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Financial 1

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3.

Net Concept (gains and losses)


a.

Gains
Gains are reported at their net amounts (i.e., proceeds less net book value). A
gain is the recognition of an asset either not in the ordinary course of business
(e.g., gains on the sale of a fixed asset) or without the incurrence of an
expense (e.g., finding gold on the company's property).

b.

Losses
Losses are reported at their net amounts (i.e., proceeds less net book value).
A loss is cost expiration either not in the ordinary course of business (e.g., loss
on the sale of investment assets) or without the generation of revenue (e.g.,
abandonment).

II.

PRESENTATION ORDER OF THE mAJOR COmPONENTS OF AN INCOmE AND RETAINED


EARNINGS STATEmENT
R E P O R T E d O N I N C O M E S TAT E M E N T

A.

Income (or Loss) From Continuing Operations (individual line items show "gross of tax," then

total reported "net of tax")

Income from continuing operations includes operating activities (i.e., revenues, costs of
goods sold, selling expenses, and administrative expenses), nonoperating activities (e.g.,
other revenues and gains and other expenses and losses), and income taxes.
B.

Income (or Loss) From Discontinued Operations (reported "net of tax")


Income from discontinued operations is presented net of tax.
R E P O R T E d O N S TAT E M E N T O F R E TA I N E d E A R N I N G S

C.

Cumulative Effect of Change in Accounting Principle (reported "net of tax")


The cumulative effect of a change in accounting principle is presented net of tax. It is the
cumulative effect (calculated as of the beginning of the earliest period presented in the period
of implementation of the new method) of a change from one acceptable method of
accounting to another ("GAAP to GAAP") because the new method presents the financial
information more fairly than the old method.

Note: The FASB has eliminated the concept of extraordinary items. Items of income or loss that are unusual or
infrequent or both should be reported separately as part of income from continuing operations. The nature of the
item and the financial statement effects should be disclosed on the face of the income statement or in the footnotes.
U.S. GAAP and IFRS are now aligned in their treatment of unusual or infrequent items.

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I N C O M E F R O M C O N T I N U I N G O P E R AT I O N S
Income from continuing operations
Discontinued operations
Accounting principle change

Income statement
Retained earnings statement
Accounting
Changes

I. MULTIPLE STEP INCOME STATEMENT

The multiple step income statement reports operating revenues and expenses separately from
nonoperating revenues and expenses and other gains and losses. The benefit of the multiple step
income statement is enhanced user information (because the line items presented often provide the
user with readily available data with which to calculate various analytical ratios).
EXAMPLE

Radon Industries, Inc.


Income Statement (multiple step)
for the Year Ended December 31, Year 1 (in thousands)
Net sales (including goods, services, and rentals)

$650

(410)
Cost of sales (including goods, services, and rentals)
Gross margin
Selling expenses

$240

$100

General and administrative expenses

70

Depreciation expense

80

(250)

Income (loss) from operations

$ (10)

Other revenues and gains:


Interest income

170

Gain on sale of fixed assets (e.g., equipment) 50


Other income

130 350

Other expenses and losses:


Interest expense

50

Loss on sale of fixed assets (e.g., equipment)

40

Income before unusual items and income tax

(90)
$250

Unusual and/or infrequent items:


Loss on sale of available-for-sale securities
Income before income tax

(100)
150

Provision for income taxes:


Current 180
Deferred

(80)

(100)

$ 50
Net income (or "income from continuing operations")*
* "Income from continuing operations" would be used if the income statement includes "discontinued operations."
1. Inventory Cost............................... Purchase price, freight in
2. Selling Expense.............................. Freight out, salaries and commissions, advertising
3. General & Administrative.............. Officer's salaries, accounting and legal, insurance
4. Nonoperating................................ Auxiliary activities, interest expense

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d I S C O N T I N U E d O P E R AT I O N S A N d E X I T O R d I S P O S A L A C T I v I T I E S
Income from continuing operations
discontinued operations
Accounting principle change
I.

205
Income statement
Retained earnings statement

INTRODUCTION TO DISCONTINUED OPERATIONS

discontinued
Operations

Discontinued operations are reported separately from continuing operations in the income
statement according to the IDA mnemonic, net of tax. The (normally) loss from discontinued
operations can consist of an impairment loss, a gain/loss from actual operations, and a gain/loss on
disposal. All of these amounts are included in discontinued operations in the period in which they
occur.
II.

DEFINITIONS
A.

Component of an Entity
A component of an entity is a part of an entity (the lowest level) for which operations and
cash flows can be clearly distinguished, both operationally and for financial reporting
purposes, from the rest of the entity.
1.

U.S. GAAP
Under U.S. GAAP, a component of an entity may be:

2.

a.

An operating segment,

b.

A reportable segment (as those terms are defined in segment reporting),

c.

A reporting unit (as that term is defined in goodwill impairment testing),

d.

A subsidiary, or

e.

An asset group (a collection of assets to be disposed of together as a group in a


single transaction and the liabilities directly associated with those assets that will
be transferred in that same transaction).

IFRS
Under IFRS, a component of an entity may be:

B.

a.

A separate major line of business or geographical area of operations, or

b.

A subsidiary acquired exclusively with a view to resale.

Business
A business is an integrated set of activities and assets that is conducted and managed for the
purpose of providing a return to investors or other owners, members, or participants.

C.

Nonprofit Activity
A nonprofit activity is an integrated set of activities and assets that is conducted and managed
for the purpose of providing benefits, other than goods or services at a profit, to fulfill an entity's
purpose or mission.

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2.

Financial 1

Definition of "Directly Related"


In order for a settlement to be considered directly related to a component of an entity,
itmust:
a.

Have a demonstrated cause-and-effect relationship, and

b.

Occur no later than one year after the date of the disposal transaction (unless
circumstances beyond the control of the entity exist).

F. Measurement and Valuation


A component classified as held for sale is measured at the lower of its carrying amount or fair
value less costs to sell. Costs to sell are the incremental direct costs to transact the sale.
G.

Presentation and Disclosure


1.

Present as a Separate Component of Income


The results of discontinued operations, net of tax, are reported as a separate
component of income.

2.

Disclose in Face or in Notes


A gain or loss recognized on the disposal shall be disclosed either on the face of the
income statement or in the notes to the financial statements.

IV. EXIT OR DISPOSAL ACTIVITIES


As part of its convergence with IFRS, U.S. GAAP requires the recognition of a liability for the costs
associated with an exit or disposal activity.
A.

Exit and Disposal Costs


Costs associated with exit and disposal activities include:

B.

1.

Involuntary employee termination benefits.

2.

Costs to terminate a contract that is not a capital lease.

3.

Other costs associated with exit or disposal activities, including costs to consolidate
facilities or relocate employees.

Criteria for Liability Recognition


An entity's commitment to an exit or disposal plan, by itself, is not enough to result in liability
recognition. A liability associated with an exit or disposal activity should be recognized only
when all of the following criteria are met:
1.

An obligating event has occurred,

2.

The event results in a present obligation to transfer assets or to provide services in the
future, and

3.

The entity has little or no discretion to avoid the future transfer of assets or providing of
services.

Future operating losses expected to be incurred as part of an exit or disposal activity are
recognized in the period(s) incurred.

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B.

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Reporting a Change in Estimate


1. Prospectively
Changes in accounting estimate are accounted for prospectively (i.e., implement in the
current period and continue in future periods). They do not affect previous periods (i.e.,
no effect on previously reported retained earnings).
2.

Change in Estimate Affecting Future Periods


If a change in accounting estimate affects several future periods (e.g., a revision of
service lives of depreciable assets), the effect on income from continuing operations,
net income, and the related per share information for the current year should be
disclosed in the notes to the financial statements.
Note: Changes in ordinary accounting estimates (e.g., uncollectible accounts and inventory
adjustments) usually made each period do not have to be disclosed unless they are material.

Changes in
Accounting Principle

III.

CHANGES IN ACCOUNTING PRINCIPLE (retrospective application)


A change in accounting principle is a change in accounting from one accounting principle to
another acceptable accounting principle (i.e., GAAP to GAAP or IFRS to IFRS).
A.

Rule of Preferability
An accounting principle may be changed only if required by GAAP/IFRS or if the alternative
principle is preferable and more fairly presents the information.

B.

Nonrecurring Changes
An accounting change should not be made for a transaction or event in the past that has
been terminated or is nonrecurring.

C.

Effects of a Change
1.

Direct Effects
The direct effects of a change in accounting principle are adjustments that would be
necessary to restate the financial statements of prior periods.

2.

Indirect Effects
The indirect effects of a change in accounting principle are differences in
nondiscretionary items based on earnings (e.g., bonuses) that would have occurred if
the new principle had been used in prior periods.

3.

Cumulative Effect
If noncomparative financial statements are being presented, then the cumulative effect
of a change in accounting principle is equal to the difference between the amount of
beginning retained earnings in the period of change and what the retained earnings
would have been if the accounting change had been retroactively applied to all prior
affected periods. It includes direct effects and only those indirect effects that are
entered in the accounting records. If comparative financial statements are being
presented, then the cumulative effect is equal to the difference between beginning
retained earnings in the first period presented and what retained earnings would have
been if the new principle had been applied to all prior periods.

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E X A M P L E C U M U L AT I V E E F F E C T O F A C H A N G E I N A C C O U N T I N G P R I N C I P L E

On January 1, 20X5, Harbor Construction Company decided to switch to the percentage-of-completion


method in accounting for all of its long-term construction contracts. Prior to 20X5, Harbor used the
completed contract method for some of its contracts. Harbor's effective tax rate is 30%. For income tax
purposes, Harbor continues to use the completed contract method for all its contracts.
Contract information is as follows:
Pretax Income from
Percentage-of-Completion
Prior to 20X5

$800,000

Cumulative effect adjustment as of 1/1/20X5 =


Less income tax effect @ 30%

$600,000
$200,000
(60,000)

Cumulative effect net of income tax

D.

Completed Contract

$140,000

Reporting Changes in an Accounting Principle


The general rule is that changes in accounting principle should be recognized by adjusting
beginning retained earnings in the earliest period presented for the cumulative effect of the
change, and, if prior period financial statements are presented, they should be restated
(retrospective application).
U.S. GAAP vs. IFRS

Under IFRS, when an entity disclosing comparative information applies an accounting principle retroactively
or makes a retrospective restatement of items in the financial statements, the entity must (at a minimum)
present three balance sheets (end of current period, end of prior period, and beginning of prior period) and
two of each other financial statement (current period and prior period). The cumulative effect adjustment
would be shown as an adjustment of the beginning retained earnings on the balance sheet for the beginning
of the prior period. U.S. GAAP does not have a three balance sheet requirement.

