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Composition of tax provision . . . . . . . . . . . . . . . . . . . . . . . . 280  Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280  Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250  Research and development costs . . . . . . . . . . . . . . . . . . . . . . 234 DISCONTINUED OPERATIONS  Adjustment of previously reported amounts . . . . . . . . . . . . . . 220  Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219, 220  Gain or loss on disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220  Identifying a component . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219  Income statement presentation . . . . . . . . . . . . . . . . . . . . . 219, 220  Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220  Presentation considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

E
EXIT OR DISPOSAL ACTIVITIES  Consolidate or close facilities . . . . . . . . . . . . . . . . . . . . . . . . . .  Contract termination costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Presentation and disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . .  Resulting from a business combination . . . . . . . . . . . . . . . . . . 223 223 221 224 224

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Companion to PPC's Guide to Preparing Financial Statements  Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285  Cumulative accounting adjustments . . . . . . . . . . . . . . . . . 285  Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . 281, 285  Extraordinary items . . . . . . . . . . . . . . . . . . . 218, 281, 283, 285  Item charged directly to stockholders' equity . . . . . . . . . . 286  Operating losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281  Priorperiod adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . 285  Unusual or infrequent items . . . . . . . . . . . . . . . . . . . . . . . . 219 Investment tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280, 284 Loss carrybacks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282 Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . 267, 275, 280, 281, 283 Permanent differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262 Recognized by equity investee . . . . . . . . . . . . . . . . . . . . . . . . . 225 Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280, 284 Tax law changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264, 280 Temporary differences, examples of  Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245, 246, 247, 248 225 224 226 224 225 225 225 224 224 225 225

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PRIORPERIOD ADJUSTMENTS  Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Equity method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Tax allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 225 219 285

       

PROPERTY AND EQUIPMENT  Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246

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RECEIVABLES  Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248 RESEARCH AND DEVELOPMENT COSTS  Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234, 238  Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 RETAINED EARNINGS  Dividends  Cumulative preferred stock of investee . . . . . . . . . . . . . . . 224 REVENUE  Captions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Classifications in income statement . . . . . . . . . . . . . . . . . . . . .  Deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Equity in earnings of investee . . . . . . . . . . . . . . . . . . . . . . . . . .  Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Recognition as principal or agent . . . . . . . . . . . . . . . . . . . . . . .  Sales and other similar taxes . . . . . . . . . . . . . . . . . . . . . . . . . . .  Sales incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Shipping and handling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 204 246 203 224 205 207 208 208 208

INVESTMENTS  Captions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Common stockequity method  Accounting treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Different fiscal years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Dividends on investee's cumulative preferred stock . . . .  Extraordinary items recognized by investee . . . . . . . . . . .  Income statement presentation . . . . . . . . . . . . . . . . . . . . .  Income taxes of investee . . . . . . . . . . . . . . . . . . . . . . . . . . .  Intercompany profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Negative balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Other comprehensive income reported by investee . . . .  Priorperiod adjustments recognized by investee . . . . . .

L
LEASES  Bargain rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244  Contingent rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249  Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246  Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244  Assumption of lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248  Contingent rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249  Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250  Incentive payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246  Income taxes . . . . . . . . . . . . . . . . . . . . . . . . 245, 246, 247, 248  Les controls use of property . . . . . . . . . . . . . . . . . . . . . . . . 245  Recognition of rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

S
STARTUP COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

U
UNUSUAL OR INFREQUENT ITEMS  Captions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219  Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219  Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219  Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217  Income statement presentation . . . . . . . . . . . . . . . . . . . . . 216, 219  Intraperiod tax allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

M
MATERIALITY  Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216

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COMPANION TO PPC'S GUIDE TO PREPARING FINANCIAL STATEMENTS

COURSE 4 PREPARING FINANCIAL STATEMENTS: ASSETS (PFSTG084)


OVERVIEW COURSE DESCRIPTION: This interactive selfstudy course provides an introduction to the preparation of the asset portion of financial statements. Topics in the first lesson include the proper captions, classification and valuation of current assets including inventory, receivables and marketable securities. The second lesson covers longterm investments and using the equity method to account for nonmarketable equity securities. Lesson three discusses the balance sheet presentation and classifica tion of property and equipment, including capital leases and the calculation of depreciation. The last lesson is on intangible assets, the impairment of goodwill and application of SFAS No. 144. October 2008 Users of PPC's Guide to Preparing Financial Statements Basic knowledge of accounting. 8 QAS Hours, 8 Registry Hours Check with the state board of accountancy in the state in which you are licensed to determine if they participate in the QAS program and allow QAS CPE credit hours. This course is based on one CPE credit for each 50 minutes of study time in accordance with standards issued by NASBA. Note that some states require 100minute contact hours for self study. You may also visit the NASBA website at www.nasba.org for a listing of states that accept QAS hours. FIELD OF STUDY: EXPIRATION DATE: KNOWLEDGE LEVEL: LEARNING OBJECTIVES: Lesson 1Current Assets Completion of this lesson will enable you to:  Use correct balance sheet captions for current assets such as cash, receivables, and inventory.  Calculate and account for the value of marketable securities and treasury securities at the balance sheet date.  Report appropriate information regarding receivables and inventory. Lesson 2LongTerm Investments Completion of this lesson will enable you to:  Use appropriate captions and valuation for longterm investments such as nonmarketable securities, cash value of life insurance policies, and property held for investment.  Determine the accounting treatment for nonmarketable equity securities.  Report information on cash value life insurance policies. Accounting Postmark by December 31, 2009 Intermediate

PUBLICATION/REVISION DATE: RECOMMENDED FOR: PREREQUISITE/ADVANCE PREPARATION: CPE CREDIT:

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Lesson 3Property and Equipment Completion of this lesson will enable you to:  Describe the balance sheet presentation options for property and equipment.  Classify and properly record assets acquired by capital lease, contribution or exchange.  Calculate depreciation. Lesson 4Intangible Assets, Other Deferred Costs and LongLived Assets Completion of this lesson will enable you to:  Use appropriate accounting for goodwill and other intangibles.  Assess impairment of goodwill.  Apply SFAS No. 144 to appropriate longlived assets. TO COMPLETE THIS LEARNING PROCESS: Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to: Thomson Reuters Tax & AccountingR&G PFSTG084 Selfstudy CPE P .O. Box 966 Fort Worth, TX 76101 See the test instructions included with the course materials for more information. ADMINISTRATIVE POLICIES: For information regarding refunds and complaint resolutions, dial (800) 3238724 for Customer Service and your questions or concerns will be promptly addressed.

