Ver38_3_Financial_Accounting_Reporting

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Unformatted text preview: Financial Accounting & Reporting Updating Supplement Version 38.3 FINANCIAL ACCOUNTING & REPORTING CPA2901US3-38 TABLE OF CONTENTS About Updating Supplement Version 38.3 .................................................................................................... 2 Study Options Available to Candidates......................................................................................................... 2 Other Sources of Information for Candidates................................................................................................ 2 Recent Announcements ................................................................................................................................ 3 Recent Pronouncements............................................................................................................................... 4 Errata............................................................................................................................................................. 8 Revisions ....................................................................................................................................................... 9 2008 Released AICPA Questions and Answers .......................................................................................118 2009 Released AICPA Questions and Answers .......................................................................................139 We wish to thank the American Institute of Certified Public Accountants and other organizations for permission to reprint or adapt the following copyrighted © materials: 1. Uniform CPA Examination Questions and Unofficial Answers, Copyright © American Institute of Certified Public Accountants, Inc., Harborside Financial Center, 201 Plaza Three, Jersey City, NJ 07311-3881. 2. Accounting Research Bulletins, APB Opinions, Audit and Accounting Guides, Auditing Procedure Studies, Risk Alerts, Statements of Position, and Code of Professional Conduct, Copyright © American Institute of Certified Public Accountants, Inc., Harborside Financial Center, 201 Plaza Three, Jersey City, NJ 07311-3881. 3. FASB Accounting Standards and Statements of Financial Accounting Concepts, Copyright © Financial Accounting Standards Board, 401 Merrit 7, P.O. Box 5116, Norwalk, CT 06856. 4. GASB Statements, Interpretations, and Technical Bulletins, Copyright © Governmental Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk CT 06856-5116. 5. Statements on Auditing Standards, Statements on Standards for Consulting Services, Statements on Responsibilities in Personal Financial Planning Practice, Statements on Standards for Accounting and Review Services, Statements on Quality Control Standards, Statements on Standards for Attestation Engagements, and Statements on Responsibilities in Tax Practice, Copyright © American Institute of Certified Public Accountants, Inc., Harborside Financial Center, 201 Plaza Three, Jersey City, NJ 07311-3881. 6. ISB Standards, Copyright © Independence Standards Board, 6th Floor, 1211 Avenue of the Americas, New York, NY 10036-8775 Copyright © 2009 by Bisk Education, Inc. Tampa, FL 33631-3028 All rights reserved. Reproduction in any form is expressly prohibited. Printed in the United States of America. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.—From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 1 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 ABOUT UPDATING SUPPLEMENT VERSION 38.3 This supplement is designed to bring the very latest information to candidates using our products in preparation for the CPA exam in the January-February 2010, and later, exam windows. Candidates with the 38th edition CPA Review textbook or the corresponding Version 12 series software will find the information in updating supplement Version 38.3 more than adequate for these exam windows. When new information first becomes available, the examiners tend to test new or changed portions of concepts lightly. Coverage of information after that point may increase, if it is in a heavily tested area. Do not fall into the trap of attaching undue significance to new information merely because it is new. Accounting and auditing pronouncements are eligible to be tested on the CPA exam in the testing window beginning six months after a pronouncement’s effective date, unless early application is permitted. When early application is permitted, a new pronouncement may be tested in the window beginning 6 months after the issuance date. In this case, both the previous and the new pronouncements can be tested until the previous pronouncement has been superseded. Remember, with the information and techniques in our material, passing the exam is an attainable goal. Adhere to a reasonable study plan—and pass the first time! __________________ STUDY OPTIONS AVAILABLE TO CANDIDATES As every candidate’s needs are different, Bisk Education offers a variety of CPA Review formats and packages that are guaranteed* to help you pass the CPA exam on your next sitting. Options include: our Online CPA Review with structured Internet classes and our self-study CPA Review utilizing multimedia CD-ROM software, video lectures, audio lectures, and books. * Purchase of software required. Call for complete details. (1-800-404-7231) __________________ OTHER SOURCES OF INFORMATION FOR CANDIDATES Candidates choosing to use previous editions of our books must accept responsibility for adequately updating their materials and should consider the strain that this will add to the already time-consuming process of studying for the exam. Candidates with the 36th and earlier editions are strongly encouraged to purchase new materials. Please contact a customer service representative at 1-800-280-9718. Candidates with the 37th edition CPA Review textbook or corresponding Version 11 series software will also need FAR Updating Supplement Version 37.3. FAR Updating Supplement Version 37.3 contains summaries of GASB 52 and SFAS 141(R), 160, 161, 162, and 163. It also contains information on the FASB Accounting Standards Codification, global convergence of accounting standards, and the newest research task format used in the CPA exam. (This content is integrated into the 38th edition.) __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 2 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 RECENT ANNOUNCEMENTS New Content and Skill Specification Outlines (CSOs/SSOs) for the Uniform CPA Examination On May 15, 2009, the American Institute of Certified Public Accountants (AICPA) Board of Examiners (BOE) approved new Content and Skill Specification Outlines (CSOs/SSOs) for the Uniform CPA Examination. The effective date for the new CSOs/SSOs is January 1, 2011. The largest of the changes is the inclusion of testing of International Financial Reporting Standards (IFRS). This change will directly affect both the Auditing and Attestation (AUD) and Financial Accounting and Reporting (FAR) sections of the CPA Examination. The new CSOs/SSOs are now available on the CPA Examination website, www.cpa-exam.org. __________________ TM FASB Accounting Standards Codification On July 1, 2009, the Financial Accounting Standards Board (FASB) launched the FASB Accounting Standards CodificationTM (Codification) as the single official source of authoritative, nongovernmental U.S. generally accepted accounting principles (GAAP). The Codification is effective for interim and annual periods ending after September 15, 2009. All existing accounting standards documents are superseded as described in FASB Statement No. 168, The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles. All other accounting literature not included in the Codification is nonauthoritative. The Codification does not change GAAP; it presents it in an organized and easily accessible new structure. It reorganizes the thousands of U.S. GAAP pronouncements into approximately 90 accounting topics. Also included is relevant SEC guidance that follows the same topical structure. __________________ FASB Accounting Standards Updates Effective July 1, 2009, changes to the source of authoritative U.S. GAAP, the FASB Accounting Standards Codification™ (FASB Codification), are communicated through an Accounting Standards Update (ASU). ASUs will be published for all authoritative U.S. GAAP promulgated by the FASB, regardless of the form in which such guidance may have been issued prior to release of the FASB Codification (e.g., FASB Statements, EITF Abstracts, FASB Staff Positions, etc.). ASUs also will be issued for amendments to the SEC content in the FASB Codification as well as for editorial changes. An ASU is a transient document that (1) summarizes the key provisions of the project that led to the ASU, (2) details the specific amendments to the FASB Codification, and (3) explains the basis for the Board’s decisions. Although ASUs will update the FASB Codification, the FASB does not consider ASUs as authoritative in their own right. Prior to the release of the FASB Codification as the single source of authoritative U.S. GAAP, the FASB amended pre-Codification standards and issued them in an “as amended” form. The FASB will not amend ASUs. It will only amend the FASB Codification. __________________ CBT-e On September 25, 2009, the American Institute of Certified Public Accountants (AICPA) Board of Examiners (BOE) announced the date of January 1, 2011 for CBT-e. CBT-e is, in effect, a new Uniform CPA Examination. The CPA Examination has been transformed in structure, content, and format and will be supported by enhanced technology. The major changes include the transfer of written communication tasks to the Business and Concepts (BEC) section, introduction of new Task-Based Simulations (TBS) instead of Case-Based Simulations (CBS), implementation of the new Content and Skill Specification Outlines (CSOs/SSOs), and a new release of authoritative literature with a new research task format. The Fall 2009 issue of The Uniform CPA Examination Alert contains additional information about the changes that CBT-e will bring. The two previous issues of the newsletter include information about the development of the CBT-e initiative. These issues are available on the CPA Examination website, www.cpa-exam.org. __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 3 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 RECENT PRONOUNCEMENTS FAS 164, Not-for-Profit Entities: Mergers and Acquisitions—Including an amendment of FASB Statement No. 142 (Issued 04/09) This statement is eligible to be tested beginning in the July-August 2010 exam window. In April 2009, the FASB issued Statement of Financial Accounting Standards No. 164, Not-for-Profit Entities: Mergers and Acquisitions—Including an amendment of FASB Statement No. 142. This Statement establishes principles and requirements for how a not-for-profit entity: a. Determines