1.

Exceptions to the General Rule


a.

Impracticable to Estimate
To prepare a change in accounting principle handled retrospectively, the amount
of the cumulative effect adjustment must be calculated as of the beginning of the
first period presented. If it is considered "impractical" to accurately calculate this
cumulative effect adjustment, then the change is handled prospectively (like a
change in estimate). An example of a change handled in this manner is a
change in inventory cost flow assumption to LIFO (under U.S. GAAP). Since a
cumulative effect adjustment to LIFO would require the reestablishment and
recalculation of old inventory layers, it is considered impractical to try and rebuild
those old cost layers. This change is therefore handled prospectively. The
beginning inventory of the year of change is the first LIFO layer. Additional LIFO
layers are added on from that point forward.

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b.

Change in Depreciation Method


A change in the method of depreciation, amortization, or depletion is considered
to be both a change in accounting principle and a change in estimate. These
changes should be accounted for as changes in estimate and are handled
prospectively. The new depreciation method should be used as of the beginning
of the year of the change in estimate and should start with the current book value
of the underlying asset. No retroactive or retrospective calculations should be
made, and no adjustment should be made to retained earnings.

2.

Applications of the General Rule


a.

The amount of cumulative effect to be reported on the retained earnings


statement is the difference between:
(1) Retained earnings at the beginning of the earliest period presented, and
(2) Retained earnings that would have been reported at the beginning of the
earliest period presented if the new accounting principle had been applied
retrospectively for all prior periods, by recognizing only the direct effects
and related income tax effect.

b.

The new accounting principle is used for all periods presented (prior periods are
restated).

c.

If an accounting change is not considered material in the year of change but is


reasonably expected to become material in later periods, it should be fully
disclosed in the year of change.

Changes in
Accounting Entity

IV. CHANGES IN ACCOUNTING ENTITY (retrospective application)


Under U.S. GAAP, a change in accounting entity occurs when the entity being reported on has
changed composition. Examples include consolidated or combined financial statements that are
presented in place of statements of the individual companies and changes in the companies
included in the consolidated or combined financial statements from year to year.
A.

Restatement to Reflect Information for the New Entity (if comparative financial statements are

presented)

If a change in accounting entity occurs in the current year, all previous financial statements
that are presented in comparative financial statements along with the current year should be
restated to reflect the information for the new reporting entity.
B.

Full Disclosure
Full disclosure of the cause and nature of the change should be made, including changes in
income from continuing operations, net income, and retained earnings.
U.S. GAAP vs. IFRS

IFRS does not include the concept of a change in accounting entity.

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COMPREhENSIvE INCOME

220

Pension adjustments
Unrealized gains and losses (available-for-sale securities)
Foreign currency items
Effective portion cash flow hedges
Revaluation surplus (IFRS only)
I.

DEFINITIONS
A.

Comprehensive Income

Comprehensive
Income

Comprehensive income is the change in equity (net assets) of a business enterprise during a
period from transactions and other events and circumstances from nonowner sources. It
includes all changes in equity during a period except those resulting from investments by
owners and distributions to owners.
Net income
+ Other comprehensive income
Comprehensive income

B.

Net Income
Net income includes the following items:

C.

1.

Income from continuing operations

2.

Discontinued operations

Other Comprehensive Income


Other comprehensive income items are revenues, expenses, gains, and losses that are
included in comprehensive income but excluded from net income under U.S. GAAP and/or
IFRS.
An entity must classify the specific items by their nature, such as:
1.

Pension Adjustments
Under U.S. GAAP, changes in the funded status of a pension plan due to gains or
losses, prior service costs, and net transition assets or obligations must be recognized
in other comprehensive income in the year the changes occur. All gains or losses,
prior service costs, and transition assets or obligations are included in other
comprehensive income until recognized as a component of net periodic benefit cost.
Under IFRS, certain actuarial gains and losses may be included in other
comprehensive income. These gains and losses are not reclassified to net income in
subsequent periods.

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Financial 1

GOING CONCERN
I.

GOING CONCERN
An entity is considered to be a going concern if it is reasonably expected to remain in existence and
to be able to settle all its obligations for the foreseeable future.
Prior to 2014, U.S. auditing standards addressed the topic of going concern, but there was a lack
of guidance in U.S. GAAP specific to going concern. In 2014, the FASB issued a new standard
addressing management's responsibilities and disclosures required under U.S. GAAP.
A.

Going Concern Presumption


Under U.S. GAAP, preparation of financial statements presumes that the reporting entity will
continue as a going concern. Under this presumption, financial statements are prepared under
the going concern basis of accounting.

B.

Imminent Liquidation
If an entity's liquidation is imminent (and the entity is therefore no longer considered to be a
going concern), financial statements are prepared under the liquidation basis of accounting.

C.

management's Responsibility to Evaluate


Management is required to evaluate whether there is substantial doubt about an entity's ability
to continue as a going concern for a reasonable period of time not to exceed one year beyond
the date of the financial statements.

D.

1.

Substantial doubt exists when relevant conditions and events, when considered in the
aggregate, indicate it is probable (defined as "likely to occur") that the entity will not
be able to meet its obligations as they become due within one year from the financial
statement issuance date (in contrast to the balance sheet date).

2.

Management's evaluation should occur for each annual and interim reporting period.

3.

Management's evaluation should be based on relevant conditions and events that are
known and reasonably knowable at the financial statement issuance date.

4.

Management's evaluation should consider both quantitative and qualitative factors, such
as the following:
a.

The entity's current financial condition, including sources of liquidity (e.g., cash and
access to credit).

b.

The entity's obligations due or anticipated in the next year, even if they are not
recognized in the financial statements.

c.

Funds necessary to maintain operations based on resources, obligations, and


expected cash flows in the next year.

d.

Other conditions that could adversely affect the entity's ability to meet its obligations,
such as negative financial trends, other indications of financial difficulties, and
internal and external matters.

mitigating Factors
If conditions or events exist that raise substantial doubt about an entity's ability to continue as
a going concern, management should consider whether the entity's plans intended to mitigate
those conditions or events will be successful in alleviating the substantial doubt.

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1.

E.

The mitigating effect should be evaluated based on:


a.

whether it is probable that the plans will be effectively implemented; and, if so,

b.

whether it is probable that the implemented plans will be successful in mitigating the
adverse conditions or events.

No Substantial Doubt
No disclosures related to going concern are required if the evaluation does not give rise to
substantial doubt.

F.

Substantial Doubt Alleviated


If there is substantial doubt about an entity's ability to continue as a going concern, but the
substantial doubt is alleviated as a result of management's plans, the financial statements
should be prepared under the going concern basis of accounting and should include the
following footnote disclosures:

G.

1.

The primary conditions or events that initially raised substantial doubt about the entity's
ability to continue as a going concern.

2.

Management's evaluation of the significance of those conditions or events in relation to


the entity's ability to meet its obligations.

3.

Management's plans that alleviated the substantial doubt.

Substantial Doubt Not Alleviated


If there is substantial doubt about an entity's ability to continue as a going concern, and the
substantial doubt is not alleviated as a result of management's plans, the financial statements
would continue to be prepared under the going concern basis of accounting, but they must
state in the footnotes that there is substantial doubt about the entity's ability to continue as
a going concern within one year of the financial statement issuance date. In addition, the
following footnote disclosures are required:

H.

1.

The primary conditions or events that raise substantial doubt about the entity's ability to
continue as a going concern.

2.

Management's evaluation of the significance of those conditions or events in relation to


the entity's ability to meet its obligations.

3.

Management's plans that are intended to mitigate the adverse conditions or events.

U.S. GAAP vs. IFRS


U.S. GAAP and IFRS both emphasize management's responsibility to evaluate the entity's
ability to continue as a going concern and provide relevant disclosures when necessary.
Differences between U.S. GAAP and IFRS include the following distinctions:

F1-46

1.

U.S. GAAP requires the liquidation basis of accounting if liquidation is imminent and the
going concern basis requirements are not met, whereas IFRS does not provide guidance
on the basis of accounting to use if liquidation is imminent.

2.

U.S. GAAP requires certain disclosures when there is substantial doubt about an entity's
ability to continue as a going concern, even if that doubt is alleviated by management's
plans to address it. IFRS requires disclosures when management is aware of material
uncertainties that may give rise to substantial doubt about an entity's ability to continue as
a going concern.

3.

U.S. GAAP requires management to assess going concern conditions within one year of
the financial statement issuance date, whereas IFRS requires assessment at least one
year from the balance sheet date.

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B.

Financial 1

Unusual and/or Infrequent Transactions


Unusual and/or infrequent transactions that are material, such as the effects of a disposal of a
segment of business, should be reported separately.

C. Minimum Disclosure Requirements (U.S. GAAP)


U.S. GAAP outlines the following minimum disclosure requirements for interim reporting:
1.

Gross sales or revenues, provision for income taxes, and net income.

2.

Basic and diluted earnings per share.

3.

Material seasonal variations of revenues, costs, or expenses.

4.

Significant changes in estimates or provisions for income taxes.

5.

Disposal of a component of a business and unusual and/or infrequently occurring items.

6.

Contingent items.

7.

Changes in accounting principles or estimates.

8.

Significant changes in financial position.

9.

Reportable operating segment disclosures.

10. Defined benefit pension and postretirement benefit plan disclosures.


11. Fair value measurement disclosures for assets and liabilities, including financial
instruments.
12. Derivative disclosures.
13. Disclosures for certain debt and equity securities.
14. Disclosures about other-than-temporary impairments.
D. Minimum Disclosure Requirements (IFRS)

IFRS

IFRS outlines the following minimum disclosure requirements for interim reporting:
1.

A statement that the accounting policies and methods of calculation used in the most
recent annual financial statements are followed in the interim financial statements, or if
those policies and methods have changed, a description of the change.

2.

Explanations of seasonal or cyclical interim operations.

3.

Nature and amount of unusual items affecting assets, liabilities, equity, net income, or
cash flows, including:
a.

Inventory write-downs and reversals of write-downs.

b.

Impairment losses and reversals of impairment losses.

c.

Reversal of any provisions for restructuring costs.

d.

Acquisitions and disposals of fixed assets.

e.

Fixed asset purchase commitments.

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f.

Litigation settlements.

g.

Unremedied loan defaults or breaches of loan agreements.

h.

Related party transactions.

4.

Changes in accounting estimates and error corrections.

5.

Issuances, repurchases and repayments of debt and equity securities.

6.

Dividends paid in total or per share.

7.

Segment disclosures.

8.

Material subsequent events not reflected in the interim financial statements.

9.