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Lesson 1: Current Assets


Introduction
Current assets normally include the following items: a. Cash available for current operations and items that are the equivalent of cash b. Marketable securities representing the investment of cash available for current operations c. Inventories of raw materials, goods in process, finished goods, operating supplies, and ordinary maintenance materials and parts d. Receivables: (1) Trade accounts and notes (2) Receivables from officers, employees, affiliates, and others if collectible in the ordinary course of business within one year e. Prepaid expenses such as insurance, interest, rents, taxes, unused royalties, current paid advertising service not yet received, and operating supplies Learning Objectives: In this lesson the proper captions, classification and valuation of current assets including inventory, receivables and marketable securities are discussed. Completion of this lesson will enable you to:  Use correct balance sheet captions for current assets such as cash, receivables, and inventory.  Calculate and account for the value of marketable securities and treasury securities at the balance sheet date.  Report appropriate information regarding receivables and inventory. Cash and Cash Equivalents Cash as a balance sheet caption should ordinarily include cash on deposit with banks and other institutions and cash on hand (for example, change funds and undeposited receipts). It is generally presented as a single item, but may be combined with shortterm investments considered to be cash equivalents. When the two are combined, the captions should be descriptive, such as Cash and cash equivalents." When cash and cash equivalents are presented as a single amount, the notes to financial statements frequently disclose the components. For example: NOTE XCASH AND CASH EQUIVALENTS Cash and cash equivalents consist of the following: 20X2 Cash Certificates of deposit Shortterm securities $ 50,000 100,000 45,000 195,000 $ 20X1 45,000 95,000 140,000

GAAP states that the total amount of cash and cash equivalents shown in the statement of cash flows should be the same amount as similarly titled line items or subtotals in the balance sheet. Thus, best practices indicate that if there are several cash accounts in the balance sheet (for example, cash on hand and money market accounts) that 307

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should be combined to agree with the statement of cash flows, the balance sheet should subtotal those amounts. Similarly, cash and shortterm investments that are not cash equivalents should not be combined in the balance sheet. Operating Accounts. Even though banks offer a variety of deposit instruments, small and midsize nonpublic entities ordinarily have at least one operating account. Operating accounts that bear interest typically have a low interest rate and do not generate significant amounts of interest income. Depending on the facts and circum stances, however, entities may want to disclose the balances of interestbearing operating accounts. Relevant information may be disclosed in a note to the financial statements or through an expansion of the asset caption, such as: Cash, including interestbearing accounts of $275,000, with interest averaging 3% $ 390,000

Certificates of Deposit. Certificates of deposit generally are not subject to withdrawal limitations although with drawal before maturity usually results in a loss of a portion of the interest earned. Accordingly, best practices indicate that certificates of deposit may be included with cash and need not be separately disclosed. Some accountants, however, disclose the amount of certificates of deposit that have been included with cash or present certificates of deposit as a separate balance sheet caption as follows: 20X2 Cash, including certificates of deposit (20X2$150,000; 20X1$125,000) Marketable securities or Cash Certificates of deposit Shortterm investments $ 55,000 200,000 250,000 $ 500,000 100,000 $ 20X1 430,000 200,000

As previously discussed, best practices indicate that subtotals of cash and cash equivalents that agree with the amounts in the statements of cash flows should be presented. Money Market Accounts. Money market accounts offered by banks, savings and loan associations, and broker age houses are typically subject to only minimal withdrawal restrictions. Therefore, they are more in the nature of interestbearing checking accounts and should be included in the cash caption. Repurchase Agreements. Repurchase agreements are shortterm investments typically sold by banks as alterna tives to certificates of deposit. Transfers to and from the fund are made daily to cover checks clearing in operating accounts. Accordingly, repurchase agreements should be presented in the financial statements in a manner similar to money market accounts. Held Checks. Checks written but not released as of the balance sheet date should be reinstated on the company's books, thus increasing cash as of the date of the financial statements. The offsetting entry generally increases accounts payable. Overdrafts. Overdrafts are a result of either of the following situations: a. The bank statement at the balance sheet date reports an overdraft (a real overdraft). b. The bank statement at the balance sheet date reports a positive balance, and the overdraft, in essence, arises from playing the float" (a book overdraft). However, there is no reason for captions to distinguish between a real overdraft and a book overdraft, and the single caption cash overdraft" or bank overdraft" should be used. If the company has a positive cash balance in one 308

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year and a negative balance in the other, the following captions would be appropriate in comparative balance sheets: 20X2 CURRENT ASSETS Cash CURRENT LIABILITIES Cash overdraft $ 5,000 $ 20X1 10,000

Entities frequently have cash accounts with more than one financial institution. Generally, for each financial institution, all cash account balances should be totaled to determine whether the entity has a net positive or negative balance. If a net negative balance with a financial institution is immaterial, generally it may be offset against positive balances in other financial institutions. However, if it is material, generally it should be included with current liabilities and either presented separately or included with accounts payable. Restricted Cash. Cash restricted for special purposes should be segregated from cash available for general operations and, normally, should be excluded from current assets. However, as noted in Chapter3 of ARB No. 43 (FASB ASC 21010454), it may be included in current assets when it is considered to offset maturing debt that has been properly set up as a current liability. Examples of the presentation of restricted cash are as follows: a. Cash deposited with a trustee for mortgage loan payments: CURRENT ASSETS Cash Restricted cash for mortgage loan repayment Accounts receivable Inventory TOTAL CURRENT ASSETS PROPERTY AND EQUIPMENT OTHER ASSETS Deposits Restricted cash for mortgage loan repayment $ $ 100,000 25,000 400,000 600,000 1,125,000 575,000 50,000 150,000 1,900,000

b. Total cash of $150,000 of which $100,000 is restricted proceeds from industrial revenue bonds: CURRENT ASSETS Cash OTHER ASSETS Deposits Restricted cash from industrial revenue bonds $ 50,000 10,000 100,000

Note that, as in example (a), restricted cash may have both a current and noncurrent portion. Compensating Balances. There is no GAAP requirement to disclose compensating balance agreements unless the agreement legally restricts the use of the funds. Escrow Accounts. In practice, two types of escrow accounts are often encountered: a. Amounts on deposit that will be used to pay expenses 309

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b. Agency accounts A common example of the first type is the portion of debt service accumulated for payment of real estate taxes and insurance. Typically, the company has no control over those accounts and cannot convert them into cash. They should be excluded from cash and included with prepaid expenses or charged to expense if not material. A common example of the second type is an account maintained by realtors for deposits on real estate contracts or for rent payments on property managed for an owner. Realtors may write checks on those accounts, but state laws normally prohibit them from using the cash for their own business (or personal) purposes even as a temporary loan. The realtors have custody of the funds, but do not have the legal right to them. Preferably such funds should be excluded from the company's balance sheet, but if the accounts are material, the amount and nature of the company's agency obligation under the arrangement should be disclosed. To avoid cluttering the balance sheet, the disclosure may be in a note.