whether a combination is a merger or an acquisition b. Applies the carryover method in accounting for a merger c. Applies the acquisition method in accounting for an acquisition, including determining which of the combining entities is the acquirer d. Determines what information to disclose to enable users of financial statements to evaluate the nature and financial effects of a merger or an acquisition. This Statement also amends both FASB Statement No. 142, Goodwill and Other Intangible Assets, and ARB No. 51, Consolidated Financial Statements, as amended by FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements, to make their provisions fully applicable to not-for-profit entities. This Statement is effective for: a. Mergers for which the merger date is on or after the beginning of an initial reporting period beginning on or after December 15, 2009 b. Acquisitions for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2009. It may not be applied to mergers or acquisitions before those dates. __________________ FAS 165, Subsequent Events (Issued 05/09) This statement is eligible to be tested beginning in the January-February 2010 exam window. On May 28, 2009, the FASB issued Statement of Financial Accounting Standards No. 165, Subsequent Events. The objective of this Statement is to establish general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In particular, this Statement sets forth: 1. The period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements 2. The circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements 3. The disclosures that an entity should make about events or transactions that occurred after the balance sheet date. This Statement applies to interim or annual financial periods ending after June, 2009. __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 4 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 FAS 166, Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140 (Issued 06/09) This statement is eligible to be tested beginning in the July-August 2010 exam window. In June 2009, the FASB issued Statement of Financial Accounting Standard No. 166, Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140. The objective of this Statement is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. The Board undertook this project to address (1) practices that have developed since the issuance of FASB of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, that are not consistent with the original intent and key requirements of that Statement and (2) concerns of financial statement users that many of the financial assets (and related obligations) that have been derecognized should continue to be reported in the financial statements of transferors. This Statement must be applied as of the beginning of each reporting This Statement must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Earlier application is prohibited. This Statement must be applied to transfers occurring on or after the effective date. Additionally, on and after the effective date, the concept of a qualifying special purpose entity is no longer relevant for accounting purposes. Note: The editors do not expect the material in this Statement to be heavily tested. __________________ FAS 167, Amendments to FASB Interpretation No. 46(R) (Issued 06/09) This statement is eligible to be tested beginning in the July-August 2010 exam window. In June 2009, the FASB issued Statement of Financial Accounting Standard No. 167, Amendments to FASB Interpretation No. 46(R). The Board’s objective in issuing this Statement is to improve financial reporting by enterprises involved with variable interest entities. The Board undertook this project to address (1) the effects on certain provisions of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, as a result of the elimination of the qualifying special-purpose entity concept in FASB Statement No. 166, Accounting for Transfers of Financial Assets, and (2) constituent concerns about the application of certain key provisions of Interpretation 46(R), including those in which the accounting and disclosures under the Interpretation do not always provide timely and useful information about an enterprise’s involvement in a variable interest entity. This Statement shall be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. Note: The editors do not expect the material in this Statement to be heavily tested. __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 5 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 FAS 168, The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162 (Issued 06/09) This statement is eligible to be tested beginning in the January-February 2010 exam window. In June 2009, the FASB issued Statement of Financial Accounting Standard No. 168, The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162. This Statement applies to financial statements of nongovernmental entities that are presented in conformity with GAAP. This Statement identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). The FASB Accounting Standards CodificationTM (Codification) will become the source of authoritative U.S. generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. Following this Statement, the Board will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates. The Board will not consider Accounting Standards Updates as authoritative in their own right. Accounting Standards Updates will serve only to update the Codification, provide background information about the guidance, and provide the bases for conclusions on the change(s) in the Codification. FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles, which became effective on November 13, 2008, identified the sources of accounting principles and the framework for selecting the principles used in preparing the financial statements of nongovernmental entities that are presented in conformity with GAAP. Statement 162 arranged these sources of GAAP in a hierarchy for users to apply accordingly. Once the Codification is in effect, all of its content will carry the same level of authority, effectively superseding Statement 162. In other words, the GAAP hierarchy will be modified to include only two levels of GAAP: authoritative and nonauthoritative. As a result, this Statement replaces Statement 162 to indicate this change to the GAAP hierarchy. In the Board’s view, the issuance of this Statement and the Codification will not change GAAP, except for those nonpublic nongovernmental entities that must now apply the American Institute of Certified Public Accountants Technical Inquiry Service Section 5100, “Revenue Recognition”. This Statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009. __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 6 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 ASU No. 2009-1, Topic 105-Generally Accepted Accounting Principles amendments based on Statement of Financial Accounting Standard No. 168—The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles (Issued 06/09) The material in this update is eligible to be tested beginning in the January-February 2010 exam window. On June 30, 2009, the FASB issued Accounting Standards Update No. 2009-01, Topic 105-Generally Accepted Accounting Principles amendments based on Statement of Financial Accounting Standard No. 168—The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 168, The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles. Statement applies to financial statements of nongovernmental entities that are presented in conformity with GAAP. This Accounting Standards Update includes Statement 168 in its entirety, including the accounting standards update instructions contained in Appendix B of the Statement. __________________ ASU No. 2009-2, Omnibus Update—Amendments to Various Topics for Technical Corrections (Issued 06/09) The material in this update is eligible to be tested beginning in the January-February 2010 exam window. On June 30, 2009, the FASB issued Accounting Standards Update No. 2009-02, Omnibus Update— Amendments to Various Topics for Technical Corrections. This Codification Update represents technical corrections to various Topics to update Codification text. Note: The editors do not expect the material in this Accounting Standards Update to be heavily tested, if at all. __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 7 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 ERRATA The following items are in the textbook only, unless otherwise noted. If you find other items that you believe are ambiguous or in error, please contact the Bisk Education editors (editor@cpaexam.com) with details. Foreword: Page F-18, Diagnostic Examination, Question 10 (3279). The first sentence should start with the following phrase: “In an exchange with commercial substance,”. Chapter 7: Page 7-41, Question 52 (4427). The correct answer is a., not c. Chapter 9: Page 9-11, Example 3. Under the 12/31, yr 5 entry it should read “To record year 5 pension expense and funding” instead of “To record year 4 pension expense and funding”. Also, in the Summary section, the Total return on plan assets should include the $492.87 figure from year 5. Chapter 10: Page 10-21, Example 13. The beginning of the first sentence should state “Same situation as in Example 12” instead of “Same situation as in Example 11”. Chapter 10: Page 10-54, Question 48 (9042). In the explanation, the first journal entry under December 31, year 3 should be a debit and credit for “$32,000” instead of “$30,000”. Chapter 11: Pages 11-31 and 11-53, Question 4 (1115). The question should not include the line “Cumulative change in previous two years income due to change in depreciation method (net of $750 tax effect)” for 1,500. Total revenues will then amount to $213,900. Answer choice (b.) should also be changed to $213,900. The correct answer explanation text should read as follows: “The results from discontinued operations cannot be included in the revenues section of the single-step income statement. The results from discontinued operations is reported separately below income from continuing operations”. Chapter 11: Pages 11-33 and 11-55, Question 19 (6770). Answer choice a. should read “Appear as a part of discontinued operations and extraordinary items” and not include “and cumulative effect of a change in accounting principle”. The second sentence of the explanation should read as follows: “Discontinued operations and extraordinary items are components of the income statement, reported after income from continuing operations and before net income.” Chapter 13: Page 13-12, Exhibit 4. The bonus depreciation (179, etc.) in the IRC Tax Return column should read “250K for ’08, 133K for ’09;” instead of “125K for ’07, 128K for ’08;”. Page 13-40, Problem 13-2, Reconciliation tab. The amount choice for F should be “$112,500” instead of $120,000” and the amount choice for G should be “$120,000” instead of “$112,500”. Also, the pretax financial income should be “$1,000,000” instead of “$1,200,000” for April 30, year 2 and “$1,200,000” instead of “$1,000,000” for April 30, year 3. Chapter 14: Page 14-39, Solution 14-3, Reconciliation of Net Income tab. In the explanation for number 15, the “$80,000” figure should be “$180,000” (25% of Zach’s $720,000 reported net income). Chapter 15: Page 15-5, Exhibit 17. The second sentence should read “Common stockholders’ equity is measured as indicated in Exhibit 14” instead of “Common stockholders’ equity is measured as indicated in Exhibit 14.” Chapter 15: Page 15-32, Solution 15-3, Diluted Earnings Per Share tab. In the calculations section, the third entry, second line should read “cash proceeds” instead of “option price.” Also, the explanation for number 15 should read “675,000 (cash proceeds)” instead of “$22.50 (option price)”. Chapter 16: Page 16-6, section I.D.2.c.