The effect of changes in the composition of the entity during the interim period.

10. Changes in contingent assets or liabilities.


U.S. GAAP vs. IFRS

IFRS requires that the nature and amount of a change in estimate made in the fourth quarter be disclosed in
a note to the annual financial statements if a separate financial report is not published for the fourth quarter.
U.S. GAAP requires disclosure in a note to the annual financial statements of fourth quarter activity related to
changes in accounting principle, discontinued operations, and unusual and/or infrequent items if a separate
financial report is not published for the fourth quarter.

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G.

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Segment Profit (or Loss) Defined


1. Formula
Revenues
Less: Directly traceable costs
Less: Reasonably allocated costs
Operating Profit (or loss)

2.

3.

Items Normally Excluded From Segment Profit (or Loss)


a.

General corporate revenues

b.

General corporate expenses

c.

Interest expense (except for financial institutions)

d.

Income taxes

e.

Equity in earnings and losses of an unconsolidated subsidiary (i.e., under the


equity method)

f.

Gains or losses from discontinued operations

g.

Minority interest

Income and Expense Allocation


Income and expenses are not allocated to a segment unless they are included in the
determination of segment profit or loss reported to the "Chief Operating Decision
Maker."

III. reportable Segment Disclosures


A.

Identifying Factors
Factors used to identify the enterprise's reportable segments, including the basis of
organization (e.g., products and services, geographic areas, regulatory environments) should
be disclosed. Also disclose whether any operation segments have been aggregated.

B.

Products and Services


The types of products and services from which the reportable segment derives its revenues
must be disclosed.

C.

Profit or Loss
The following items must be individually disclosed if the amounts are included in the
calculation of segment profit or loss reviewed by the chief operating decision maker:

F1-54

1.

Revenues from external customers.

2.

Revenues from transactions with other internal operating segments.

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Financial 1

3.

Interest revenue.

4.

Interest expense.

5.

Depreciation, depletion, and amortization.

6.

Unusual items, including unusual events and transactions.

7.

Equity in net income of investees accounted for by the equity method.

8.

Income tax expense or benefit.

9.

Significant noncash items other than depreciation, depletion, and amortization expense.

D. Assets
1.

The amount of investment in equity method investees.

2.

Total expenditures for:


a.

Additions to long-lived assets other than financial instruments.

b.

Long-term customer relationships of a financial institution.

c.

Mortgage and other servicing rights.

d.

Deferred policy acquisition costs.

e.

Deferred tax assets.


IFRS

E. Liabilities (IFRS only)


Under IFRS, an entity discloses a measure of liabilities for each reportable segment if such
an amount is regularly provided to the chief operating decision maker.
F. Measurement Criteria
1.

Basis of accounting for any internal transactions.

2.

Nature of any differences between measurements of the reportable segments' profits or


losses and the enterprise's consolidated income.

3.

Nature of any differences between measurements of the reportable segments' assets


and the enterprise's consolidated assets, if not apparent from the reconciliation
provided.

4.

Nature of any changes from prior periods in the measurement methods used to
determine reported segment profit or loss.

5.

The nature and effect of any asymmetrical allocations to segments.

G. Reconciliations
1.

The total of the reportable segments' revenues to the enterprise's consolidated


revenues.

2.

The total of the reportable segments' measures of profit or loss to the enterprise's
consolidated income before income taxes, discontinued operations, and the cumulative
effects of changes in accounting principles.

3.

The total of the reportable segments' assets to the enterprise's consolidated assets.

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A ppen d ix
IFRS vs. U.S. GAAP

Note: Unless specifically noted, IFRS and U.S. GAAP accounting rules are the same. This chart highlights the significant
differences between IFRS and U.S. GAAP covered in this lecture.
ISSUE

IFRS

U.S. GAAP

Conceptual Framework

Entities are directed to refer to and consider


the applicability of the concepts in the IASB
Conceptual Framework when developing
accounting policies in the absence of a
standard or interpretation that specifically
applies to an item.

Entities cannot apply the FASB conceptual


framework to specific accounting issues.

Discontinued Operations

Before a component can be classified as held


for sale, the individual assets and liabilities of
the component must be measured in
accordance with applicable standards and any
resulting gains and losses must be recognized.
After classification as held for sale, the
component is reported at the lower of
carrying value and fair value less costs to sell.

Assets and liabilities are not required to be


remeasured before a component is classified
as held for sale, but the classification of a
component as held for sale does trigger an
impairment analysis of the component.

Accounting Changes

When an entity applies an accounting change


retroactively or makes a retrospective
restatement of items in the financial
statements, the entity must (at a minimum)
present three balance sheets (end of current
period, end of prior period, and beginning of
prior period) and two of each other financial
statement. The cumulative effect adjustment
is an adjustment to beginning retained
earnings at the beginning of the prior period.

Comparative financial statements are not


required by U.S. GAAP. Note that the SEC
does require comparative annual financial
statements for public companies (at a
minimum, two balance sheets and three
statements of income, changes in owners'
equity, and cash flows). Neither GAAP nor
the SEC have a three balance sheet
requirement when an entity applies an
accounting change retroactively. The
cumulative effect adjustment is an
adjustment to the beginning retained
earnings of the earliest period presented.

Change in Accounting Entity

IFRS does not include the concept of a change


in accounting entity.

If a change in accounting entity occurs in the


current year, all previous financial
statements that are presented in
comparative financial statements along with
the current year should be restated to
reflect the information for the new
reporting entity.

F1-64

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Financial 2

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B. ExerciseThree-Year Net Income and Ending Balance Sheet


This exercise is designed to illustrate the effect on income of the following transactions.
3-Year Income Statement*

Net Income Per Books

Year 1

Year 2

Year 3

(5,000)

(8,000)

(10,000)

1. The company purchased a $300, 3-year insurance policy on 1/1/Year


2 and expensed it all in Year 2.
2. $2,000 of credit sales made in Year 2 were not recorded until
collected in Year 3.

(200)

100

(2,000)

2,000

3. $3,000 of Year 3 sales and related accounts receivable outstanding on


12/31/Year 3 was not recorded.

(3,000)

4. $1,500 of accounts payable (for expenses incurred) during Year 3


were omitted at 12/31/Year 3 and expensed when paid in Year 4.
5. $400 was paid in Year 3 and was charged to rent expense. This
payment covers rent for December Year 4 in a lease ending
12/31/Year 4.
6. The direct write off method (non-GAAP method) was used to write off
a $650 bad debt in Year 3. The original sale was made in Year 1.

Balance Sheet 12/31/Year 3


DR

650

A/C Title

(Unexpired ins.)
prepaid insurance

100

Accounts
receivable

3,000

1,500
(400)

CR

1,500
400

Accounts
payable
Prepaid rent

(650)

7. Two identical inventory purchases were made by two separate


operating divisions - Division A and Division B. Both $1,300 purchases
of raw materials were purchased FOB shipping point and were in
transit on 12/31/Year 3. They were not included in the actual
12/31/Year 3 inventory count (the effect of this correction on the
financial statements is the same whether the perpetual or periodic
inventory system is used).
1,300
a. Division A: Inventory and liability not recorded.

-0-

b. Division B: Inventory not recorded, but liability and "cost of sales"


were recorded.
Correct net income
Balance sheet adjustments

(1,300)
(4,350)

(10,200)

Inventory
1,300

1,300

Accounts payable
Inventory

(11,750)
6,100

2,800
3,300

Retained earnings

*Note: The brackets under the Years 1, 2, and 3 columns represent income, not losses. Thus, Year 1 net income per books is $5,000 and the subsequent
$650 adjustment would decrease income by $650 to ($4,350).

F2-26

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Financial 2

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Explanations:
1. The $300 paid for insurance in Year 2 should have been debited to prepaid insurance. At year-end of Year 2, two
years of insurance coverage are left and one year has expired. The ($200) is a credit to income in Year 2. This
combined with the $300 insurance expense already charged in Year 2, results in the proper $100 charge to
income. The $100 charge to income for Year 3, represents the correct amount of insurance expense for Year 3,
$100 per year. The $100 debit under balance sheet 12/31/Year 3, reflects the correct balance of prepaid
insurance as of that date. As of 12/31/Year 3, one year of insurance coverage remains.
2. According to the revenue recognition principle and accrual accounting, sales should be recorded in the period the
revenue is earned. The Year 2 ($2,000) credit to income, properly records the credit sales. The Year 3, $2,000
charge to income removes the revenue recorded in that period.
3. The rationale for the income statement adjustment is the same as in #2. The credit sales should be reflected in
the period of sale, Year 3, and the 12/31/Year 3 balance sheet should reflect the correct $3,000 accounts
receivable balance.
4. Expenses should be recorded in the period "incurred." The Year 3, $1,500 charge to income, records the correct
expense incurred. The 12/31/Year 3 balance sheet will now show the $1,500 as accounts payable.
5. The $400 paid in Year 3 represents prepaid rent. The ($400) adjustment to Year 3 removes the incorrect charge
to income, and the 12/31/Year 3 balance sheet is adjusted to properly reflect the asset prepaid rent.
6. According to the matching principle, expenses should be recorded in the same period as the related revenue. Since
the sale was made in Year 1, the related expense of the sale (the bad debt expense) should be recorded in Year 1.
The adjustment here ($650) removes the charge from Year 3 income and puts it in the proper year, Year 1.
7. The correct journal entry for either division would have been:
DR

Inventory (perpetual system)


OR

DR

Purchases (periodic system)

CR

Accounts payable

$1,300
$1,300

Since division A did not make any entry, the correction entry for division A is just the correct original entry. Since
division B charged cost of sales instead of inventory or purchases, the correction here removes the charge to
Year 3 income and sets up the proper inventory balance. Accounts payable is already correctly stated.
The final $3,300 increase to retained earnings, reflects all cumulative adjustments to income through Year 3:
$200 + 100 2,000 + 2,000 3,000 + 1,500 400 + 650 650 1,300 = $3,300
Remember: In this schedule, ($) are credits or increases to income.

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F2-27

Financial 2

Becker Professional Education | CPA Exam Review

II. EXCHANGES LACKING COMMERCIAL SUBSTANCE


If projected cash flows after the exchange are not expected to change significantly, then the
exchange lacks commercial substance. The following accounting treatment is used (note that this
method must also be used in any exchange in which fair values are not determinable, or if the
exchange is made to facilitate sales to customers):
A. Gains
1.

No Boot Is Received = No Gain


If the exchange lacks commercial substance and no boot is received, no gain is
recognized.

2.

Boot Is Paid = No Gain (<25% rule)


If the exchange lacks commercial substance and boot is paid, no gain is recognized.

3.