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 1. Company A has the following account balances with Bank of the U.S. on 12/31/X1: Operating account: $100,000; Money market account $50,000; Payroll account ($10,000) Also, on 12/31/X1, Company A wrote $15,000 worth of checks from its operating account, but held on to them until 1/10/X2. How much does Company A report as Cash" on its 12/31/X1 balance sheet? a. $105,000. b. $140,000. c. $155,000. d. $165,000. 2. Which of the following is segregated from cash available for general operations? a. Restricted cash. b. Certificates of deposit. c. Repurchase agreements. d. Shortterm investments.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 1. Company A has the following account balances with Bank of the U.S. on 12/31/X8: Operating account: $100,000; Money market account $50,000; Payroll account ($10,000) Also, on 12/31/X8, Company A wrote $15,000 worth of checks from its operating account, but held on to them until 1/10/X9. How much does Company A report as Cash" on its 12/31/X8 balance sheet? (Page 307) a. $105,000. [This answer is incorrect. Money market accounts are in the nature of interestbearing checking accounts and should be included in the cash caption.] b. $140,000. [This answer is incorrect. Checks written but not released as of the balance sheet date should be reinstated on the company's books, thus increasing cash as of the date of the financial statements.] c. $155,000. [This answer is correct. Cash as a balance sheet caption should ordinarily include cash on deposit with banks and other institutions and cash on hand. An overdraft in an account of a financial institution can be offset with a positive balance in another account in the same institution. Checks written but not released as of the balance sheet date should be reinstated on the company's books.] d. $165,000. [This answer is incorrect. An overdraft in an account of a financial institution can be offset with a positive balance in another account in the same institution, and be reported as cash if it is a net positive balance.] 2. Which of the following is segregated from cash available for general operations? (Page 309) a. Restricted cash. [This answer is correct. Cash restricted for special purposes should be segregated from cash available for general operations and, normally, should be excluded from current assets.] b. Certificates of deposit. [This answer is incorrect. CDs are generally not subject to withdrawal limitations although withdrawal before maturity usually results in a loss of a portion of the interest earned. Usually, CDs are included with cash and need not be separately disclosed.] c. Repurchase agreements. [This answer is incorrect. Repurchase agreements are alternatives to CDs sold by banks. Transfers to and from the fund are made daily to cover checks clearing in operating accounts. Repurchase agreements should be presented in the financial statements in a manner similar to money market accounts.] d. Shortterm investments. [This answer is incorrect. Shortterm investments that are considered cash equivalents can be combined in the balance sheet under the Cash and cash equivalents" caption.]

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Marketable Securities The balance sheet caption marketable securities" includes equity securities and debt securities. Examples of those types of securities are: Equity Securities Common Stock Preferred Stock Warrants Calls Puts Debt Securities Bonds Bankers Acceptances U.S. Treasury Notes Convertible Debt Preferred Stock (that must be redeemed)

This lesson discusses both current and noncurrent marketable securities because decisions about classification may influence captions and, in some cases, measurement. Money market accounts, repurchase agreements, and certificates of deposit (except for some jumbo CD's") are not marketable securities. SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (FASB ASC 32010), establishes accounting standards for both marketable equity and debt securities. This guidance requires business entities to account for marketable equity securities and most marketable debt securities at fair value. It applies to business entities other than those that use specialized accounting principles for investments, such as securities brokers and dealers, defined benefit pension plans, and investment companies. (It does not apply to nonprofit organizations, however.) Certain debt securities that entities intend to hold to maturity are accounted for at amortized cost; most marketable debt and equity securities, however, are accounted for at fair value. Definitions. SFAS No. 115 (FASB ASC 32010) defines debt and equity securities as follows: DEBT SECURITY Any security representing a creditor relationship with an enterprise. ExamplesU.S. Treasury securities, U.S. government agency securities, municipal securities, corporate bonds, convertible debt, redeemable preferred stock, commercial paper, all securi tized debt instruments (such as collateralized mortgage obligations and real estate mortgage investment conduits) EQUITY SECURITY Any security representing an ownership interest in an enterprise or the right to acquire or dispose of an ownership interest in an enterprise at fixed or determinable prices. Equity securities do not include convertible debt or redeemable preferred stock. ExamplesCommon, preferred, and other capital stock; stock rights and warrants; put and call options This guidance applies to equity securities whose fair value is readily determinable and all debt securities. It also applies to restricted stock if the restrictions terminate within one year. It does not apply to investments in equity securities that would be required to be accounted for using the equity method, if not for the election of the fair value option under SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or to investments in consolidated subsidiaries. The fair value of an equity security is readily determinable if: a. sales prices or bidandasked quotations are currently available in: (1) a securities exchange registered with the Securities and Exchange Commission. (2) an overthecounter market publicly reported by the National Association of Securities Dealers Automated Quotations systems or by Pink Sheets LLC. 313