(1). Marketable securities carried at cost should include the following at the end: “(equity securities and debt securities not intended to be held until maturity)”. __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 8 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 REVISIONS The following items are revisions to the text to either better clarify information or update the information because of changes in accounting standards. Please ensure you annotate your study material accordingly. Chapter 1: E. Page 1-4. Add section I.E titled “Accounting Policies” (information from Chapter 11) as follows: Accounting Policies All significant accounting policies followed by an enterprise should be disclosed in its financial statements. No specific disclosure format is required. A separate note, or a summary preceding the notes entitled Summary of Significant Accounting Policies is preferred. The accounting policy disclosures should identify and describe the principles and methods that materially affect the financial position and operations. Prospective financial statements should not only include a summary of significant policies, but they should also include a summary of significant assumptions. 1. Policy Choices Disclosure should include policies involving a choice of alternative acceptable policies, policies peculiar to that particular industry, and unusual applications of acceptable principles. 2. Examples Examples of disclosure requirements include criteria for determining which investments are treated as cash equivalents, depreciation methods, methods of pricing inventory, methods of recognizing profit on long-term construction contracts, and basis of consolidation. 3. No Duplication of Information Financial statement disclosure of accounting policies should not duplicate details presented elsewhere as part of the financial statements, such as composition of inventories or plant assets, depreciation expense, and maturity dates of long-term debt. Chapter 1: Page 1-16. Change section VI.C.1 title from “User-Specific Factors” to ”User-Specific Qualities”. Chapter 1: Page 1-16. Change section VI.C.2 title from “Primary Decision Specific Factors” to ”Primary Decision-Specific Qualities” and add the following sentence to the end of the title paragraph: “Comparability, which includes consistency, is a secondary quality that interacts with relevance and reliability to contribute to the usefulness of information.” Also add c. under this section as follows: c. Comparability and Consistency Information an entity gains greatly if it can be compared with similar information about other entities and with similar information about the same entity for some other period or point in time. Comparability between entities and the consistency in the application of methods over time increases the informational value of relative economic opportunities or performance. Chapter 1: Page 1-21. Replace the last two sentences of section VII.A.4 titled “Financial Accounting Standards Board (1973–Present 73)” with the following: “The FASB did a major restructuring of accounting and reporting standards into the FASB Accounting Standards Codification. The Codification superseded all accounting standards in existing FASB, EITF, AICPA, and related standards.” Chapter 1: Page 1-21. Replace section VII.B titled “GAAP Hierarchy” with the following: B. FASB Accounting Standards Codification On July 1, 2009, the FASB Accounting Standards Codification became the single official source of authoritative, nongovernmental U.S. generally accepted accounting principles (GAAP), superseding existing FASB, AICPA, EITF, and related literature. The Codification does not change GAAP; it presents it in an organized and easily accessible new structure. It reorganizes the thousands of U.S. GAAP pronouncements into approximately 90 accounting topics. Also included is relevant SEC guidance that follows the same topical structure. 1. GAAP Hierarchy With the Codification, only two levels of U.S. GAAP exist: 1) authoritative represented by the Codification, and 2) nonauthoritative represented by all other literature. For reference by public companies, the Codification also includes Securities and Exchange Commission (SEC) content (displayed separately below the related topical content). Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 9 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 2. 3. Chapter 2: Content The Codification includes all previous level A—D GAAP issued by a standard setter, including pronouncements issued by the FASB, EITF, the Accounting Standards Executive Committee (AcSEC), the APB, etc. The source of material used by the Codification is from the as-amended versions of accounting standards, and as such, the Codification does not identify any documents that only amended other standards. The Codification will contain content from new standards not yet fully effective for all entities. This content will be labeled as such and appear specially marked. Exclusions The Codification does not include guidance for non-GAAP matters such as Other Comprehensive Basis of Accounting (OCBOA), Cash Basis, Income Tax Basis, and Regulatory Accounting Principles (RAP). The Codification also does not include governmental accounting standards. Page 2-1. The chapter title changed from “Cash, Marketable Securities & Receivables” to “Cash, Receivables & Investments” and the chapter was rearranged according to the following table of contents (Example and exhibit numbers were reordered accordingly): I. Current Assets ........................................................................................................................................ 2-2 A. Definition.......................................................................................................................................... 2-2 B. Examples......................................................................................................................................... 2-2 C. Cash & Cash Equivalents................................................................................................................ 2-2 D. Exclusions ....................................................................................................................................... 2-2 E. Bank Reconciliation ......................................................................................................................... 2-3 II. Accounts Receivable .............................................................................................................................. 2-4 A. Definition.......................................................................................................................................... 2-4 B. Valuation.......................................................................................................................................... 2-4 III. Notes Receivable .................................................................................................................................... 2-7 A. Definition.......................................................................................................................................... 2-7 B. Types ............................................................................................................................................... 2-7 C. Valuation.......................................................................................................................................... 2-7 D. Impairment....................................................................................................................................... 2-9 IV. Receivables as Immediate Sources of Cash ...................................................................................... 2-11 A. Overview........................................................................................................................................ 2-11 B. Discounting.................................................................................................................................... 2-11 C. Assignment.................................................................................................................................... 2-12 D. Factoring........................................................................................................................................ 2-13 E. Pledging......................................................................................................................................... 2-13 V. Investments in Marketable Securities................................................................................................. 2-14 A. Uses............................................................................................................................................... 2-14 B. Applicability.................................................................................................................................... 2-14 C. Classification ................................................................................................................................. 2-14 D. Acquisition Cost............................................................................................................................. 2-15 E. Year-End Valuation ....................................................................................................................... 2-15 F. Other Than Temporary Decline in Fair Value ............................................................................... 2-17 G. Transfers Between Categories...................................................................................................... 2-17 H. Sale................................................................................................................................................ 2-17 VI. Investments in Equity Securities ........................................................................................................ 2-18 A. Accounting Methods ...................................................................................................................... 