Boot Is Received = Recognize Proportional Gain (<25% rule)


If the exchange lacks commercial substance and the boot received is less than 25%
of the total consideration received, a proportional amount of the gain is recognized. A
ratio (the total boot received / the total consideration received) is calculated, and that
proportion of the total gain realized is recognized.

4.

Boot Is 25% or More of Total Consideration


When the boot received equals or exceeds 25% of the total consideration, both parties
consider the transaction a monetary exchange and gains and losses are recognized in
their entirety by both parties to the exchange.

B. Losses
If the transaction lacks commercial substance and a loss is indicated, the loss should be
recognized.
E XAMPL E N o Boot = N o G a in recogni z ed

Assume:
Machine A is exchanged for Machine B
Machine A, carrying value (BV) = $10,000
Machine A, fair value (FV) = $12,000
Machine B, fair value (FV) = $12,000 (FV given = FV received)
Calculate the total gain as follows:
FV of asset given BV of asset given
$12,000 10,000 = $2,000 gain
The gain is not recognized because the exchange lacks commercial substance and boot is not included in the
transaction. As a result, the basis of the acquired asset is equal to the basis of the old asset, which is also
equal to the assets fair value less the deferred gain.
Journal entry to record the above transaction:
DR

CR

F2-38

Machine B
Machine A

$10,000
$10,000

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Financial 3

Becker Professional Education | CPA Exam Review

P R I vAT E C O M PA N Y A C C O U N T I N G A LT E R N AT I v E

Under U.S. GAAP, a private company (an entity that is not a public entity or not-for-profit entity) may elect an accounting policy
under which it would not separately recognize the following intangible assets when accounting for a business combination:
1. Intangible assets that would otherwise arise from noncompete agreements; or
2. Customer-related intangible assets that cannot be separately sold or licensed, such as customer lists, order backlogs, and
customer contracts.
Instead, the value of these assets would be included in goodwill.
This accounting alternative also applies where a private company is required to recognize the fair value of intangible assets
as a result of:
1. Applying the equity method to joint ventures.
2. Adopting fresh-start reporting in a reorganization.
A private company may elect this alternative only if it also elects the private company goodwill accounting alternative. However,
a private company can elect the goodwill accounting alternative without electing this alternative for a business combination.
Once elected, a private company should apply this accounting alternative prospectively to all business combinations.
U.S. GAAP vS. IFRS

Under IFRS, goodwill (and noncontrolling interest as discussed above) can be calculated using either the "partial goodwill"
method or the "full goodwill" method.
Full Goodwill Method
The full goodwill method is the method used under U.S. GAAP (as described above), in which goodwill is calculated as follows:
Goodwill = Fair value of subsidiary Fair value of subsidiary's net assets
Partial Goodwill Method
Under the partial goodwill method, goodwill is calculated as follows:
Goodwill = Acquisition cost Fair value of subsidiary's net assets acquired
Note: Partial goodwill and full goodwill methods differ only when the parent owns less than 100% of the subsidiary.
E X A M P L EU.S. g A A P/I F RSF U L L g O O dW I L L

TAG Inc. purchases 60% of Gearty Co.'s equity for $75,000,000 in cash. The fair value of Gearty is $125,000,000 ($125,000,000
60% = $75,000,000). TAG uses the full goodwill method under IFRS. The fair value of Gearty Co.'s net identifiable assets is
$60,000,000 and carrying amount of Gearty's net assets is $50,000,000. Under the full goodwill method:
Noncontrolling interest = $125,000,000 40% = $50,000,000
Goodwill = $125,000,000 $60,000,000 = $65,000,000
S U B ' S T O TA L (100%) FA I R VA L U E = $125,000,000

Goodwill

$65,000,000

Identifiable intangible assets FV

$50,000,000

NCI

$75,000,000

Investment
in subsidiary

-0-

Balance sheet FV adjustment

$10,000,000

Book value (CAR)

$50,000,000

DR

CR

DR Common stock subsidiary


DR A.P.I.C. subsidiary

$50,000,000

DR Retained earnings subsidiary

CR

Investment in subsidiary

$75,000,000

CR

Noncontrolling interest

50,000,000

DR Balance sheet adjustments to FV


DR Identifiable intangible assets to FV
DR Goodwill

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10,000,000
-065,000,000

00000000000

$125,000,000

$125,000,000
F3-33

Financial 4

III.

Becker Professional Education| CPA Exam Review

VALUATION OF INVENTORY
U.S. GAAP requires that inventory be stated at its cost. Where evidence indicates that cost will be
recovered with an approximately normal profit on a sale in the ordinary course of business, no loss
should be recognized even though replacement or reproduction costs are lower.
A. Cost
Inventories are generally accounted for at cost, which is defined as the price paid or
consideration given to acquire an asset. Methods used to determine the cost of inventory
include first-in, first-out (FIFO), last-in, first-out (LIFO), average cost, and the retail inventory
method. IFRS does not permit the use of LIFO.
B.

Departure From the Cost Basis


1.

Lower of Cost or Market and Lower of Cost and Net Realizable Value
In the ordinary course of business, when the utility of goods is no longer as great as
their cost, a departure from the cost basis principle of measuring inventory is required.
This is usually accomplished by stating such goods at market value or net realizable
value, as appropriate. The purpose of reducing inventory to the lower of cost or market
or the lower of cost and net realizable value is to show the probable loss sustained
(conservatism) in the period in which the loss occurred (matching principle).
pass ke y

The FASB issued ASU 2015-11, Simplifying the Measurement of Inventory, in July 2015. This Accounting Standards
Update (ASU) states that all inventory that is not costed using LIFO or the retail inventory method should be measured
at the lower of cost and net realizable value. Inventory costed using LIFO or the retail inventory method should be
measured at the lower of cost or market. This ASU is effective for fiscal years beginning after December 15, 2016.
However, early application is permitted, which means that this ASU may be tested on the CPA Exam beginning April 1,
2016. Under IFRS, all inventory is measured at the lower of cost and net realizable value.

2.

Precious Metals and Farm Products


Gold, silver, and other precious metals, and meat and some agricultural products, are
valued at net realizable value, which is net selling price less costs of disposal. When
inventory is stated at a value in excess of cost, this fact should be fully disclosed in the
financial statements. Inventories reported at net realizable value include:
a.

Inventories of gold and silver, when there is effective government-controlled market


at a fixed monetary value.

b.

Inventories of agricultural, mineral, or other products meeting all of the


followingcriteria:
(1) Immediate marketability at quoted prices;
(2) Unit interchangeability; and
(3) Inability to determine appropriate costs.

3.

Recognize Loss in Current Period


Under U.S. GAAP, the write-down of inventory is usually reflected in cost of goods sold,
unless the amount is material, in which case the loss should be identified separately in
the income statement. IFRSs do not specify where an inventory write-down should be
reported on the income statement.

F4-22

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 PA Exam Review

4.

Financial 4

Reversal of Inventory Write-downs


Under U.S. GAAP, reversals of inventory write-downs are prohibited. IFRSs allow the
reversal of inventory write-downs for subsequent recoveries of inventory value. The
reversal is limited to the amount of the original write-down and is recorded as a reduction
of total inventory costs on the income statement (COGS) in the period of reversal.

5. Exceptions
The lower of cost or market and lower of cost and net realizable value rules will not
applywhen:

C.

a.

The subsequent sales price of an end product is not affected by its market value; or

b.

The company has a firm sales price contract.

Lower of Cost or Market (U.S. GAAP only)


The lower of cost or market principle may be applied to a single item, a category, or
total inventory, provided that the method most clearly reflects periodic income.
1.

Lower of
Cost or
Market

Determining Market Value


Under U.S. GAAP, the term "market" in the phrase "lower of cost or market" generally
means current replacement cost (whether by purchase or reproduction), provided the
current replacement cost does not exceed net realizable value (the "market ceiling")
orfall below net realizable value reduced by normal profit margin (the "market floor").

2. Terms
a.

Market Value
Under U.S. GAAP, market value is the median (middle value) of an inventory item's
replacement cost, its market ceiling, and its market floor.

b.

Replacement Cost
Replacement cost is the cost to purchase the item of inventory as of the
valuationdate.

c.

Market Ceiling
Market ceiling is an item's net selling price less the costs to complete and dispose
(called the net realizable value).

d.

Market Floor
Market floor is the market ceiling less a normal profit margin.

D.

Lower of Cost and Net Realizable Value (IFRS and U.S. GAAP)
The lower of cost and net realizable value principle may be applied to a single
item, a category, or total inventory, provided that the method most clearly reflects
periodicincome.
1.

Lower
of Cost
and Net
Realized
Value

Net Realizable Value


Net realizable value is an item's net selling price less the costs to complete and dispose
of the inventory. Net realizable value is the same as the "market ceiling" in the lower of
cost or market method.

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F4-23

IFRS

Financial 4

Becker Professional Education| CPA Exam Review

E X A M P L E lo w er of cost or market and L o w er of C ost and N et R eali z able V alue


Lower of cost or market
MARKET

Item
1
2
3
4

Cost
$20.50
26.00
10.00
40.00

Replacement
Cost
$19.00
20.00
12.00
55.00

Selling
Price
$25.00
30.00
15.00
60.00

Costs of
Completion
$1.00
2.00
1.00
6.00

Normal
Profit
$6.00
7.00
3.00
4.00

Determine the lower of cost or market for the above four items.
Item 1:

Determine the maximum ("ceiling") and minimum ("floor") limits for the replacement cost.
Ceiling

$24.00 ($25 $1)

Floor

$18.00 ($25 $1) $6

Since replacement cost falls between the maximum and minimum, market price is $19.00. Market ($19.00) is lower
than cost ($20.50), therefore inventory would be valued at market ($19.00).
Item 2:

Determine the maximum and minimum limits for the replacement cost.
Ceiling = $28.00
Floor = $21.00
Since replacement cost is less than the minimum, market value is the minimum, or $21.00. Market ($21.00) is lower
than cost ($26.00), therefore inventory would be valued at market ($21.00).

Item 3:

Determine the maximum and minimum limits for the replacement cost.
Ceiling = $14.00
Floor = $11.00
Replacement costs falls within these limits. Since cost ($10.00) is less than replacement cost ($12.00), the cost of
$10.00 is used.

Item 4:

Determine the maximum and minimum limits for the replacement cost.
Ceiling = $54.00
Floor = $50.00
Since the replacement cost exceeds the maximum limit, the maximum ($54.00) is compared to cost ($40.00). Inventory
is valued at cost ($40.00).