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b. the security trades only in a foreign market, but that market is of a breadth and scope comparable to one of the U.S. markets previously discussed. c. the fair value per share or unit of a mutual fund is determined and published and is the basis for current transactions. Summary of Accounting Principles. Accounting for investments depends on (a) the type of securityeither debt or equityand (b) the entity's intent and ability to hold it to maturity. At acquisition, investments should be classified into one of the following categories:  Held to Maturity. Debt securities for which the entity has both the positive intent and ability to hold to maturity. Securities for which an entity has an intent to hold for an indefinite time or a lack of an intent to sell should not be classified in this category. If an entity's intent is uncertain, this category is not appropriate. In addition, a security cannot be classified as held to maturity if it can be contractually prepaid or otherwise settled such that the security holder would not recover substantially all of its recorded investment. A debt security with those characteristics should be evaluated to determine whether it contains an embedded derivative that must be accounted for separately.  Trading. Debt securities that do not meet the intenttohold" criterion and equity securities that have readily determinable fair values, both of which are bought and held principally for the purpose of selling them in the near term (e.g., the entity's normal operating cycle), and thus generally are held for only a short period of time.  Available for Sale. Securities that do not meet the criterion to be classified as held to maturity or trading. Most entities classify their securities into one of two categorieseither held to maturity or available for sale. Trading securities are held principally by financial institutions and similar entities, such as entities with mortgage banking activities. According to Question 34 of the FASB Q & A on SFAS No. 115 (FASB ASC 32010251), such securities generally have a holding period measured in hours and days rather than months or years. However, classifying securities as trading is not prohibited just because they will be held longer. Generally, as a practical matter, the securities activities of small and mediumsized entities normally are incidental and classifying them as available for sale better captures their substance. Accordingly, the provisions of SFAS No. 115 (FASB ASC 32010) as they apply to trading securities are not discussed in detail in this course. Exhibit 41 summarizes the accounting for investments. For debt securities classified as held to maturity, the securities are carried at amortized cost (unless there is a decline in the value of individual securities that is not due to temporary declines). Realized gains and losses are recorded in the income statement in the period that they are earned. Debt and equity securities classified as available for sale are recorded at fair value. Generally, the fair value of the securities held is the product of the number of shares held and the pershare price or quotation. The fair value is not reduced for expected transaction costs or for any blockage discount. As a practical matter, if a quoted market price is not available for an equity security, it probably is not subject to the requirements discussed in this lesson. Realized gains and losses are recorded in the income statement in the period that they are earned. Unrealized gains and losses are reported in other comprehensive income. However, declines in value of individual securities below amortized cost that are other than temporary should be included in earnings. See further discussion of impairment of securities later in this lesson.

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Exhibit 41 Accounting for Marketable Securities Category Held to maturity Type of Investment Debtentity has posi tive intent and ability to hold to maturity, and the security cannot be contractually prepaid or otherwise settled such that the security holder would not recover sub stantially all of its recorded investment Debt and equityheld principally for sale in the near term Debt and equity other than above Basis Amortized cost, reduced for nontemporary declines Reporting Unrealized Gains and Losses Charge nontemporary losses to earnings; do not recognize other unrealized gains and losses Balance Sheet Classification Current or noncurrent depending on ARB No. 43 (FASB ASC 2101045) (generally noncurrent; classify as current when matu rity is within 12 months)

Trading

Fair value

Report in earnings

Current or noncurrent depending on ARB No. 43 (FASB ASC 2101045) Current or noncurrent depending on ARB No. 43 (FASB ASC 2101045)

Available for sale

Fair value

Report in other com prehensive income; charge nontemporary losses to earnings

According to the FASB Q&A on SFAS No. 115 (FASB ASC 32010), if an entity decides to sell an availableforsale security that has declined in value below its amortized cost and the decline is not considered to be temporary, the investment should be written down to its fair value in the period that the decision to sell was made, rather than in the period in which the sale occurs. In that case, the writedown should be charged to earnings rather than recorded in other comprehensive income. The situation might be most obvious if a company sells a security at a loss shortly after the balance sheet date. The value to which a security is written down becomes its new cost basis. Impairment of securities is discussed further later in this lesson. Categorizing Securities. Categorizing securities under GAAP may be challenging. The most difficult decisions are likely to surround whether a security meets the positiveintent and abilitytohold criteria to classify it as held to maturity. Unfortunately, GAAP provides no guidance on evaluating an entity's intent, so classification decisions may be inconsistent in practice. Although many entities intend to hold securities for a long term or an indefinite period, GAAP precludes classifying debt securities as held to maturity if they would be available to be sold in response to factors such as the following: a. Changes in market interest rates and related changes in the securities' prepayment risk b. Need for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrender of insurance policies, or payment of insurance claims) c. Changes in the availability of and the yield on alternative investments d. Changes in funding sources and terms e. Changes in foreign currency risk 315

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Transferring Securities between Categories. An entity should reconsider whether a marketable security is properly categorized at each reporting date. Changes in circumstances, such as an entity no longer having the ability to hold a debt security to maturity, may cause a security to be transferred to another category. Transferring a security to a different category requires adjusting the carrying amount of the security to its fair value at the date of transfer so that all of the unrealized holding gain or loss is recognized as of that date. Accounting for the unrealized holding gain or loss depends on the type of transfer, as follows: a. Transfers from the Trading Category. For securities transferred from the trading category, the unrealized holding gain or loss at the date of transfer is already recognized in earnings and should remain in retained earnings after the transfer, regardless of the category to which the securities are transferred. For example, the unrealized holding gain or loss on a security transferred from the trading category to the availableforsale category is included in retained earnings at the transfer date, while subsequent changes in the unrealized holding gain or loss should be included in accumulated other comprehensive income. b. Transfers to the Trading Category. For securities transferred to the trading category, recognize in earnings the portion of the unrealized holding gain or loss at the transfer date that has not been previously recognized in earnings. For transfers of availableforsale securities, that will entail reclassifying into earnings amounts reported in accumulated other comprehensive income through the transfer date. For example, assume that an availableforsale security has an unrealized gain of $20,000 at the beginning of the year and its fair value increases by an additional $5,000 to $80,000 by the transfer date. The security first should be adjusted to its fair value at the transfer date by recognizing the additional $5,000 unrealized holding gain in other comprehensive income, as follows: Availableforsale securities Other comprehensive income 5,000 5,000

The carrying amount of the security is then its $80,000 fair value, and accumulated other comprehensive income related to the security is the $25,000 cumulative holding gain at the transfer date (of which $20,000 was recognized in prior years and $5,000 was recognized in the current year). The transfer from the availableforsale category to the trading category should be recorded by reclassifying the $25,000 unrealized holding gain into earnings, as follows: Trading securities Other comprehensive income Availableforsale securities Unrealized gain on securities 80,000 25,000