2-18 B. Cost Method .................................................................................................................................. 2-19 C. Equity Method................................................................................................................................ 2-19 VII. Financial Instruments & Derivatives ................................................................................................... 2-24 A. Definitions and Disclosures ........................................................................................................... 2-24 B. Derivative Instruments & Hedging Activities.................................................................................. 2-26 C. Transfers & Servicing of Financial Assets & Extinguishments of Liabilities.................................. 2-32 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 10 of 160 Financial Accounting & Reporting Chapter 2: Updating Supplement Version 38.3 Page 2-35. Replace old “Exhibit 5” (now Exhibit 1) – “Sale of Receivables” with the following: Exhibit 1 Sale of Receivables I s sales of receivables w ith recourse? R ecord as a sale; Remove the receivable from the books, Record assets received/ liabilities incurred at FV, Record the gain or loss No Y es Are the assets isolated from the transferor? No Y es I s transferee free to pledge/ exchange the assets?* No Yes Is there an agreement for the transferor to repurchase? Ye s No R ecord as a sale; Remove the receivable from the books, Record a g ain or loss Record as a secured borrow ing; Record a liability; Leave the receivable, Record interest expense, No gain or loss is recognized * o r i f tra ns fe ree i s a s pe cial pu rpo se en tity, do es it h a ve s ta nd ing a t law ? Chapter 3: Page 3-3. Replace section II.B.1.d titled “Abnormal Costs” with the following and renumber section II.B.1.e to section II.B.1.f: d. Abnormal Costs Abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges rather than as a portion of the inventory cost. e. Fixed Production Overhead Allocation of fixed production overheads to the costs of conversion should be based on the normal capacity of production facilities. Chapter 3: Page 3-4. Add the following two lines to the end of section II.B.3.d titled “Losses on Purchase Commitments”: “There should be a note in the financial statements describing the nature of the contract. The journal entry would be a debit to Loss on Purchase Commitment and a credit to Allowance for Loss on Purchase Commitment.” Chapter 4: Pages 4-2 through 4-8. Replace section II.A titled “Acquisition Cost” with the following: A. Acquisition Cost Assets are to be recorded at their acquisition cost. Acquisition cost is defined as the cash price, or its equivalent, plus all other costs reasonably necessary to bring it to the location and to make it ready for its intended use. Examples of these additional costs include transportation, insurance while in-transit, special foundations, installation, test runs, and the demolition of an old building, less any scrap proceeds received. Property, plant, and equipment may be acquired in various ways. 1. Purchase for Cash Record the asset net of any trade or quantity discounts available. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 11 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 2. Purchase on Deferred Payment Plan The fixed asset should be recorded at its cash equivalent price. If the cash equivalent price is unavailable, an imputed interest rate should be used to record the asset at the present value of the payments to be made. 3. Purchase by Issuance of Securities The asset should be recorded at its fair value or the fair value of the securities issued, whichever is more clearly determinable. If there is an active market for the security and the additional securities issued can be reasonably expected to be absorbed without a decline in their value, the fair value of the securities should be used. If the securities exchanged are bonds and no established market exists, the asset should be recorded at the present value of the interest and principal payments to be made, discounted by use of an implicit or “imputed” rate. If equity securities are issued and no fair value is determinable, the appraisal value of the asset acquired should be used for the recording of the transaction. 4. Group Purchases If several dissimilar assets are purchased for a lump sum, the total amount paid should be allocated to each individual asset on the basis of its relative fair value. Exhibit 1 Allocation Formula Asset Y = Total cost of assets × FV of Y / Total FV 5. Nonmonetary Transactions Both exchanges and nonreciprocal transfers that involve little or no monetary assets or liabilities are referred to as nonmonetary transactions. a. Monetary Assets and Liabilities Assets and liabilities whose amounts are fixed in terms of units of currency by contract or otherwise. Examples are cash, accounts and notes receivable in cash, accounts and notes payable in cash. b. Nonmonetary Assets and Liabilities Assets and liabilities other than monetary ones. Examples are inventories; investments in common stocks; property, plant and equipment; and liabilities for rent collected in advance. c. Exchanges An exchange is a reciprocal transfer between an enterprise and another entity that results in the enterprise's acquiring assets (or services) or satisfying liabilities by surrendering other assets (or services) or through incurring liabilities. A reciprocal transfer of a nonmonetary asset shall be deemed an exchange only if the transferor has no substantial continuing involvement in the transferred asset such that the usual risks and rewards of ownership of the asset are transferred. d. Nonreciprocal Transfers Transfer of assets or services in one direction, either from an enterprise to its owners (whether or not in exchange for their ownership interests) or another entity or from owners or another entity to the enterprise. An entity’s reacquisition of its outstanding stock is an example of a nonreciprocal transfer. e. Exceptions The accounting guidance for nonmonetary transactions does not apply to the following transactions (in the following circumstances): (1) An exchange of a business for a business. (2) A transfer of nonmonetary assets solely between companies (or persons) under common control. Examples include transfers between a parent company and subsidiaries of the parent; transfers between subsidiaries of the same parent; and transfers between a corporate joint venture and its owners. (3) Acquisition of nonmonetary assets (or services) on issuance of the capital stock of an enterprise. (4) Stock that was issued or received in stock dividends and stock splits. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 12 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 (5) Transfers of assets to an entity for an equity (ownership) interest in that entity. (6) The pooling of assets in a joint undertaking intended to find, develop, or produce oil or gas from a particular property or group of properties. (7) Exchange of a part of an operating interest owned for a part of an operating interest owned by another party, a joint venture, in the oil and gas industry. (8) Transfer of a financial asset. (9) Involuntary conversions of nonmonetary assets (for example, as a result of total or partial destruction, theft, seizure, or condemnation) to monetary assets that are then reinvested in other nonmonetary assets. f. Gains and Losses In general, accounting for nonmonetary transactions should be based on the fair values of the assets involved. The acquisition cost of a nonmonetary asset is recorded at the fair value of the asset(s) surrendered, or the FV of the asset received if more clearly evident, and gains or losses should be recognized. g. Based on Recorded Amounts Nonmonetary exchanges should be based on recorded amounts (rather than fair values) of the exchanged assets if any of the following conditions apply: (1) (2) The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers (other than the parties to the exchange). (3) h. Neither the fair value of the assets received nor the fair value of the assets surrendered is determinable within reasonable limits. For purposes of applying this literature, fair values should be determined by referring to estimated realizable values in cash transactions of the same (or similar) assets, quoted market prices, independent appraisals, estimated fair values of assets (or services) received in exchange for the transferred assets, and/or any other available evidence. If either party involved in the nonmonetary exchange could have elected to receive cash (rather than the nonmonetary asset) in the transaction, the amount of cash that could have been received may be evidence of the fair value of the nonmonetary assets exchanged. The transaction lacks commercial substance. Commercial Substance A nonmonetary exchange has commercial substance if the entity’s future cash flows are expected to change significantly as a result of the exchange. The entity’s future cash flows are expected to significantly change if either of the following criteria is met: (1) (2) i. The configuration (risk, timing, and amount) of the future cash flows of the asset(s) received differs significantly from the configuration of the future cash flows of the asset(s) transferred. The entity-specific value of the asset(s) received differs from the entity-specific value of the asset(s) transferred, and the difference is significant in relation to the fair values of the assets exchanged. (A conclusive determination related to whether a transaction or exchange involves commercial substance, in some cases, can be based on a qualitative assessment rather than detailed calculations associated with the transaction or exchange.) No Commercial Substance In a nonmonetary exchange that has no commercial substance, the assets exchanged are accounted for at book value (after reduction, if Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 13 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 appropriate, for an indicated impairment of value) of the nonmonetary asset(s) given up; therefore, no gains or losses are normally recognized on the exchange itself. However, if the asset’s carrying amount exceeds its fair value when exchanged, an impairment loss should be recognized. Also, the recipient of any boot would realize some amount of gain. Example 1 Nonmonetary Exchange of Assets—No Commercial Substance Axel Company exchanged an asset with a fair value of $15,000 and a carrying value of $12,000 for an asset from Berry Company with a fair value of $17,000 and a carrying value of $18,000. Required: (a) Prepare the journal entry Axel Company would make for the exchange. (b) Prepare the journal entry Berry Company would make for the exchange. Solutions: (a) j. 12,000 Loss on impairment Asset given up To record the reduction for impairment. 