When market is lower than cost, the maximum prevents a loss in future periods by valuing the inventory at its estimated selling
price less costs of completion and disposal. The minimum prevents any future periods from realizing any more than a normal
profit.
Journal entry to record the write-down to a separate account:
DR Inventory loss due to decline in market value

CR

Inventory

$XXX
$XXX

lo w er of cost and net reali z able value

Item
1
2

Cost
$28.50
21.00

Selling
price
$30.00
26.00

Costs of
Completion
$3.00
4.00

Determine the lower of cost or net realizable value for the above two items.
Item 1:

Determine the net realizable value (NRV):


NRV = $27.00 ($30 $3)
Net realizable value ($27.00) is lower than cost ($28.50); therefore, inventory would be valued at net realizable value
($27.00).

Item 2:

Determine the net realizable value:


NRV = $22.00
Net realizable value ($22.00) is greater than cost ($21.00); therefore, inventory would be valued at cost ($21.00).

F4-24

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Financial 4

A p p e n d i x II

I F R S v s . U . S . G A A P
Note: Unless specifically noted, IFRS and U.S. GAAP accounting rules are the same. This chart highlights the important
differences between IFRS and U.S. GAAP covered in this chapter.
Issue

IFRS

U.S. GAAP

Inventory Valuation

Inventory is reported at the lower of cost or net


realizable value. Reversal of inventory write-downs is
allowed for subsequent recoveries of inventory value.

FASB ASU 2015-11 (testable beginning April 2016)


states that inventory that is not costed using LIFO or
the retail inventory method should be measured at the
lower of cost and net realizable value. Inventory costed
using LIFO or the retail inventory method should be
measured at the lower of cost or market. Reversal of
inventory write-downs is prohibited.

Inventory Cost Flow


Assumptions

The method used to account for inventory should


match the actual flow of goods

The method used to account for inventory should be


the method that most clearly reflects periodic
income

The use of LIFO is prohibited

The method is not required to have a rational


relationship with the physical inventory flow
The use of LIFO is permitted

Fixed Asset
Valuation

Fixed assets are reported using one of two models


Cost model:
Carrying value = Historical cost Accumulated
depreciation Impairment

Fixed assets are reported using the cost model:


Carrying value = Historical cost Accumulated
depreciation Impairment

Revaluation model:
Carrying value = Fair value on revaluation date
Subsequent accumulated depreciation
Subsequent impairment
Revaluation losses are reported on the income
statement
Revaluation gains are reported in other
comprehensive income as revaluation surplus
Investment
Property

Defined as land and/or buildings held to earn rental


income or for capital appreciation

No "investment property" classification

Investment property is reported using one of two


models
Cost Model:
Carrying value = Historical cost Accumulated
depreciation
If the cost model is used, fair value must be
disclosed
Fair Value Model:
Investment property is reported at fair value and
is not depreciated. Gains and losses from
changes in fair value are reported on the income
statement

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F4-65

Financial 5

Becker Professional Education | CPA Exam Review

2.

Amortization of the PremiumGeneral


Bond premium represents interest paid in advance to the issuer by bondholders who
then receive a return of this premium in the form of larger periodic interest payments (at
the stated rate). The bond premium is amortized over the life of the bond, with
amortized amounts decreasing interest expense each period. Therefore, the
amortization of the premium is subtracted from the amount of cash paid at the stated
rate to obtain GAAP interest expense.

F.

Carrying Value
As bonds approach maturity, their carrying values approach face value, so that the carrying
value of the bonds equals face value at maturity. The carrying value of a bond equals face
plus the balance of unamortized premium or face minus the balance of unamortized discount.
The carrying value of a bond with a discount increases to maturity value as the discount is
amortized. The carrying value of a bond with a premium decreases to maturity value as the
premium is amortized.
FACE
+ Unamortized premium
Carrying value

G.

FACE
Unamortized discount
Carrying value

BOND ISSUANCE COSTS


1.

Accounting for Bond Issuance Costs


Bond issuance costs are transaction costs incurred when bonds are issued. Examples
include legal fees, accounting fees, underwriting commissions, and printing. When bonds
are accounted for at amortized cost, bond issuance costs are accounted for as follows
under both U.S. GAAP and IFRS:
a.

Bond issuance costs are presented on the balance sheet as a direct reduction
tothe carrying amount of the bond, similar to bond discounts.

b.

When bonds are issued, the bond proceeds are recorded net of the bond
issuancecosts.

c.

Bond issuance costs are amortized as interest expense over the life of the bond
using the effective interest method.
E x a m p l e B O N D with bond I SS U a n c e C O S T S

On December 31, Year 1, Kristi Corporation issued a 10 percent $1,000,000 bond due in five years. Interest is due on
June 30 and December 31. The yield or market rate is 12 percent and the bond sold for $926,395. Bond issuance
costs of $20,000 were incurred. The effective interest rate is 12.58 percent.
DR

Cash

DR

Discount and bond issuance costs

CR

$906,395
93,605*

Bonds payable

$1,000,000

* $93,605 = $73,605 discount + $20,000 bond issuance costs


The bonds would be reported as follows on the December 31, Year 1 balance sheet:
Long-term debt

Principal amount

Less: Unamortized discount and bond issuance costs

Long-term debt less unamortized discount and bond issuance costs

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$1,000,000
93,605
$ 906,395

F5-37

Financial 5

Becker Professional Education| CPA Exam Review

2. Effective Interest Rate


The inclusion of bond issuance costs and bond discount/premium in the calculation of
the carrying amount of the bond results in an effective interest rate for the bond that
differs from the market rate. The effective interest rate is used to determine the interest
expense for the period as the bond discount/premium and bond issuance costs are
amortized. The effective interest rate must be disclosed in the footnotes.
p a s s key

Some CPA Exam questions may make the simplifying assumption that bond issuance costs are recognized as
interest expense on a straight-line basis.

3.

Deferred Bond Issuance Costs


Bond issuance costs incurred before the issuance of the bonds are deferred on the
balance sheet until the bond liability is recorded.
E x a m p l e D eferred B ond I s s u a n c e Co s t s

On November 1, Year 1, Kristi Corporation incurred bond issuance costs of $20,000 related to bonds to be
issued on December 31, Year 1. On November 1, Kristi Corporation recorded the following journal entry:
DR

Deferred bond issuance costs

$20,000

CR Cash

$20,000

On December 31, Kristi issued the bonds for $926,395 and recorded the following journal entry:
DR Cash
DR

V.

Discount and bond issuance costs

CR

Bonds payable

CR

Deferred bond issuance costs

$926,395
93,605
$1,000,000
20,000

METHODS OF DISCOUNT, PREMIUM, AND BOND ISSUANCE COST AMORTIZATION


A.

Amortization

Amortization Period
Under U.S. GAAP, the period over which to amortize a bond premium or discount and bond
issuance costs is the time period that the bonds are outstanding (i.e., from the date the bonds
are sold). In general, U.S. GAAP amortization is done over the contractual life of the bond.
Example

A five-year bond dated January 1 doesn't actually sell until November 1. In this case, the period of amortization
is 50 months (not 60 months).
U . S . GAAP v s . I F R S

Under IFRS, amortization is done over the expected life of the bond, not the contractual life of the bond.

B. Straight-Line Method
Straight-Line
Method

F5-38

To amortize a discount, premium, or bond issuance cost using the straight-line method,
simply divide the unamortized discount or premium by the number of periods the bonds are
outstanding and amortize the same amount of discount or premium each period. This method
of amortization results in a constant dollar amount of interest each period. The straight-line
method is not GAAP but is allowed under U.S. GAAP if the results are not materially different
from the effective interest method.

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Financial 5

D.

Becker Professional Education| CPA Exam Review

Bond Amortization Including Bond Issuance Costs


Example

Bond Discount Amortization Including Bond Issuance CostsEffective Interest Method


Assume that Kristi Corporation issued a 10 percent $1,000,000 bond due in five years. The yield or market rate is 12 percent
and the bond sold for $926,395. Bond issuance costs of $20,000 were incurred. The effective interest rate on this bond is
12.58 percent.
JE Impact
Income Statement

Balance Sheet

Difference

End of Period
Net Carrying
Value

Beginning of
Period Net
Carrying
Value

6.29%
Semiannual
Amortization
Interest

N.C.V.
x Effective

Face
x Coupon

Amortization
of Discount
and Bond
Issuance Costs

06/30/Year 1

$906,395

6.29%

$57,012

$50,000

$7,012

$913,407

12/31/Year 1

913,407

6.29%

57,453

50,000

7,453

920,860

06/30/Year 2

920,860

6.29%

57,922

50,000

7,922

928,782

12/31/Year 2

928,782

6.29%

58,420

50,000

8,420

937,202

06/30/Year 3

937,202

6.29%

58,950

50,000

8,950

946,152

12/31/Year 3

946,152

6.29%

59,513

50,000

9,513

955,665

06/30/Year 4

955,665

6.29%

60,111

50,000

10,111

965,776

12/31/Year 4

965,776

6.29%

60,747

50,000

10,747

976,523

06/30/Year 5

976,523

6.29%

61,423

50,000

11,423

987,946

12/31/Year 5

987,946

6.29%

62,054*

50,000

12,054

1,000,000

Date

* This amount is adjusted for rounding.


BORROWER

INVESTOR**

January 1, Year 1
DR Cash
DR

Discount and bond


issuance costs

January 1, Year 1
$906,395

DR Investment in bonds

CR

93,605

CR Bond payable

Bond interest expense

CR

Discount and bond


issuance costs

DR Cash

7,012
$50,000

December 31, Year 1


DR

Bond interest expense

$50,000

DR Investment in bonds

CR

5,585

Bond interest revenue

$55,585

December 31, Year 1


$57,453

Discount and bond issuance costs

CR Cash

$926,395

June 30, Year 1


$57,012

CR Cash

CR

Cash

$1,000,000

June 30, Year 1


DR

$926,395

DR Cash

7,453
$50,000

$50,000

DR Investment in bonds

CR

5,920

Bond interest revenue

$55,920

** Note that the investor accounting is not affected by the bond issuance costs.

F5-44

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XII. eXtINGUIsHMeNt oF DeBt

Extinguishment

of Debt
Corporations issuing bonds may call or retire them prior to maturity. Callable bonds
can be retired after a certain date at a stated price. Refundable bonds allow an existing issue to be
retired and replaced with a new issue at a lower interest rate.

A.

Definition of extinguishment
A liability cannot be derecognized in the financial statements until it has been extinguished.
A liability is considered extinguished if either of the following conditions is met:
1.

Debtor Pays
A liability is considered extinguished if the debtor pays the creditor and is relieved of its
obligation for the liability.
a.