80,000 25,000

Since $20,000 of the unrealized holding gain was recognized in comprehensive income in prior years (as other comprehensive income), recording the transfer only increased comprehensive income (and equity) for the current year by the $5,000 additional unrealized gain that arose during the current year through the transfer date. The increase should be reported in two componentsa $20,000 net reduction in other comprehensive income (the $5,000 additional unrealized holding gain less the $25,000 reclassification) and a $25,000 increase in earnings. However, if the security originally had been classified as heldtomaturity instead of availableforsale, none of the unrealized holding gain would have been recognized in comprehensive income previously, and in addition to increasing earnings by $25,000, the transfer also would increase current year comprehensive income (and equity) by $25,000. c. Transfers to Availableforsale from Heldtomaturity. For debt securities transferred to the availableforsale category from the heldtomaturity category, recognize the unrealized holding gain or loss in other comprehensive income at the transfer date. For example, if the fair value of a heldtomaturity security has increased by $20,000 to $70,000, the carrying amount of the security should be increased by $20,000 from its $50,000 cost basis to its $70,000 fair value, with the $20,000 unrealized holding gain recognized in other comprehensive income as follows: Heldtomaturity securities Other comprehensive income 316 20,000 20,000

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The transfer then would result in reporting the security as an availableforsale security with a carrying amount of $70,000 as follows: Availableforsale securities Heldtomaturity securities 70,000 70,000

Since the security previously was classified as heldtomaturity, none of the unrealized gain was recognized in prior years, and the transfer therefore increased current year comprehensive income (and equity) by $20,000. d. Transfers to Heldtomaturity from Availableforsale. For debt securities transferred to the heldtomaturity category from the availableforsale category, the security's fair value at the transfer date becomes its new cost basis. (Subsequent changes in the security's fair value only should be recognized when they are realized, unless a decline in fair value is other than temporary. In that situation, the decline should be recognized immediately in earnings, and the fair value at that date becomes the security's new cost basis.) The unrealized holding gain or loss at the date of transfer should remain in accumulated other comprehensive income but be amortized over future years as a premium or discount. (A premium accumulates when there is an unrealized gain at the date of transfer, and a discount accumulates when there is an unrealized loss.) The offset to the change in the discount or premium is an increase or decrease in other comprehensive income. Consequently, increasing a premium reduces accumulated other comprehensive income and the carrying amount of the security, while increasing a discount increases accumulated other comprehensive income and the carrying amount of the security. When the security matures, its carrying amount will equal its face value. This accounting results in recognizing comprehensive income for the unrealized holding gains or losses that arise while a security is classified as available for sale. However, since those gains or losses will not be realized, comprehensive income is correspondingly eliminated over the period from the transfer date to the security's maturity. To illustrate, assume that an entity purchases a debt security for its $50,000 face value and classifies it as availableforsale at the beginning of the year. The security bears interest at 8% and is due in three years. At the end of the year, when the security's fair value is $60,000, the entity reclassifies it as heldtomaturity. To record the realization of the amounts due under the security, the transfer to the heldtomaturity category, and the amortization of the unrealized holding gain at the transfer date, the entity should: (1) Recognize $4,000 ($50,000 face value Cash Interest income 8%) interest income for the year. 4,000 4,000

(2) Increase the carrying amount of the security by $10,000 from its $50,000 cost to its $60,000 fair value and reclassify the security to heldtomaturity at the transfer date. Availableforsale securities Other comprehensive income Heldtomaturity securities Availableforsale securities 10,000 60,000 10,000 60,000

(3) Compute the level effective rate that will fully amortize the $60,000 fair value at the transfer date through receipt of the two remaining annual interest payments and the principal that is due in two years. That rate is 15.71%. (4) At the end of the following year, multiply $60,000 (the security's carrying amount) by 15.71%, and subtract the $4,000 interest income from the $9,426 result. Record the $5,426 difference as a premium on the debt security, with an offsetting reduction in other comprehensive income as follows:

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Cash Other comprehensive income Premium on debt security Interest income

4,000 5,426

5,426 4,000

After that adjustment, $4,574 ($10,000 * $5,426) of the $10,000 unrealized holding gain at the transfer date remains in accumulated other comprehensive income. The carrying amount of the security is $54,574, consisting of the $60,000 fair value at the transfer date less the $5,426 accumulated premium. (5) At the end of the following year, multiply the $54,574 carrying amount of the security by 15.71%, and subtract the $4,000 interest income from the $8,574 result. Record the $4,574 difference as a premium on the debt security, with an offsetting reduction in other comprehensive income as follows: Cash Other comprehensive income Premium on debt security Interest income 4,000 4,574

4,574 4,000

After that adjustment, no balance remains in accumulated other comprehensive income for the debt security since the current year's amortization eliminated the $4,574 balance at the beginning of the year. The current year's amortization correspondingly increased thecumulative premium from $5,426 to $10,000. Consequently, the carrying amount of the security is $50,000 (consisting of the $60,000 fair value at the transfer date less the $10,000 accumulated premium). That equals the $50,000 receipt of principal, recorded as follows: Cash Premium on debt security Heldtomaturity securities 50,000 10,000

60,000

Transfers from the heldtomaturity category and into or out of the trading category should be rare, due to the high threshold for classifying investments into those categories. In addition, SFAS No. 115, Paragraph 81, notes that availableforsale securities should not be automatically transferred to the trading category merely because the company decides to sell the security or because the passage of time has caused the security's maturity date to be within one year. Subsequent Changes in Fair Value. The fair value measurements should be based on values at the end of the reporting period. Changes in fair value occurring after the end of the reporting period but before the issuance of the financial statements should not be recognized. For example, if the quoted market price of an equity security traded on a national exchange is $100,000 at the end of the reporting period but declines to $50,000 prior to the issuance of the financial statements, the security should be reported at $100,000. That conclusion is not affected by whether the decline in value began before the end of the reporting period. GAAP does not address disclosure of subsequent changes in fair value prior to issuing the financial statements. However, measurement of a security's fair value is not intended to estimate the value the reporting entity will realize; it is purely a measure of the number of shares held multiplied by the per share price at the end of the reporting period. Fair value under SFAS No. 115 (FASB ASC 32010) does not consider factors that could affect the amount realized (such as control premiums, blockage factors, and selling costs), nor does it consider changes in value that will occur before the security is sold. Accordingly, the disclosure requirements of SFAS No. 5, Accounting for Contingencies (FASB ASC 45020), and SOP 946, Disclosure of Certain Significant Risks and Uncertainties (FASB ASC 2751050), do not apply. In addition, members of the Auditing Standards Board's Audit Issues Task Force discussed the issue and do not believe that SAS No. 1 (AU Section 560) requires disclosure of subsequent declines in value that occur prior to issuing the financial statements. Impairment of Securities. When the fair value of an availableforsale or heldtomaturity security declines below its amortized cost and the decline is determined to be other than temporary, the security's fair value at the 318