1, 000 Asset received Asset given up To record the exchange. (b) Asset received Asset given up To record the exchange. 17,000 12,000 1,000 17,000 Boot A small monetary consideration that is sometimes included in exchanges of nonmonetary assets, even though the exchange is essentially nonmonetary. Exchanges of nonmonetary assets that would otherwise be based on recorded amounts may include an amount of boot. (1) The recipient of the boot realizes a gain on the exchange to the extent the monetary receipt exceeds a proportionate share of the recorded amount of the assert surrendered. The portion of the cost applicable to the realized amount should be based on the ratio of the monetary consideration to the total consideration received or, if more clearly evident, the fair value of the nonmonetary asset transferred. (2) The entity paying the monetary consideration should not recognize any gain but should record the asset received at the amount of the monetary consideration paid plus the recorded amount of the nonmonetary asset surrendered. (3) If the terms of the transaction indicate a loss, the entire loss on the exchange should be recognized. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 14 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Example 2 Nonmonetary Exchange With Boot—No Commercial Substance Beta Company exchanges asset A to Delta Company for asset C. Asset C has a book value of $12,000. Required: Prepare journal entries to record this exchange under the following different conditions. (a) Asset A has a book value of $11,000 and $3,000 cash is received. (b) Asset A has a book value of $16,000 and $3,000 cash is received. Solutions: (a) Beta’s journal entry: Asset C (see note 2) Cash Asset A Gain on Exchange (see note 3) Delta’s journal entry: Asset A Loss on exchange (see note 4) Asset C Cash (b) Beta’s journal entry: Asset C (see note 5) Cash Loss on Exchange (see note 6) Asset A Delta’s journal entry: Asset A (see note 7) Asset C Cash Note 1: Note 2: Note 3: Note 4: Note 5: Note 6: Note 7: 6. 8,800 3,000 11,000 800 11,000 4,000 12,000 3,000 12,000 3,000 1,000 16,000 15,000 12,000 3,000 BV of old asset × [boot / (boot + BV of new asset)] = portion of BV sold; $11,000 × [$3,000 / ($3,000 + $12,000)] = $2,200. BV of old asset – portion of BV sold = carrying amount of new asset; $11,000 – $2,200 = $8,800. Cash received – portion of BV sold = gain on sale of old asset; $3,000 – $2,200 = $800. BV of new asset – [BV of old asset + cash given] = gain (loss) on exchange; $11,000 – [$12,000 + $3,000] = ($4,000). BV of old asset × [boot / (boot + BV of new asset)] = portion of BV sold; $16,000 × [$3,000 / ($3,000 + $12,000)] = $3,200. The portion of BV sold being greater than cash received indicates a loss. [BV of new asset + cash received] – BV of old asset = gain (loss) on exchange; [$12,000 + $3,000] – $16,000 = $1,000. If a loss is indicated, the entire amount of loss is recognized ($1,000). BV of new asset – [BV of old asset + cash given] = gain (loss) on exchange; $16,000 – [$12,000 + $3,000] = $1,000. The entity paying the boot does not recognize gain, but instead records the asset received at the amount of cash given plus recorded amount of asset given. Self-Construction The cost of assets constructed for the use of the business should include all directly related costs, such as direct materials, direct labor, and additional overhead incurred. Interest costs incurred during the construction period must be capitalized. The interest cost capitalized is also a part of the cost of acquiring the asset. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 15 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 a. Assets qualifying for interest capitalization include assets constructed or produced for self-use on a repetitive basis, assets acquired for self-use through arrangements requiring down payments or progress payments, and assets constructed or produced as discrete projects for sale or lease (e.g., ships or real estate developments). Assets not qualifying for interest capitalization include inventories that are routinely manufactured on a repetitive basis, assets in use or ready for use, and assets not in use and not being prepared for use. b. The amount of interest cost to be capitalized is the interest cost incurred during the acquisition period that could have been avoided if expenditures for the asset had not been made. If a specific interest rate is associated with the asset, that rate should be used to the extent that the average accumulated expenditures on the asset do not exceed the amount borrowed at the specific rate. If the average accumulated expenditures on an asset exceed the amount of specific new borrowings associated with the asset, the excess should be capitalized at the weighted average of the rates applicable to other borrowings of the enterprise. c. The interest rate determined above is applied to the average amount of accumulated expenditures for the asset during the period. For example, if construction of a qualifying asset begins in January and the accumulated expenditures at year-end amount to $400,000, the interest rate is applied to the $200,000 average accumulated expenditure [($0 + $400,000) / 2]. (NOTE: The preceding assumes that construction expenditures take place evenly throughout the period. If expenditures fluctuate widely, the average accumulated expenditure should be computed monthly.) Example 3 Capitalizing Interest on Assets Constructed for Self-Use On January 1, year 2, Expansions Inc. borrowed $1,000,000 to finance the construction of a warehouse for its own use. The loan was to be repaid in 10 equal payments of $199,250, including interest of 15%, beginning on January 1, year 3. No other loans are presently outstanding. The total cost of labor, materials, and overhead assigned to the warehouse was $1,000,000. Construction was completed on December 30, year 2. The warehouse is depreciated using the straight-line method over an estimated useful life of 20 years, with no salvage value. The proceeds borrowed were invested in short-term liquid assets until needed to pay construction expenditures, yielding $24,000 interest income. Required: Determine the capitalized cost of the asset, as of December 30, year 2, the interest expense for year 2 (assume no other debt outstanding), and the depreciation expense for year 3. Solution: Materials, labor, overhead, etc. Capitalized interest cost, [($0 + $1,000,000) / 2] × 0.15 Capitalized cost of asset $1,000,000 75,000 $1,075,000 Total interest cost incurred, year 1 ($1,000,000 × 0.15) Less capitalized interest cost Interest expense, year 2 $ 150,000 (75,000) $ 75,000 Capitalized cost of asset Estimated useful life Depreciation expense, year 3 $1,075,000 / 20 $ 53,750 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 16 of 160 Financial Accounting & Reporting Example 4 Updating Supplement Version 38.3 Partial Amount Borrowed The same as in Example 1, except that Expansions Inc., needed to borrow only $300,000 (at 15%) to finance construction of the $1,000,000 warehouse. The remaining cash was provided from operations and from the sale of miscellaneous investments. During all of year 2, Expansions’ only other long-term liabilities consisted of $2,000,000, 10%, 20-year bonds (sold at par in year 1) and a $500,000, 14%, interest-bearing note payable due in three years. Required: Determine the amount of interest that should be capitalized in year 2. Solution: Total interest cost incurred during the year is ($300,000 × 15%) + ($2,000,000 × 10%) + ($500,000 × 14%) = $315,000. Accumulated average expenditures ($0 + $1,000,000) / 2 $500,000 Interest on new borrowings specifically associated with asset ($300,000 × 0.15) $ 45,000 Weighted average rate on other borrowings, applied to accumulated average expenditures in excess of $300,000 ($200,000 × 0.108*) 21,600 Total interest cost capitalized during year 2 $ 66,600 *Computation of weighted average rate: Total interest ($2,000,000 × 10%) + ($500,000 × 14%) = = 0.108 Total principal $2,000,000 + $500,000 d. e. 7. The total interest cost capitalized in a period may not exceed the total interest cost incurred during that period. Interest earned by the enterprise during the period is not offset to interest costs incurred in determining the amount of interest to be capitalized. Gifts Donated assets should be recorded at their fair value along with any incidental costs incurred. When the asset is received from a governmental entity, no income is recognized, and the offsetting credit is to an owners’ equity account, Additional Paid-In Capital—Donated Assets. Assets donated by entities other than governmental units are included in revenue in the period of receipt. Chapter 5: Page 5-2. Replace the second line of section I.A.1 titled “Patent” with the following two lines: “Only the external acquisition costs, which includes items such as legal costs associated with obtaining a patent on a new product, of a patent are capitalized. Research and development costs incurred to internally develop a patent are expensed as incurred.” Chapter 5: Pages 5-3 through 5-4. Replace sections I.B and I.C titled “Initial Recognition & Measurement” and “After Acquisition”, respectively, with the following: B. Initial Recognition & Measurement An intangible asset may be externally acquired or internally developed. It may be acquired individually or with a group of other assets. 1. Externally Acquired Acquired intangible assets initially are recognized and measured based on fair value. If acquired as a group of assets in a transaction other than a business combination, the cost is allocated to individual assets based on their relative fair values and shall not give rise to goodwill. Intangible assets acquired in a business combination are discussed in the chapter on consolidated financial statements as deemed necessary. 2. Internally Developed The costs of internally developing, maintaining, or restoring intangible assets (including goodwill) that are not specifically identifiable and that have indeterminate lives, are expensed when incurred. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 17 of 160 Financial Accounting & Reporting C. Updating Supplement Version 38.3 After Acquisition Accounting for a recognized intangible asset is based on its useful life. An intangible asset with a finite useful life is amortized; an intangible with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. 