Bond extinguishment at Maturity


If a bond is paid at maturity, the carrying value of the bond is equal to the face
amount of the bond and no gain or loss is recorded:
Journal entry retirement at maturity of a bond issued for $1,081,105:

b.

DR

Bonds payable

CR

Cash

$1,000,000
$1,000,000

Bond extinguished Before Maturity


If a bond is extinguished before maturity, a gain or loss is generally recorded.

2.

Debtor Legally Released


A liability is considered extinguished if the debtor is legally released from being the
primary obligor under the liability, either judicially or by the creditor.

B.

In-substance Defeasance Not extinguishment


An in-substance defeasance is an arrangement where a company places purchased
securities into an irrevocable trust and pledges them for the future principal and interest
payments on its long-term debt. Because the company remains the primary obligor while
there is outstanding debt, the liability is not considered extinguished by an in-substance
defeasance.

C.

Gain or Loss on Bond extinguishment Before Maturity


1.

Adjust Items in the Financial statements


In any bond reacquisition, the following items must be accounted for and adjusted in
the financial statements:
a.

Any related unamortized bond issuance costs;

b.

Any related unamortized discount or premium; and

c.

The difference between the bond's face value and the reacquisition proceeds.

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2.

Calculation of the Gain or Loss


Gain or loss on extinguishment of debt is the difference between the reacquisition price
and the net carrying amount of the bond at the date of extinguishment.
(Gain) or loss = Reacquisition price Net carrying amount

a.

Reacquisition Price
Reacquisition price is usually shown as a percentage of the bond's face value
(e.g., $100,000 at 102 or $100,000 at 95). To calculate the reacquisition price,
multiply the percentage by the face value (e.g., $100,000 102% = $102,000 or
$100,000 95% = $95,000).

b.

Net Carrying Amount


The net carrying amount of the bond is the carrying value (i.e., face value of
the bond plus unamortized premium or minus unamortized discount and minus
unamortized bond issuance costs).
P a s s K ey

Reacquisition price

Face % paid

Face
< Carrying value >
< Gain >

Loss

Unamortized discount

Unamortized premium

Unamortized issuance cost

Income from continuing operations (gross of tax)


Discontinued operations (net of tax)
Accounting adjustment and change (net of tax)

F5-56

Income
Statement
Retained
Earnings

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E x a m p l e L O SS O N E X T I N G U I S H M E N T O F B O N D S

Assume that $1,000,000 bonds due in five years are issued on January 1, Year 1, at a discount for $926,395.
Bond issuance costs of $20,000 were incurred. Two years later, on January 1, Year 3, the entire issue is
redeemed at 101 and cancelled (ignore income tax considerations.)
Note: This example uses the numbers from the earlier table showing bond discount amortization, including
bond issuance costs.
Reacquisition price:
Face % paid ($1,000,000 101) = $1,010,000
Bond carrying value:
Face 1,000,000
Less: Unamortized discount
and bond issuance costs

(62,798)

Net carrying value

(937,202)

Total loss on extinguishment

72,798

Components of the loss are:


Unamortized bond discount

and bond issuance costs
Premium paid to retire ($1,000,000 1%)
Total loss

$62,798
10,000
$72,798

Journal entry:
DR Bonds payable
DR Loss on extinguishment of bonds

$1,000,000
72,798

CR

Discount on bonds payable and bond issuance costs

$ 62,798

CR

Cash

1,010,000

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E x a m p l e GA I N O N E X T I N G U I S H M E N T O F B O N D S

Assume that $1,000,000 bonds due in five years are issued on January 1, Year 1 at a premium for
$1,081,105. The entire issue is redeemed two years later, on January 1, Year 3, for 96 and cancelled.
(Ignore income tax considerations.)
Note: this example uses the numbers from the bond premium amortization table shown earlier in the text.
Reacquisition price:
Face % paid ($1,000,000 96) =

$960,000

Bond carrying value:


Face 1,000,000
Plus: Unamortized premium

52,417

Net carrying value

(1,052,417)

Total gain on extinguishment

(92,417)

Components of the gain are:


Unamortized bond premium
Discount to retire ($1,000,000 4%)
Total gain

$52,417
40,000
$92,417

Journal entry:
DR Bonds payable
DR Premium on bond payable

CR

Cash

CR

Gain on extinguishment of bonds

$1,000,000
52,417
$ 960,000
92,417

XIII. DISCLOSURE REQUIREMENTS

F5-58

A.

Companies having large amounts of debt issues often report only one balance sheet total
that is supported by comments and schedules in the accompanying notes. Notes often show
details regarding the liability maturity dates, interest rates, call and conversion privileges,
assets pledged as security, and borrower imposed restrictions.

B.

Part of the disclosure should include any future sinking fund payments and maturities for
each of the next five years to aid users in evaluating the timing and amounts of cash flows.
The maturity amounts and sinking fund requirements are reported in the aggregate.

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App e n d i x

I F R S v s . U . S . G A A P
Note: Unless specifically noted, IFRS and U.S. GAAP accounting rules are the same. This chart highlights the significant
differences between IFRS and U.S. GAAP covered in this lecture.
Issue

IFRS

U.S. GAAP

Leases classification

Leases are classified as operating leases or


finance leases. Both the lessor and lessee
use these classifications.

Lessees classify leases as operating leases


or capital leases. Lessors classify leases as
operating leases, sales-type leases, or
direct financing leases.

Capital (finance) lease criteria

Both the lessee and lessor classify a lease as a


finance lease if the lease transfers
substantially all the risks and rewards of
ownership to the lessee.

The lessee classifies a lease as a capital


lease if at least one of four (OWNS)
criteria are met:
Ownership transfer
Written bargain purchase option
Ninety % rule: FV leased property is at
least 90% of PV of lease payments
Seventy-five % rule: Lease term is at
least 75% of asset life
The lessor classifies a lease as a sales-type or
direct financing lease if at least one of
the OWNS criteria is met plus two
additional criteria:
Uncertainties do not exist regarding
unreimbursable costs to be incurred by
the lessor
Collectability of the lease payments is
reasonably predictable

Initial direct costs of lease

Initial direct costs paid by the lessee are


added to the amount recognized as a finance
lease asset.

Initial direct costs paid by the lessee are


expensed when incurred.

Sale-leaseback transactions

Recognition of gains is dependent on the


classification of the lease as an operating
lease or a finance lease.

Recognition of gains is dependent on the


rights to the leased property retained by
the seller-lessee.

Bond discount/premium amortization

The effective interest method is required and


the straight-line method is prohibited.
Amortization is done over the expected life of
the bond.

The effective interest method is required,


although the straight-line method can be
used if it is not materially different from
the effective interest method.
Amortization is done over the contractual
life of the bond.

Convertible bonds

A liability (bond) and equity component


(conversion feature) should be recognized
when convertible bonds are issued. The
bond liability is recorded at fair value, with
the difference between the actual proceeds
received and the fair value of the bond
recorded as a component of equity.

No separate recognition is given to the


conversion feature when convertible
bonds are issued. The bonds are recorded
in the same manner as non-convertible
bonds.

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F5-59

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Brown's balance sheet at December 31, Year 2, will reflect the following:
Funded statusDecember 31, Year 1
+ Contributions
- Net loss incurred during Year 2
- Service cost / interest cost / return on plan assets
Funded statusDecember 31, Year 2

$(1,250,000)
420,000
(30,000)
(496,000)
$(1,356,000)

AOCI (before tax)December 31, Year 1


Net loss incurred during Year 2
Amortization of prior service cost
Amortization of net loss
Amortization of net transition obligation
AOCI (before tax)December 31, Year 2

$(1,125,000)
(30,000)
25,000
19,000
5,000
$(1,106,000)a

Accumulated other comprehensive income is reported on an after-tax basis: $1,106,000 (1 40%)


= $663,600.

E.

Measurement Date
U.S. GAAP requires that the measurement date of the plan assets and benefit obligations of
a defined benefit pension plan must be aligned with the date of the employer's balance sheet,
with few exceptions.
1. Exceptions
a.

When a plan is sponsored by a subsidiary that has a different fiscal year-end


from the parent company, then the subsidiary's plan assets and benefit
obligations can be measured as of the subsidiary's balance sheet date.

b.

When a plan is sponsored by an equity method investee that has a different fiscal
year-end from the investor's fiscal year-end, then the investee's plan assets and
benefit obligations can be measured as of the date of the investee's financial
statements used to apply the equity method.

c.

When a company's fiscal year-end does not coincide with a month-end, it may elect
to measure defined benefit plan assets and obligations using the month-end closest
to its fiscal year-end. Contributions made between the measurement date and the
fiscal year-end should be disclosed, but will not change the fair value reported at
themeasurement date.

IV. PENSION SETTLEMENT AND CURTAILMENT AND TERMINATION BENEFITS


A. Settlements
Settlements

F6-18

Settlements occur when the pension plan assets increase in value to the point that sale of the
pension plan assets allows a company to purchase annuity contracts to satisfy pension
obligations. Remaining funds from the sale of assets may, with restrictions, be used by the
corporation.

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b.

Reconciliation of the beginning and ending balances of the fair value of plan
assets, including the effects of:
(1) Actual return on plan assets.
(2) Foreign currency exchange rate changes.
(3) Contributions by employer.
(4) Contributions by plan participants.
(5) Benefits paid.
(6) Business combinations.
(7) Divestitures.
(8) Settlements.

c.
2.

The measurement date, when it is differs from the fiscal year-end date.

Funded Status
The funded status of the plan(s) and the amounts recognized on the balance sheet,
showing separately the assets and current and noncurrent liabilities recognized.

3.

4.

Plan Assets
a.

A narrative description of investment policies and strategies, including target


allocation percentages for the major categories of plan assets.

b.

The fair value of each major category of plan assets as of the date of each
balance sheet presented.

c.

A narrative description of the basis used to determine the overall expected longterm rate of return on plan assets.

d.

Information that enables users of financial statements to assess the inputs and
valuation techniques used to develop fair value measurements of plan assets at
the reporting date.

e.

The amount and timing of any plan assets expected to be returned to the
employer during the 12-month period following the most recent balance sheet
date.

Components of Net Periodic Pension (Benefit) Cost


Amount of net periodic benefit cost recognized, showing separately:

F6-20

a.

Service cost component.

b.

Interest cost component.

c.

Expected return on plan assets for the period.

d.

The prior service cost component.

e.

The gain or loss component.

f.

The transition asset or obligation component.

g.

The amount of gain or loss recognized due to a settlement or curtailment.

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a C C O U N T I N G F O R I N C O m E Ta x E S
I.

oVeRVIeW
Deferred
Taxes
-income
Taxes

Accounting for income taxes involves both intraperiod and interperiod tax allocation. Intraperiod
allocation matches a portion of the provision for income tax to the applicable components of net
income and retained earnings.