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measurement date becomes its new cost basis. The decline in value below cost should be accounted for the same as a realized loss with the amount of the writedown included in earnings. FSP FAS 1151 and FAS 1241, The Meaning of OtherThanTemporary Impairment and Its Application to Certain Investments" (FASB ASC 32010), provides guidance regarding the meaning of otherthantemporary impairment and its application to debt and equity securities. The FSP provides guidance for (a) determining when an invest ment is considered impaired, (b) determining whether the impairment is other than temporary, and (c) measuring and recognizing an impairment loss if the impairment is deemed other than temporary. Determining When an Investment Is Impaired. An investment is deemed impaired if its fair value is less than its cost. For this purpose, cost includes adjustments made to an investment's cost basis for accretion, amortization, previous otherthantemporary impairments, foreign exchange, and hedging. Generally, an investment should be assessed for impairment each reporting period, including interim periods if interim financial statements are issued. If an investment is deemed impaired, the impairment should be analyzed to determine if the impairment is other than temporary. Determining Whether the Impairment Is Other Than Temporary. If an investment is deemed impaired, the next step is to determine whether the impairment is temporary or other than temporary. The FSP states that other than temporary does not mean permanent, but it does not provide specific guidance on determining whether the decline in fair value below cost is temporary or other than temporary. Instead, it says to follow the appropriate guidance in either paragraph 16 of Statement 115 (FASB ASC 3201035) (which references SEC Staff Accounting Bulletin Topic 5M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities), paragraph 6 of Opinion No. 18 (FASB ASC 32520), or EITF Issue No. 9920, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" (FASB ASC 32540). Treasury Securities Types of Treasury Securities. Many nonpublic companies invest in debt securities, and often in U.S. Treasury securities. The three types of Treasury securities are bills, notes, and bonds.  Treasury bills, or T bills, are shortterm obligations of the U.S. government with a term of one year or less. They require a minimum investment of $10,000 and, when initially issued, are scheduled to mature in three months (13 weeks or 91 days), six months (26 weeks or 181 days), or 12 months. (T bills with different remaining maturities can also be purchased in secondary markets after they are initially issued.) T bills do not pay coupon interest; instead, they trade at a discount from their par value of $10,000 and mature at par value. The discount, however, is based on the quoted yield, which is similar to an interest rate (and is the basis for determining interest rates in some agreements). The difference between purchase price and the par value of the T bill is called accreted interest," which is paid when the Tbill matures. Physical certificates are not issued for T bill purchases; they are issued in book form only.  Treasury notes are intermediateterm obligations of the U.S. government with terms of two to ten years. They are initially issued at par value and can be purchased in $1,000 denominations (although, depending on how they are purchased, a five note minimum may be required). Treasury notes pay semiannual coupon interest, and they repay par value at maturity. Most Treasury notes are issued in book form only.  Treasury bonds are similar to Treasury notes except that they have maturities over ten years. They are initially issued at par value, pay semiannual coupon interest, and repay par value at maturity. Most Treasury bonds are issued in book form only. Accounting for Treasury Bills. When purchased, T bills should be recorded at cost, which will be a discount from their $10,000 par value. For example, a company would make the following entry to record the purchase of a 91day T bill on September 14, 20X1, at 97: Shortterm investments Cash To record the purchase of T bill. 319 9,700 9,700

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As discussed previously, even though T bills do not pay coupon interest, the discount represents interest at the yield quoted at the date of acquisition. Accordingly, a question arises about whether the discount should be accreted during the period the T bill is held. Specific guidance is provided for the tax accounting of T bills. According to IRC Section 454(b)(2), the discount is not accreted. If a T bill is held to maturity, all of the discount is reported as interest income. However, if it is sold prior to maturity, Section 1271(a)(3) requires the following:  Recognizing interest income in the amount of the discount that would have been accreted through the sale date  Treating the remainder of the difference between the sales proceeds and the acquisition cost as a shortterm capital gain or loss Since tax rules view the discount as interest income and capital gain or loss is recognized only for value changes other than discount accretion, best practices indicates that IRC Section 454's approach of not accreting the discount probably results from the view that accretion normally is not material. For financial reporting, the only guidance that addresses accounting for T bills is found in accounting textbooks and similar publications, and they differ in their conclusions about whether to accrete the discount. If the effect would be material to the financial statements, best practices indicate accreting the discount because that is consistent with the general accounting for other discounts. As a practical matter, however, since T bills normally have low yields and mature over short periods, best practices indicates that the effect of discount accretion normally is not material to the financial statements. To illustrate the accounting considerations, if the discount on the T bill in the immediately previous example, were accreted and the company's year ends in October, interest income of $155 would be recognized for the year, as follows:  Number of days since September 14 (date T bill was purchased)  Number of days T bill is outstanding  Discount ($10,000 par value less $9,700 acquisition cost)  Discount accreted at the end of October ($300 The following entry would record the accretion: Shortterm investments Interest income To accrete interest income on T bill. After that entry, the balance of the T bill would be $9,855 ($9,700 + $155). If the T bill were classified as a heldtomaturity security, it would be recorded in the company's financial statements at $9,855 if the discount were accreted and at $9,700 if it were not. (Even though the financial statements would only report a net amount, separate general ledger accounts may be maintained for the par value and the discount.) If the T bill were classified as availableforsale, GAAP requires it to be recorded at fair value. Accordingly, the company would make an entry debiting or crediting the carrying amount of the T bill with a corresponding entry to other comprehensive income for the unrealized gain or loss. Determining Fair Value. SFAS No. 157 (FASB ASC 82010) provides guidance on measuring fair value. In many cases, quoted market prices will be used to measure fair value. T bills are quoted in terms of bid and asked prices. Instead of specifying a price for T bills, however, they are quoted at a discount from par value. For example, financial publications, such as the Wall Street Journal, often show market prices of T bills as follows: 320 155 155 47/91) $ $ 47 91 300 155