1. Useful Life Estimate The estimate of the useful life should be based upon the analysis of all pertinent factors, in particular: a. b. The expected useful life of another asset or group of assets to which the useful life of the intangible asset may relate. c. Any legal, regulatory, or contractual provisions that may limit the useful life. d. The entity’s own historical experience in renewing or extending similar arrangements. In the absence of that experience, the assumptions that market participants would use about extension or renewal. e. The effects of obsolescence, demand, competition and other economic factors. f. 2. The expected use of the asset by the entity. The level of maintenance expenditures required to obtain the expected future cash flows from the asset. Finite Useful Life An intangible asset with a finite useful life shall be amortized over its useful life to the reporting entity. If the precise length of that life is not known, the intangible asset shall be amortized over the best estimate of its useful life. a. Amortization The method of amortization should reflect the pattern in which the economic benefits of the intangible asset are consumed or used up. If that pattern cannot be reliably determined, a straight-line amortization method shall be used. The amount to be amortized shall be the amount initially assigned to the asset less any residual value. b. Residual Value The residual value of an intangible asset shall be assumed to be zero unless at the end of its useful life to the entity the asset is expected to continue to have a useful life to another entity and (a) the reporting entity has a commitment from a third party to purchase the asset at the end of its useful life or (b) the residual value can be determined by reference to an exchange transaction in an existing market for that asset and that market is expected to exist at the end of the asset’s useful life. c. Reevaluation Each reporting period, the remaining useful life of an intangible asset being amortized should be evaluated to determine whether events and circumstances warrant a revision to the remaining period of amortization. (1) (2) 3. If the remaining useful life changes, the remaining amount of the intangible asset should be amortized prospectively over the revised remaining useful life. If it’s determined the asset has an indefinite useful life, the asset shall be tested for impairment and is no longer amortized. It is then accounted for in the same manner as intangible assets with indefinite useful lives. Indefinite Useful Life If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life, it is considered to be indefinite. The term indefinite does not mean infinite. Goodwill and intangible assets with indefinite useful lives are not amortized, but rather are tested at least annually for impairment. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 18 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 a. Amortization If an intangible asset is determined to have an indefinite useful life, it shall not be amortized until its useful life is determined to be no longer indefinite. b. Reevaluation Each reporting period, an entity shall evaluate the remaining useful life of the intangible asset to determine whether events and circumstances continue to support an indefinite life. If it’s determined the asset has a finite useful life, the asset shall be tested for impairment and then be amortized prospectively over its estimated remaining useful life. It is then accounted for in the same manner as other intangible assets with finite useful lives. 4. Impairment At least annually, all intangible assets that are not amortized should be tested for impairment. The testing is done by comparing the fair values of those intangible assets with their recorded amounts. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss in an amount equal to that excess is recognized. After an impairment loss is recognized, the adjusted carrying amount of the asset is its new basis. Subsequent reversal of a previously recognized impairment loss is prohibited. 5. Goodwill Impairment Testing Goodwill is tested for impairment at least annually, using a two-step process, beginning with an estimation of a reporting unit’s fair value. If certain criteria are met, the annual requirement can be satisfied without a remeasurement of the reporting unit’s fair value. The goodwill impairment test may be performed any time during the fiscal year, provided the test is performed at the same time every year. a. Reporting Unit Accounting for goodwill is based on reporting units, (the units of the combined entity into which an acquired entity is integrated) as an aggregate view of goodwill. Goodwill is tested for impairment at a reporting unit level. A reporting unit is an operating segment or one level below an operating segment, referred to as a component. A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and segment management regularly reviews the operating results of that component. b. Two-Step Impairment Test The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. (1) (2) Chapter 6: A. Step One The first step used to identify potential impairment compares reporting unit’s fair value with its carrying amount, including goodwill. If the fair value exceeds its carrying amount, the reporting unit’s goodwill is considered not impaired and the second step is unnecessary. If the carrying amount exceeds Step Two The second step compares the implied fair value of reporting unit’s goodwill with its carrying amount. If the carrying amount exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The loss recognized cannot exceed the goodwill’s carrying amount. After an impairment loss is recognized, the adjusted carrying amount of goodwill is its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited. Page 6-2. Replace section I.A titled “Overview” with the following: Overview Bonds are contractual agreements wherein the issuer (borrower) promises to pay the purchaser (lender) a principal amount at a designated future date. In addition, the issuer makes periodic interest payments based on the face amount of the bond and the stated rate of interest. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 19 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 1. Held-to-Maturity Securities Held-to-maturity (HTM) securities are defined as debt securities that the enterprise has the intent and the ability to hold to maturity. HTM securities are accounted for under the amortized cost method discussed here. Trading and available-forsale securities are not accounted for under the amortized cost method. Temporary fluctuations in the market value of bonds classified as HTM are not recognized in the accounts. 2. Debenture Bonds Unsecured bonds; they are not supported by a lien or mortgage on specific assets. 3. Term Bonds Bonds maturing at a specified date. 4. Callable Bonds Bonds that may be retired at the issuer’s option. 5. Serial Bonds Bonds providing for repayment of principal in a series of installments. 6. Convertible Bonds Bonds that may be converted to stock at the bondholder’s option. Chapter 6: Page 6-10. Replace the sentence directly under section IV.A titled “Serial Bonds” with the following sentence: “A set of bonds issued at the same time but having different maturity dates. These are also called installment bonds because they provide a series of installments for repayment of principal.” Chapter 6: Pages 6-10 through 6-16. Change section IV.B titled “Convertible Bonds” to section IV.C and change section IV.C titled “Debt With Detachable Stock Warrants to section IV.B as “Bonds With Detachable Stock Warrants”. Also reorder the examples, as needed, on the pages that follow. Chapter 7: Pages 7-5 through 7-9. Change section I.E titled “Estimated Liabilities” to section I.F and change section I.F titled “Contingent Liabilities” to section I.F. Also reorder the exhibits, as needed. Then under “Estimated Liabilities”, replace section F.1.a and F.1.b titled “Recording” and “Year-End Adjustment”, respectively, with the following: a. Point of Sale When the liability is recorded at the point of sale, an entry is made to record the warranty expense and estimated warranty liability on that date. Any direct costs for servicing customer claims are debited to estimated warranty liability and credited to cash or other assets. Exhibit 6 Recording at Point of Sale Warranty Expense Estimated Warranty Liability To record estimated warranty expense at point of sale XX Estimated Warranty Liability Cash or Other Assets To record actual warranty expenditures as incurred XX b. XX XX End of Accounting Period Adjustment When the liability is recorded at the end of the accounting period, no entry is made at the date of sale, and any direct costs for servicing customer claims are debited to warranty expense and credited to cash or other assets. At the end of the period, an estimate of the year’s warranty liability is made based on past experience and current estimates. If the estimated liability exceeds the amounts actually charged, the difference is debited to warranty expense and credited to estimated warranty liability. No additional entry is necessary if the estimated liability does not exceed the amounts actually charged. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 20 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Exhibit 7 Recording at End of Accounting Period Warranty Expense Cash or Other Assets To record actual warranty expenditures as incurred XX XX Warranty Expense XX Estimated Warranty Liability To record remaining estimated warranty expense at end of accounting period XX Chapter 8: Page 8-5. Move sections II.B.3 and II.B.4 titled “Direct Financing” and “Operating Leases”, respectively, to before Exhibit 2 titled “Capital Lease Criteria”. Chapter 8: Page 8-5. Replace Exhibit 2 titled “Capital Lease Criteria” with the following exhibit: Exhibit 2 Capital Lease Criteria Yes Ownership of property transferred to lessee by end of lease term No Yes Lease contains a bargain purchase option No Yes Lease term = 75% of estimated economic life of property No Yes Lessee Lessor PV of MLP = 90% of FV of leased property (N/A in last 25% of lease term) Collectibility of the MLPs is reasonably predictable No No Yes No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor No Yes Capital Lease Copyright © 2009 by Bisk Education, Inc. All rights reserved. Operating Lease Page 21 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Chapter 10: Pages 10-1 and 10-13 through 10-19. Change section VII titled “Employees & Stock” to be section V titles “Employees & Stock” and renumber sections V titled “Treasury Stock” to section VI and the section VI titled “Equity Reclassification” to section VII. Then replace sections V, VI, and VII with the following: V. Employees & Stock A. Share-Based Payment Plans Basically, the appropriate accounting treatment for share-based payment plans is determined by whether the plan is compensatory or noncompensatory. Corporations often adopt plans whereby employees may obtain shares of stock under specified conditions. The reasons for establishing such plans include to raise additional equity capital, to enhance employees’ loyalty to the company through widespread employee ownership of stock, and to provide additional compensation to key personnel. B. Noncompensatory Plans Noncompensatory plans (employee-share purchase plans) pose no unique accounting problems. These plans are adopted primarily to raise capital and induce widespread stock ownership among a company’s employees. When the stock is issued, it is accounted for as an ordinary issue of stock. An employee share purchase plan that satisfies all of the following criteria does not give rise to recognizable compensation cost (that is, the plan is noncompensatory): 1. Conditions The plan satisfies at least one of the following conditions: a. The terms of the plan are no more favorable than those available to all holders of the same class of shares. b. Any purchase discount from the market price does not exceed the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering. A purchase discount of 5 percent or less from the market price shall be considered to comply with this condition without further justification. A purchase discount greater than 5 percent that cannot be justified under this condition results in compensation cost for the entire amount of the discount. 