Income for federal tax purposes and financial accounting income frequently differ. Obviously,
income for federal tax purposes is computed in accordance with the prevailing tax laws, whereas
financial accounting income is determined in accordance with GAAP. Therefore, a company's
income tax expense and income taxes payable may differ. The incongruity is caused by temporary
differences in taxable and/or deductible amounts and requires interperiod tax allocation.

II.

INtRAPeRIoD tAX ALLoCAtIoN


Intraperiod tax allocation involves apportioning the total tax provision for financial accounting
purposes in a period between the income or loss from:

Income from continuing operations,

Discontinued operations,

Accounting principle change (retrospective)

Other comprehensive income


Pension funded status change

Unrealized gain/loss on available for sale security

Foreign translation adjustment

effective portion of cash flow hedge

Revaluation surplus (IFRS only)

Components of stockholders' equity

Retained earnings for prior period adjustments and accounting principle changes
(retrospective), and

Items of accumulated (other) comprehensive income

A.

General Rule
Any amount not allocated to continuing operations is allocated to other income statement
items, other comprehensive income, or to shareholders' equity in proportion to their individual
effects on income tax or benefit for the year. Such items (e.g., discontinued operation) are
shown net of their related tax effects.
The amount of income tax expense (or benefit) allocated to continuing operations is the tax
effect of pretax income or loss from continuing operations plus or minus the tax effects of
changes in:
1.

Tax laws or rates.

2.

Expected realization of a deferred tax asset.

3.

Tax status of the entity.

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F6-33

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eaRNINGS PeR SHaRe


I.

OVERVIEW

Under both U.S. GAAP and IFRS, all public entities (or entities that have made a filing for a public
earnings offering) are required to present earnings per share on the face of the income statement. An
Per Share entity's capital structure determines the manner in which earnings per share is disclosed.
An entity has a simple capital structure if it has only common stock outstanding. The entity
presents basic per share amounts for income from continuing operations and for net income on the
face of the income statement.
All other entities present basic and diluted per share amounts for income from continuing
operations and for net income on the face of the income statement (or statement of income and
comprehensive income if the entity is using the one-statement approach) with equal prominence.
If the entity reports a discontinued operation, the entity presents the basic and diluted (if applicable)
per share amounts for that item either on the face of the income statement or in the notes to the
financial statements.
II.

SIMPLE CAPITAL STRUCTURE (REPORT BASIC EPS ONLY)


An entity that issues only common stock (or no other securities that can become common stock,
such as noncovertible preferred stock) is said to have a simple capital structure. This organization
will present EPS for income from continuing operations and for net income on the face of the
income statement. The number of common shares outstanding (the denominator) used in the EPS
calculation is arrived at by the weighted-average method.
A.

Basic EPS Formula

For an organization with a simple capital structure, the formula for earnings per share is as
follows:
Basic EPS =

B.

Income available to common shareholders


Weighted-average number of common shares outstanding

Income Available to the Common Shareholders

Income available to common shareholders is determined by deducting from the line item
income from continuing operations and net income (1) dividends declared in the period on
non-cumulative preferred stock (regardless of whether they have been paid) and (2)
dividends accumulated in the period on cumulative preferred stock (regardless of whether
they have been declared).
If there is a loss from continuing operations (or a net loss), the amount of the loss should be
increased by the preferred shareholders' dividends or claims to determine income available to
the common shareholders.

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F7-23

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c.

If the convertible bonds were issued during the period, assume the stock was
issued at that date for the weighted-average calculation.
E x a mp l e

CONVERTIBLE BONDS IF-CONVERTED METHOD


(Recalculation of "Income Available to Common Shareholder")
ACTUAL
$100

Income

$100

< 20 >

Bond interest

<0>

80

Income before taxes

100

< 32 >

Taxes (40%)
N.I. available to
common stockholders

< 40 >

$48

2.

PRETEND

$60

Antidilution
Use the results of each assumed conversion only if it results in dilution (i.e., reduces
EPS). Do not include the results of the assumed conversion if it is antidilutive (i.e.,
increases EPS). In determining whether potential common shares are dilutive or
antidilutive, each issue will be considered separately in sequence from most to least
dilutive, with options and warrants generally included first. The tests for dilutive or
antidilutive effects should be based on income from continuing operations.

E XAMPL E APPL I C A T I O N O F T H E I F - C O N V E R T E D M E T H O D ( C O N V E R T I B L E D E B E N T U R E S )

X Company has outstanding 100,000 shares of common stock and $500,000 in 6% debentures convertible into 10 shares
for each $1,000 bond. Net income for the year is $100,000. What is diluted EPS assuming a 34% tax rate?
Diluted shares outstanding:
Common stock 100,000
Convertible debentures (500 10)
Total common shares outstanding

5,000
105,000

Diluted net income:


Net income

$ 100,000

Add: Interest on bonds, less tax effects


(0.06 $500,000 (1 0.34))

19,800

Total net income


Diluted EPS
($119,800 105,000 shares)

$ 119,800
$

1.14

Once again, we must check to see whether the inclusion of the convertible debentures in the computation of diluted EPS
is antidilutive, by comparing basic EPS computed with the bonds to diluted EPS computed without the bonds, as follows:
Basic EPS (without conversion)
($100,000 100,000 shares)

1.00

Diluted EPS with conversion of the convertible bonds ($1.14) is more than basic EPS without the conversion ($1.00). The
convertible bonds are, therefore, antidilutive and would be excluded.

F7-28

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Financial 7

E.

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Dilution from Contingent Shares

Contingent
Shares

Contingent issuable shares do not require cash consideration and depend on some
future event or on certain conditions being met. Contingent shares (that are dilutive) are also
included in the calculation of basic EPS if (and as of the date) all conditions for issuance are
met.
Issuable shares contingent on the attainment of a certain level of earnings are treated as
follows, if dilutive:
1.

If the necessary conditions have been satisfied by the end of the period, those shares
are included in basic EPS as of the beginning of the period in which the conditions
were satisfied.

2.

If the necessary conditions have not been satisfied by the end of the period, the number
of contingently issuable shares included in diluted EPS is based on the number of
shares that would be issuable, if any, if the end of the reporting period were the end of
the contingency period. These shares are included as of the beginning of the period (or
as of the date of the contingent stock agreement, if later). If the contingency is due to
attainment of future earnings and/or future prices of the shares, both earnings to date
and current market price, as they exist at the end of the reporting period, are used.
U . S . G AAP vs . I F R S

Under IFRS, contingently issuable ordinary shares are treated as outstanding and included in the
calculation of diluted EPS only if the conditions are satisfied.

IV. DISCLOSURES

Disclosures

Cash flow per share should not be reported. In addition to reporting basic EPS and diluted EPS for
both income from continuing operations and net income and the effects of discontinued operations,
the following disclosure requirements must be met:
(i)

A reconciliation of the numerators and the denominators of the basic and diluted per-share
computations for income from continuing operations.

(ii)

The effect that has been given to preferred dividends in arriving at income available to
common stockholders in computing basic EPS.

(iii) Securities that could potentially dilute basic EPS in the future that were not included in the
computation of diluted EPS because the effect was antidilutive for the period(s) presented.
(iv) Description of any transaction that occurred after the period end that would have materially
affected the number of actual and/or potential common shares outstanding.

F7-30

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Appendix
Fa i r Va l u e M e a s u r e m e n t a n d A p p l i c a t i o n ( G A S B 7 2 )
I. OVERVIEW
The Governmental Accounting Standards Board has standardized the definition of fair value and
its related guidance for financial reporting purposes. The application to investments and related
disclosures is now consistent with FASB guidance. The following outline addresses the major
issues associated with this topic; the F10 lecture contains a more detailed discussion.
II.

FAIR VALUE MEASUREMENT


A.

Fair Value
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
1.

2.

Fair value has the following characteristics:


a.

It is a market based measurement, not an entity specific measurement.

b.

It is an exit price (the price to sell an asset or transfer a liability), not an entrance
price (the price to acquire an asset or assume a liability).

Fair value assumes measurement at the highest and best use within a principal or most
advantageous market (in the absence of a principal market).

B. Orderly Transaction
An orderly transaction is one in which the asset or liability is exposed to the market for a period
before the measurement date, long enough to allow for marketing activities that are usual and
customary for transactions involving such assets or liabilities. An orderly transaction cannot be
a forced transaction.
C. Market Participants
Market participants are buyers and sellers that are independent (not related parties),
knowledgeable about the asset or liability, able to transact for the asset or liability, and
willingto transact for the asset or liability.
D. Principal Market
The principal market is the market with the greatest volume and level of activity for an asset
orliability.
E. Most Advantageous Market
The most advantageous market is the market that maximizes the amount that would be
received to sell an asset or minimizes the amount that would be paid to transfer a liability, after
considering transaction costs and transportation costs.
F. Highest and Best Use
"Highest and best use" refers to the use of a nonfinancial asset by market participants that
would maximize the value of the asset.

F8-82

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III.

Financial 8

FAIR VALUE APPLICATION


A. Valuation Techniques
Governments can use the market approach, the income approach, the cost approach, or a
combination of these as appropriate when measuring the fair value of an asset or liability.
Thevaluation technique should be appropriate to the circumstances and should maximize the
use of observable inputs and minimize the use of unobservable inputs.
1. Market Approach
The market approach uses prices and other relevant information generated by market
transactions involving identical or comparable assets and liabilities, whether individual
orgrouped.
2.

Income Approach
The income approach converts future amounts (such as cash flows or income and
expense) to a single current (discounted) amount.

3. Cost Approach
The cost approach reflects the amount that would be required to replace the present
service capacity of an asset.
B. Hierarchy of Inputs
The fair value hierarchy prioritizes the inputs that can be used in the value techniques
described above. Level 1 inputs have the highest priority and Level 3 inputs have the lowest
priority. If the fair value of an asset or a liability is measured using inputs from more than one
level of hierarchy, the level in the hierarchy in which a fair value measure falls is determined
by the lowest priority level input that is significant to the fair value measurement. Valuation
techniques should maximize the use of observable inputs (Level 1 and Level 2) and minimize
the use of unobservable inputs (Level 3).
1. Level 1 Inputs
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets
orliabilities.
2. Level 2 Inputs
Level 2 inputs are inputs other than quoted prices that are observable for the asset or
liability, either directly or indirectly. Examples include quoted prices for similar assets
or liabilities in active markets and quoted prices for similar or identical liabilities when
tradedas assets.
3. Level 3 Inputs
Level 3 inputs are unobservable inputs, such as management's assumption of the default
rate among underlying mortgages or a mortgage backed security.