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Maturity Oct 10 'X6

Days to Maturity 97

Bid 5.18

Asked 5.16

Chg. +0.05

Yield 5.31

The first two columns indicate the date on which the T bills mature and the number of days remaining to maturity. As explained above, the bid and asked prices are quoted at discounts from par. In this example, the bid price means an entity could sell a T bill from its portfolio maturing on October 10, 20X6, at a discount of 5.18% below par; it could purchase that T bill at a discount of 5.16% below par. Best practices are to use the last bid price on the balance sheet date to estimate the fair value. Using the quotations in the preceding paragraph, fair value of a $10,000 T bill would be determined as follows: FairValue + $10, 000 * ($10, 000 .0518 360 97) + $9, 860.43

Applying the yield to the fair value over the period until the T bill matures will accrete it to $10,000: Quoted yield Fair value Interest income that would be earned if the investment were held for a year at the quoted yield = $9,860.43 .0531 Number of days until maturity Number of days in the denominator (while 360 days are used to calculate the price of a T bill, 365 days are used to calculate its yield) Interest that would be earned by holding the T bill until maturity = $523.59 97/365 Accreted value at maturity = $9,860.43 + $139.15 (plus a rounding difference of $.42) 5.31 $9,860.43 $523.59 97 365 $139.15 $10,000.00

Accounting for Treasury Notes and Bonds. Treasury notes and bonds may be purchased either at par ($1,000) or above or below par, depending on market conditions. Like investments in corporate or municipal bonds, Treasury notes and bonds should be recorded at cost, and any discount or premium amortized to income using the interest method over the life of the securities. According to APB Opinion No. 12 (FASB ASC 83530352 and 353) the interest method arrives at periodic interest, including amortization, that represents a level effective rate on the sum of the face amount of the investment plus or minus the unamortized premium or discount. For convenience, an investment account is typically debited for the par value of the bond or note, and related discount or premium is recorded in a separate account. For financial reporting, however, the investment account should be shown as a net amount. To illustrate, a company would make the following entry to record the purchase of 10 fiveyear Treasury notes at 129: Investment in Treasury notes Premium on Treasury notes Cash To record the purchase of Treasury notes. 10,000 2,900

12,900

The yield implicit in the purchase price is 3.245% calculated on a semiannual basis (which is 6.49% interest). That is the rate that will discount 10 semiannual payments of $668.75 (see entries following Exhibit 42) and a single payment of $10,000 due 10 semiannual periods from the purchase date to $12,900. To find the premium amortiza tion for the first six months, subtract interest calculated using the yield from the coupon interest. (A spreadsheet for calculating amortization of premium and discount is illustrated in Exhibit 42.)

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Coupon interest Interest using the yield ($12,900 Premium amortization

3.245%)

$ $

668.75 418.60 250.15

Exhibit 42 Calculating Premium Amortization or Discount Accretion Premium amortization or discount accretion is the difference between the interest at the coupon rate and interest at the yield quoted when the Treasury obligation was bought. It can be calculated using a simple spreadsheet such as the following, which assumes 10 fiveyear notes totaling $10,000 are purchased at 129 and bear coupon interest at 13.375% annually. Par value Purchase price Period to maturity Number of years Number of semiannual periods Coupon rate Annual Semiannual Semiannual interest payments Quoted yield at the date of purchase Annual Semiannual Investment Balance Initial Payment 1 2 3 4 5 6 7 8 9 10 $ 12,900.00 12,649.85 12,391.59 12,124.95 11,849.65 11,565.42 11,271.97 10,969.00 10,656.19 10,333.23 0.00 Interest Income Using Yield $ 418.60 410.49 402.11 393.45 384.52 375.30 365.78 355.94 345.79 335.52 3,787.50 Premium Amortization $ 250.15 258.26 266.64 275.30 284.23 293.45 302.97 312.81 322.96 333.23 2,900.00 $ $ 10,000.00 $ 12,900.00 5 10 13.3750 % 6.6875 % 668.75 6.4900 % 3.2450 % Principal Received

10,000.00

$ Notes:

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3. The method used in this illustration normally will result in a small balance at maturity. This should be charged or credited to interest income for the year of maturity. In this illustration, that adjustment increases interest income of the final period by $.21. 4. As an alternative, the investment balance could be calculated using present values, with premium amortization generally computed as the change in the investment balance. That requires present value calculations of the number of remaining interest payments and the single payment of par value at maturity. 5. The following illustrates the accounting entries: Treasury notes at par value Premium on Treasury notes Cash To record acquisition of the Treasury notes. Cash Premium on Treasury notes Interest income To record receipt of the first interest payments. Cash Treasury notes at par value Premium on Treasury notes Interest income To record receipt of the final interest payments and the par value. 6. Over the period the notes are held, the following would be recorded: Cash received from 10 interest payments of $668.75 Excess of $12,900.00 cash paid for the notes over the $10,000.00 received for their par value Interest income recognized $ 6,687.50 (2,900.00 ) $ 3,787.50 10,668.75 10,000.00 333.23 335.52 668.75 250.15 418.60 10,000.00 2,900.00

12,900.00

Every six months, the company would record interest on the note and amortization of premium or discount. If the note had a coupon rate of 133/8, semiannual interest and premium amortization for the first six months would be recorded as follows: Cash Premium on Treasury notes Interest income To record semiannual income on Treasury note ($10,000 0.13375/2) and premium amortization. The entry would result in the following amounts at the end of the first six months:  Unamortized premium ($2,900.00 initial amount less $250.15)  Investment ($10,000.00 initial balance plus $2,649.85 unamortized premium) $ 2,649.85 668.75 250.15 418.60

$ 12,649.85

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(The $12,649.85 investment balance is the present value of nine semiannual interest payments of $668.75 and a single payment of $10,000 due nine semiannual periods from now, calculated using a semiannual yield of 3.245%.)  Interest income ($668.75 coupon less $250.15 using yield) $ 418.60