2. Participation Substantially all employees that meet limited employment qualifications may participate on an equitable basis. 3. Option Features The plan incorporates no option features, other than the following: a. b. C. Employees are permitted a short period of time—not exceeding 31 days—after the purchase price has been fixed to enroll in the plan. The purchase price is based solely on the market price of the shares at the date of purchase, and employees are permitted to cancel participation before the purchase date and obtain a refund of amounts previously paid (such as those paid by payroll withholdings). Compensatory Plans Compensatory plans are those that do not meet the criteria for noncompensatory plans. If the employee pays less than the quoted market price of the stock at the measurement date, compensation expense must be measured and allocated to the appropriate periods of the employee’s services. If the plan is deemed to be compensatory, then compensation cost will need to be recognized using the fair value method of option pricing. 1. Employee The definition of an employee includes elected outside members of the company’s board of directors. An individual is considered an employee if the company granting the options has sufficient control over the individual as to establish an employer-employee relationship. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 22 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 2. Measurement Date The measurement date is the date of the grant. When the measurement date occurs subsequent to the grant date, compensation expense is recorded and accrued at the end of each period based on the quoted market price at the end of the period, the estimated number of shares earned, and the option price. 3. Measurement Method Entities are required to adopt a fair value based method of accounting for stock-based compensation plans. a. Fair Value Fair value is defined as the amount at which willing parties in a current transaction would buy or sell an asset, other than in a forced or liquidation sale. The fair value based method calls for recognizing compensation cost of stock-based compensation based on the grant-date fair value of the award (with limited exceptions). b. Valuation Models The use of a valuation model is required to estimate the value of the stock-based compensation granted. Entities can use the Black-Scholes, binomial, or similar pricing model which takes into account the following information as of the grant date: (1) the exercise price, (2) the expected life of the option, (3) the current price of the stock, (4) the expected volatility of the stock, (5) the expected dividends on the stock, and (6) the risk-free interest rate for the expected term of the option. Exhibit 14 D E V I L S c. 4. — — — — — — Black-Scholes Pricing Model Dividends expected on the stock Exercise price Volatility of the stock Interest rate (risk free rate) for the expected term of the option Life of the option Stock current price Exchanges With Nonemployees When options or other equity instruments are exchanged for goods or services with a nonemployee, the transaction will need to be reflected at fair value. In such a case, the value received may be more readily determinable than the value of the options given. Future Services If the stock or options are granted as compensation for future services, Deferred Compensation Cost is debited and the amount is recognized as compensation expense in the appropriate period. Deferred Compensation Expense is a contra-equity account. Example 6 Compensatory Plan An option is granted on January 1, year 1, to a key executive to purchase 5,000 shares of $20 par common stock at $40 per share when the market price is $46 per share. The key executive is awarded the option based on services to be rendered equally over four years. The options are worth $160,000. Required: Make journal entries to record: (1) compensation cost on the measurement date, (2) annual compensation expense, and (3) issuance of the stock if the option is exercised at the end of year 4. Solution: On the balance sheet, deferred compensation cost is recorded as a deduction from stock options outstanding; it is not an asset. The “net” of these two accounts represents the compensation that the employee has earned to date. (1) January 1, year 1 Deferred Comp. Cost (value of options at date of grant) 160,000 Stock Options Outstanding 160,000 (2) December 31, year 1, year 2, year 3, and year 4 Compensation Expense ($160,000 / 4) 40,000 Deferred Compensation Cost 40,000 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 23 of 160 Financial Accounting & Reporting (3) Updating Supplement Version 38.3 December 31, year 4 Cash (5,000 shares × $40) Stock Options Outstanding Common Stock (5,000 × $20) Add’l. Paid-In Cap., Common (to balance) 200,000 160,000 100,000 260,000 5. Previously Rendered Service Where the employee works for several periods before the stock is issued, the employer accrues a portion of the compensation expense from the stock issuance. 6. Unearned Stock Compensation Where the stock is issued before some or all of the services are performed, the compensation that is unearned is shown as a separate reduction to shareholder equity, and is recognized as an expense over the years in which services are performed. 7. Unexercised Stock Options for Nonvested Employees If a stock option is not exercised because an employee fails to fulfill an obligation under the option agreement, the estimate of compensation expense recorded in previous periods should be adjusted by decreasing compensation expense in the year of forfeiture. 8. Expired Stock Options of Vested Employees Previously recognized compensation cost is not reversed if a vested employee’s stock option expires unexercised. 9. Adjustments to Compensation Expense Adjustments to compensation expense in subsequent periods may be necessary as new estimates are determined. 10. Repriced Options When a company directly or indirectly reprices options, it has changed the terms of the plan, which would convert the award from a fixed to a variable award as of the date of the reprising. Accounting for variable awards includes an element of compensation expense. 11. Employee Stock Ownership Plans (ESOP) a. Valuation The compensation expense that an entity recognizes for an ESOP is the amount contributed (or committed to be contributed) for the period. When a noncash asset or the entity’s stock is contributed to the plan, the fair value of the asset or stock is used to measure compensation expense. b. Presentation When an obligation of an ESOP is covered by an employer’s guarantee or a commitment by the employer to make future contributions to the plan sufficient to meet debt service requirements, the obligation is presented as a liability in the employer’s balance sheet. When the employer’s liability is recorded, an offsetting debit is recorded that is reported as a reduction of stockholders’ equity. Therefore, an employer reports a reduction of stockholders’ equity equal to the obligation reported for the plan. Example 7 ESOP On May 1 of the current year, Harrell Corporation established an employee stock ownership plan and contributed $20,000 cash and 1,000 shares of its $10 par value common stock to the ESOP. On this date the market price of the stock was $23 a share. Required: Determine the amount of compensation expense that Harrell should report in its current year income statement. Solution: Cash contributed $ 20,000 Fair value of common stock contributed (1,000 shares × $23) 23,000 Compensation expense recognized in the year $ 43,000 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 24 of 160 Financial Accounting & Reporting D. Updating Supplement Version 38.3 Disclosure Prominent disclosures about the method of accounting for stock-based employee compensation and the effect of the method used on the reported results are required in both annual and interim financial statements. The following information must be disclosed regardless of the method used. 1. The number and weighted-average exercise prices of options: (a) for those outstanding at the beginning of the year, (b) for those outstanding at the end of the year, (c) for those exercisable at the end of the year, (d) for those granted during the year, (e) for those exercised during the year, (f) for those forfeited during the year, and (g) for those expired during the year. 2. The weighted-average grant-date fair value of options granted during the year. 3. The number and weighted-average grant-date fair value of equity instruments other than options. 4. A description of the method and significant assumptions used during the year to estimate the fair values of options. 5. Total compensation cost recognized in income for stock-based employee compensation awards. 6. The terms of significant modifications of outstanding awards. 7. The method of reporting the change in accounting principles when a change to the fair value based method is adopted. VI. Treasury Stock A. Overview Treasury stock is the corporation’s common or preferred stock that has been reacquired by purchase, by settlement of an obligation to the corporation, or through donation. Acquisition of treasury stock reduces assets and total stockholders’ equity (unless donated) while the reissuance of treasury stock increases assets and total stockholders’ equity. There are two basic methods to account for treasury stock: the cost method and the par value method. The cost method is used more commonly. 1. 2. No gains or losses are recognized on treasury stock transactions. 3. Retained earnings may be decreased, but never increased, by treasury stock transactions. 4. Total stockholders’ equity is the same under both the cost and par value methods. Total stockholders’ equity decreases by the cost of treasury shares acquired and increases by the proceeds received from the reissuance of treasury stock, regardless of whether the treasury stock is accounted for by the cost or the par value method. 