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IV. FAIR VALUE DISCLOSURES


A. Disclosures
Required disclosures directly relate to standardized fair value measurements, including:
1.

Fair value measurement

2.

Level of fair value hierarchy

3.

Valuation techniques

B. Organization of Disclosures
Governments should organize disclosures by type of asset or liability reported at fair value.

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f.

Split-Interest Agreements
Split-interest agreements represent donor contributions of trusts or other
arrangements under which the not-for-profit organization receives benefits that
are shared with other beneficiaries.
(1) Examples include:
(a) Charitable lead trust
(b) Perpetual trust held by a third party
(c) Charitable remainder trust
(d) Charitable gift annuity
(e) Pooled life income fund
(2) During the term of the agreement, changes in the value of split-interest
agreements should be recognized for:
(a) Amortization of discounts; and
(b) Revaluations.
(3) Assets and liabilities recognized under split-interest agreements should be
disclosed separately from other assets and liabilities in the Statement of
Financial Position.
(4) Contribution revenues and changes in the value of split-interest
agreements should be disclosed as separate line items in the Statement of
Activities (or the related notes).
(5) Split-interest contributions should be:
(a) Measured at their fair values at the date of acquisition;
(b) Estimated based on the present value of the estimated future
distributions; and
(c) Displayed as temporarily restricted (unless there is a permanent
restriction established by the donor).
Pa s s K e y

Do not confuse the net asset classification concept of unrestricted and restricted with the
revenue recognition concept of conditional and unconditional. Unconditional pledges are
assured of collection and may be recognized as either restricted or unrestricted. Conditional
pledges are still subject to important contingencies and are not recorded.

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Financial 10

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TROUBL E D D E BT R E STRUCTUR I N G S
I. Introduction

Troubled Debt
Restructuring

A troubled debt restructuring is one in which the creditor allows the debtor certain
concessions to improve the likelihood of collection that would not be considered under normal
circumstances. Concessions include items such as reduced interest rates, extension of maturity
dates, reduction of the face amount of the debt, and reduction of the amount of accrued interest.
The concessions must be made in light of the debtor's financial difficulty, and the objective of the
creditor must be to maximize recovery of the investment. Troubled debt restructurings are often the
result of legal proceedings or of negotiation between parties.
II.

ACCOUNTING AND REPORTING BY DEBTORS


A debtor accounts for a troubled debt restructuring according to the type, as follows:
A.

Transfer of Assets
The debtor will recognize a gain in the amount of the excess of the carrying amount of the
payable (face amount of the payable plus accrued interest, premiums, etc.) over the fairvalue
of the assets given up. The gain or loss on disposition of the asset (i.e., difference between
book value and fair value) is reported in income of the period.
1.

Recognize ordinary gain/loss on:


FV asset transferred
< NBV asset transferred >
Ordinary gain/loss

2. Recognize ordinary gain on:


Carrying amount of the payable
< FV asset transferred >
Gain

B.

Transfer of Equity Interest


The difference between the carrying amount of the payable and the fair value of the equity
interest is recognized as an ordinary gain under U.S. GAAP.
1.

Recognize gain:
Carrying amount of the payable
< FV equity transferred >
Gain

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C.

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Modification of Terms
A restructuring that does not involve the transfer of assets or equity will often involve the
modification of the terms of the debt. In a modification, the debtor usually accounts for the
effects of the restructuring prospectively. The debtor does not change the carrying amount
unless the carrying amount exceeds the total future cash payments specified by the new
terms.
1.

Total Future Cash Payments


The total future cash payments are the principal and any accrued interest at the time of
the restructuring that continues to be payable by the new terms.

2.

Interest Expense
Interest expense is computed by a method that causes a constant effective rate (e.g.,
the effective interest method). The new effective rate of interest is the discount rate at
which the carrying amount of the debt is equal to the present value of the future cash
payments.

3.

Future Payments
When the total future cash payments are less than the carrying amount, the debtor
should reduce the carrying amount accordingly and recognize the difference as a gain.
When there are several related accounts (discount, premium, etc.), the reduction may
need to be allocated among them. All cash payments after the restructuring reduce the
carrying amount, and no interest expense is recognized after the date of restructure.
When there are indeterminate future payments, or any time the future payments might
exceed the carrying amount, the debtor recognizes no gain. The debtor should
assume that the future contingent payments will have to be made at least to the extent
necessary to obviate any gain.
Note: In estimating future cash payments for any purpose in this area, it is assumed that the maximum
amount of periods (and interest) is going to occur.

D.

Combination of Type
When a restructuring involves a combination of asset or equity transfers and modificationof
terms, the fair value of any asset or equity is used first to reduce the carrying amount ofthe
payable. The difference between the fair value and the carrying amount of any assets
transferred is recognized as gain or loss. No gain on restructuring can be recognized unless
the carrying amount of the payable exceeds the total future cash payments.
All gains on debt restructuring are aggregated and included in net income for the period.
Theyare treated and classified along with other gains of the company, typically in the
continuing operations section of the income statement.

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E XAMPL E TRANSF E R OF ASS E TS

Hull Company is indebted to Apex under a $500,000, 12%, three-year note dated December 31, Year1.
Because of Hull's financial difficulties developing in Year 3, Hull owed accrued interest of $60,000 onthenote
at December 31, Year 3. Under a troubled debt restructuring, on December 31, Year 3, Apex agreed to settle
the note and accrued interest for a tract of land having a fair value of $450,000. Hull's acquisition cost of the
land is $360,000. On its Year 3 income statement, what should Hull report as a result of the troubled debt
restructuring?
Hull's total debt is the $500,000 face value of the note plus $60,000 of accrued interest, or $560,000.
The debt was forgiven in exchange for Hull giving Apex (the lender) land worth $450,000, with a cost to Hullof
$360,000.
Hull's total gain is:
Debt forgiven
Carrying value of asset given
Total gain

$560,000
(360,000)
$200,000

($90,000 + $110,000, per below)

Breakout of Gain
Ordinary Gain on Disposal of Land (adjustment to fair value)
Fair value of land
Acquisition cost

450,000
$
(360,000)

Holding gain on sale of land

$ 90,000

Gain on restructuring
3-year note
$500,000
Accrued interest
60,000
Amount owed

Settlement amount (fair value of land)
Gain on restructuring of debt

560,000
(450,000)
$110,000

Journal entry to record the troubled debt restructuring on the books of the debtor:
DR
DR

CR
CR
CR

Notes payable
Interest payable

Land

Gain on disposal of land

Gain on restructuring

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$500,000
60,000


$360,000
90,000
110,000

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E XAMPL E TRANSF E R OF E Q U I TY

Same facts as the previous example, except that on December 31, Year 3, Apex agreed to settle the noteand
accrued interest for an equity interest in Hull Company having a fair value of $450,000 (100,000 shares of
common stock with a market value of $4.50/share and a par value of $2.00/share). On its Year 3 income
statement, what should Hull report as a result of the troubled debt restructuring?
Hull's total debt is the $500,000 face value of the note plus $60,000 of accrued interest, or $560,000.
The debt was forgiven in exchange for Hull giving Apex (the lender) equity worth $450,000.
Gain on restructuring:
Carrying amount of payable

Settlement amount (fair value of equity)
Gain on restructuring of debt

($560,000)
(450,000)
$110,000

Journal entry to record the troubled debt restructuring on the books of the debtor:
DR
DR
CR

CR
CR

Notes payable
$500,000
Interest payable
60,000

Common stock


Additional paid-in capital


Gain on restructuring

$200,000
250,000
110,000

E XAMPLe MOD I F I CAT I ON OF T E RMS

Same facts as the previous example, except that on December 31, Year 3, Apex agreed to modify the terms of
the debt. The accrued interest was forgiven, the interest rate was lowered to 3%, and the maturity date was
extended to December 31, Year 5. On its Year 3 income statement, what should Hull report as a result of the
troubled debt restructuring?
Hull's total debt is the $500,000 face value of the note plus $60,000 of accrued interest, or $560,000.
Total future cash payments under modified terms:
Face amount of note
Year 4 interest
Year 5 interest
Total

$500,000
15,000 = $500,000 3%
15,000 = $500,000 3%
$530,000

Gain on restructuring:
Carrying amount of payable

Total future cash payments
Gain on restructuring of debt

(560,000)
(530,000)
$ 30,000

Journal entry to record the troubled debt restructuring on the books of the debtor:
DR
DR

CR
CR

Notes payable
Interest payable
Note payable
Gain on restructuring

$500,000
60,000

$530,000*
30,000

*All future payments (principal and interest) will reduce the note payable.

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Re v ie w o f I FRS v s . U . S . G AAP
Note: Unless specifically noted, IFRS and U.S. GAAP accounting rules are the same. This chart highlights the significant
differences between IFRS and U.S. GAAP covered throughout this course.

F-1
ISSUE

IFRS

U.S. GAAP

Conceptual Framework

Entities are directed to refer to and consider


the applicability of the concepts in the IASB
Conceptual Framework when developing
accounting policies in the absence of a standard
or interpretation that specifically applies to an
item.

Entities cannot apply the FASB conceptual


framework to specific accounting issues.

Discontinued Operations

Before a component can be classified as held


forsale, the individual assets and liabilities of
the component must be measured in
accordance with applicable standards and any
resulting gains and losses must be recognized.
After classification as held for sale, the
component is reported at the lower of carrying
value and fair value less costs to sell.

Assets and liabilities are not required to be


remeasured before a component is classified
as held for sale, but the classification of a
component as held for sale does trigger an
impairment analysis of the component.

Accounting Changes

When an entity applies an accounting change


retroactively or makes a retrospective
restatement of items in the financial statements,
the entity must (at a minimum) present three
balance sheets (end of current period, end of
prior period, and beginning of prior period)
and two of each other financial statement. The
cumulative effect adjustment is an adjustment
to beginning retained earnings at the beginning
of the prior period.

Comparative financial statements are not


required by U.S. GAAP. Note that the SEC
does require comparative annual financial
statements for public companies (at a
minimum, two balance sheets and three
statements of income, changes in owners'
equity, and cash flows). Neither GAAP nor
the SEC have a three balance sheet
requirement when an entity applies an
accounting change retroactively. The
cumulative effect adjustment is an adjustment
to the beginning retained earnings of the
earliest period presented.

Change in Accounting Entity

IFRS does not include the concept of a change in


accounting entity.

If a change in accounting entity occurs in the


current year, all previous financial statements
that are presented in comparative financial
statements along with the current year should
be restated to reflect the information for the
new reporting entity.

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