Because Treasury notes and bonds pay coupon interest, it should be accrued and any premium or discount should be amortized as of the balance sheet date. In addition, if notes or bonds are purchased between interest dates, the purchase of accrued interest also should be recorded. Similar to Treasury bills, when Treasury notes or bonds mature, an entry debiting cash and crediting investments should be made If notes or bonds are sold before maturity, any related premium or discount would be eliminated, and accrued interest should be recorded if the sale occurs between interest dates. If Treasury notes or bonds are classified as heldtomaturity securities at the balance sheet date, they should be recorded at amortized cost (that is, cost less amortization of premium or discount). If, on the other hand, they are classified as available for sale, GAAP requires them to be recorded at fair value. In that circumstance, the company would record the fair value adjustment by debiting or crediting the carrying amount of the Treasury note or bond with a corresponding entry to other comprehensive income for the unrealized gain or loss. Determining Fair Value. The fair value of Treasury bonds or notes at the financial statement date may be determined by reference to the last quoted bid price at that date. Financial publications, such as the Wall Street Journal, might report information such as the following: Rate 67/8 Maturity Mo/Yr July X9n Bid 101:05 Asked 101:07 Chg. *7 Ask Yield 6.43

The first column indicates the coupon ratein this case, 67/8%. The second column indicates that maturity of the Treasury note is July 20X9. (The n" annotation indicates that this is a Treasury note rather than a bond.) The bid and asked quotes are not stated in percentages, as they are in the case of Treasury bills. Instead, numbers to the right of the colon represent 32nds of one point. In this case, the bid quote (the price at which an entity could sell) translates to 1015/32 or $1,011.56, and the asked quote (the price at which an entity could purchase) translates to 1017/32 or $1,012.19. The ask yield" represents the yield to maturity on the note. Accordingly, the fair value of five notes maturing July 20X9 would be $5,057.80 ($1,011.56 5). If the Treasury note were classified as available for sale, the fair value adjustment would be recorded by debiting or crediting the carrying amount of the investments (cost plus or minus any related premium or discount) with a corresponding entry to other comprehensive income for the unrealized gain or loss. Presenting Unrealized Gains and Losses. As explained earlier in this lesson, companies should debit or credit the carrying amount of investments in availableforsale marketable securities, with a corresponding entry to other comprehensive income, to record unrealized gains and losses on the securities and report them at fair value in the financial statements. GAAP (as amended) also requires the notes to the financial statements to disclose the following, by major security type, for availableforsale securities: (a) aggregate fair value, (b)total gains for securities with net gains in accumulated other comprehensive income, and (c) total losses for securities with net losses in accumulated other comprehensive income. For securities classified as heldtomaturity, the following disclosures, by major security type, are required: (a) the aggregate fair value, (b) gross unrecognized holding gains, (c) gross unrecognized holding losses, (d) the net carrying amount, and (e) the gross gains and losses in accumulated other comprehensive income for any derivatives that hedged the forecasted acquisition of the heldtomaturity securities. To keep track of that information, some companies may prefer to use more than one account for availableforsale securities (for example, initially recording all securities at cost and recording unreal ized gains and losses in a separate account). While that practice is acceptable, the financial statements should present availableforsale securities at a net amountfair valuenot cost plus or minus a valuation allowance.

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GAAP requires unrealized gains and losses on availableforsale securities to be recorded in other comprehensive income. Accordingly, the equity section of a company's balance sheet might appear as follows: Stockholders' Equity Capital stock$1.00 par value; 16,000 shares issued; 15,832 shares issued and outstanding Additional paidin capital Net unrealized gain on marketable securities Members' (deficit) 15,832 7,509,076 4,675 (4,555,357 ) 2,974,226

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SELFSTUDY QUIZ Determine the best answer for each question below. Then check your answers against the correct answers in the following section. 3. Company B purchased 20 $1,000 face value bonds on January 1, 20X1 at an amortized cost of $985 per bond. Company B will hold the bonds until maturity, 10 years later, unless there are changes in the yield on alternative investments that make it advantageous to sell the bonds. On December 31, 20X8, the bonds have a market value of $960 per bond. What does Company B report as the value of the bonds on the December 31, 20X8 balance sheet, and how is the unrealized, temporary loss reported? a. $19,200; report in earnings. b. $19,200; report in other comprehensive income. c. $19,700; no loss is reported. d. $20,000; no loss is reported. 4. Company C held bonds with a carrying amount of $30,000 which were originally classified as heldtomaturity. On December 31, 20X2, the company transfers the bonds to the availableforsale category. On that day, the market value of the bonds was $35,000. How much does Company C report as other comprehensive income due to this transfer? a. $0. b. $5,000. c. $30,000. d. $35,000. 5. A company purchases a debt security at its $80,000 face value and classifies it as availableforsale. The security bears interest at 10%, and is due in five years. On December 31, 20X1, the security's fair value is $85,000 and the company reclassifies the security as heldtomaturity. On January 31, 20X2, the security's fair value is $90,000. The 20X2 financial statements are issued on March 15, 20X2. What amount does the company reclassify from availableforsale to heldtomaturity? a. $8,000. b. $80,000. c. $85,000. d. $90,000. 6. A company purchases four 52week $10,000 Treasury bills (T bills) at 98. The company classifies the T bills as available for sale. At the end of the year, the Wall Street Journal reports the following information regarding the T bills: Days to maturity: 85; Bid 6.2; Ask 6.3; Yield 6.55. What amount is reported as the value of the bonds on its yearend financial statements? a. $38,626.15. b. $39,200.00. c. $39,405.00. d. $39,414.44. 327

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7. How should an entity present availableforsale securities on its balance sheet? a. The net fair value. b. Amortized cost. c. Cost plus or minus a valuation allowance. d. Cost less any nontemporary declines in value.

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SELFSTUDY ANSWERS This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the appropriate material. (References are in parentheses.) 3. Company B purchased 20 $1,000 face value bonds on January 1, 20X1 at an amortized cost of $985 per bond. Company B will hold the bonds until maturity, 10 years later, unless there are changes in the yield on alternative investments that make it advantageous to sell the bonds. On December 31, 20X8, the bonds have a market value of $960 per bond. What does Company B report as the value of the bonds on the December 31, 20X8 balance sheet, and how is the unrealized, temporary loss reported? (Page 314, Exhibit 41) a. $19,200; report in earnings. [This answer is incorrect. The loss would be report