5. B. Treasury stock is not an asset. In many states, retained earnings must be appropriated in the amount of the cost of treasury stock. Cost Method The cost method views the purchase and subsequent disposition of stock as one transaction. The treasury stock is recorded (debited), carried, and reissued at the acquisition cost. 1. Reissued in Excess of Acquisition Cost If the stock is reissued at a price in excess of the acquisition cost, the excess is credited to an appropriately titled paid-in capital account (e.g., Additional Paid-In Capital From Treasury Stock Transactions). 2. Reissued at Less Than Acquisition Cost If the stock is reissued at less than the acquisition cost, the deficit is first charged against any existing balance in the Additional Paid-In Capital From Treasury Stock Transactions account. The excess, if any, is then charged against Retained Earnings. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 25 of 160 Financial Accounting & Reporting 3. C. Updating Supplement Version 38.3 Balance Sheet Presentation Under the cost method, treasury stock is presented on the balance sheet as an unallocated reduction of total stockholders’ equity (i.e., contributed capital and retained earnings). Par Value Method The par value method views the purchase and subsequent disposition of stock as two distinct transactions. Under this method, the acquisition of the treasury shares is viewed as a constructive retirement of the stock. Since capital stock is carried on the balance sheet at par (or stated value), the acquisition of treasury stock is also recorded at par (or stated value), by debiting Treasury Stock. Likewise, Additional Paid-In Capital—Common Stock is charged with a pro rata amount of any excess over par or stated value recorded on the original issuance of the stock. Note that the effect of these two entries is to remove the treasury stock from the accounts, i.e., as if it had been retired. 1. If the acquisition cost of the treasury stock is less than the price at which the stock was originally issued, the difference is credited to APIC From Treasury Stock. 2. On the other hand, if the acquisition price exceeds the stock’s original issue price, then the excess is debited to APIC From Treasury Stock, but only to the extent of any existing balance (i.e., from prior treasury stock transactions). The excess, if any, is debited to Retained Earnings. 3. The reissuance of treasury stock under the par value method is accounted for in the same manner as an original stock issuance. However, any reissuances of treasury stock at less than par value will reduce (debit) Additional Paid-In Capital From Treasury Stock until that balance is exhausted, then debit Retained Earnings for any excess. Example 8 Treasury Stock Transactions Comparison Cost Method Par Value Method Original Issue of 1,000 shares of $10 par value common stock at $15 per share: Cash (1,000 shares @ $15) 15,000 Cash (1,000 shares @ $15) 15,000 10,000 Common Stock Common Stock 10,000 (1,000 sh. @ $10) (1,000 sh. @ $10) APIC—CS (1,000 sh. @ $5) 5,000 APIC—CS (1,000 sh. @ $5) 5,000 Acquisition of 100 shares at $18 per share: Treasury Stock 1,800 Treasury Stock (100 sh. @ $10) Cash (100 sh. @ $18) 1,800 APIC—CS (100 sh. @ $5) Retained Earnings (to balance) Cash Acquisition of 50 shares at $9 per share: Treasury Stock 450 Treasury Stock (50 sh. @ $10) Cash (50 sh. @ $9) 450 APIC—CS (50 sh. @ $5) Cash (50 sh. @ $9) APIC—TS (to balance) Reissuance of 50 shares at $20 per share (FIFO): Cash (50 sh. @ $20) 1,000 Cash (50 sh. @ $20) Treasury Stock Treasury Stock 900 (50 sh. @ $10) (50 sh. @ $18) APIC—TS (to balance) 100 APIC—TS (to balance) Reissuance of 50 shares at $9 per share (FIFO): Cash (50 sh. @ $9) 450 Cash (50 sh. @ $9) APIC—TS (up to existing bal.) 100 APIC—TS (to balance) Retained Earnings (to balance) 350 Treasury Stock (50 sh. @ $10) Treasury Stock 900 (50 sh. @ $18) Copyright © 2009 by Bisk Education, Inc. All rights reserved. 1,000 500 300 1,800 500 250 450 300 1,000 500 500 450 50 500 Page 26 of 160 Financial Accounting & Reporting D. Updating Supplement Version 38.3 Retirement A corporation may decide to retire some or all of its treasury stock. Retired stock is classified as authorized and unissued (i.e., as if it had never been issued). Accounting for the retirement of treasury stock depends on the method used initially to record it, i.e., cost or par value method. Example 9 Retirement of Treasury Stock Cost Method Par Value Method Original Issue of 20 shares of $100 par value common stock at $105 per share: Cash (20 shares @ $105) 2,100 Cash (20 shares @ $105) Common Stock Common Stock 2,000 (20 sh. @ $100) (20 sh. @ $100) APIC—CS (20 sh. @ $5) 100 APIC—CS (20 sh. @ $5) a) Acquisition of 20 shares at $110 per share: Treasury Stock 2,200 Treasury Stock (20 sh. @ $100) Cash (20 sh. @ $110) 2,200 APIC—CS (20 sh. @ $5) Retained Earnings (to balance) Cash (20 sh. @ $110) Retirement of the 20 shares acquired at $110 per share: Common Stock (20 sh. @ $100) 2,000 Common Stock (20 sh. @ $100) APIC—CS (20 sh. @ $5) 100 Treasury Stock Retained Earnings (to balance) 100 Treasury Stock 2,200 (20 sh. @ $110) b) Acquisition of 20 shares at $98 per share: Treasury Stock 1,960 Treasury Stock (20 sh. @ $100) Cash (20 sh. @ $98) 1,960 APIC—CS (20 sh. @ $5) Cash (20 sh. @ $98) APIC—TS (to balance) Retirement of the 20 shares acquired at $98 per share: Common Stock (20 sh. @ $100) 2,000 Common Stock (20 sh. @ $100) APIC—CS (20 sh. @ $5) 100 Treasury Stock Treasury Stock (20 sh. @ $98) 1,960 APIC—TS (to balance) 140 2,100 2,000 100 2,000 100 100 2,200 2,000 2,000 2,000 100 1,960 140 2,000 2,000 VII. Equity Reclassification A. Overview Certain instruments previously classified as equity are required to be classified as liabilities, even though this classification is inconsistent with the current definition of a liability. This concerns the classification of certain financial instruments that embody obligations to issue equity shares. B. Applicability This applies to issuer’s classification and measurement of freestanding financial instruments, including those that comprise more than one option or forward contract. The following instruments are required to be reclassified as liabilities: A financial instrument 1. That is mandatorily redeemable, issued in the form of shares—that embodies an unconditional redemption obligation requiring a transfer of assets at a specified or determinable date(s) or upon an event that is certain to occur. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 27 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 2. Other than outstanding shares, that, at inception, embodies an obligation to repurchase the issuer’s equity shares, or is indexed to an obligation to repurchase the issuer’s equity shares, and requires or may require settlement of the obligation by the transfer of assets. 3. That embodies an unconditional obligation that the issuer must or may settle by issuing a variable number of its equity shares, whether or not it is an outstanding share, if, at inception, the monetary value of the obligation is based solely or predominantly on any of the following: a. b. Variations in something other than the fair value of the issuer’s equity shares. c. C. A fixed monetary amount known at inception. Variations inversely related to changes in the fair value of the issuer’s equity shares. Exempt 1. 2. Classification or measurement of convertible bonds, puttable stock or other outstanding shares that are conditionally redeemable 3. Certain financial instruments indexed partly to the issuer’s equity shares and partly, but not predominantly, to something else. 4. Nonsubstantive or minimal features are to be disregarded. 5. D. Features embedded in a financial instrument that is not a derivative in its entirety, such as conversion or conditional redemption features. Forward contracts to repurchase an issuer’s equity shares that require physical settlement in exchange for cash are initially measured at the fair value of the shares at inception, adjusted for any consideration or unstated rights or privileges, which is the same as the amount that would be paid under the conditions specified in the contract if settlement occurred immediately. Disclosures are required about the terms of the instruments and settlement alternatives. Impact on Private Companies 1. Many privately-held businesses (including partnerships) require shares be sold back to the company upon termination of the agreement or death of the owner. 2. Events certain to occur (termination of the agreement or death of a shareholder) require classification of mandatorily redeemable shares of stock as liabilities, thus eliminating the equity of many privately-held businesses. 3. Publicly traded companies generally do not have these types of agreements. Example 10 Equity Reclassification Balance Sheet Total Assets Liabilities other than shares Shares subject to mandatory redemption Total Liabilities $2,000,000 $1,400,000 600,000 $2,000,000 Note: The balance of the equity section is zero. “Shares subject to mandatory redemption” includes the value of common stock plus retained earnings as described in the notes to the financial statements. Notes to the Financial Statements Shares, all subject to mandatory redemption upon death of the holders, consist of: Common stock, $100 par value, 10,000 shares authorized, 4,000 shares issued Retained earnings attributable to those shares Total subject to mandatory redemption Copyright © 2009 by Bisk Education, Inc. All rights reserved. $ 400,000 200,000 $ 600,000 Page 28 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Chapter 11: Pages 11-1 through 11-19. Replace the entire text portion of the chapter titled “Reporting the Results of Operations” with the following (due to various changes and complete restructuring): CHAPTER 11 REPORTING THE RESULTS OF OPERATIONS I. Overview ................................................................................................................................................ 11-2 A. Accrual Accounting........................................................................................................................ 11-2 B. Other Comprehensive Basis of Accounting................................................................................... 11-3 C. Definitions...................................................................................................................................... 11-4 II. Reporting Considerations .................................................................................................................... 11-5 A. Prior Period Adjustment................................................................................................................. 11-5 B. Changes in Accounting Principle................................................................................................... 11-5 C. Changes in Accounting Estimate .................................................................................................. 11-7 D. Changes in Reporting Entity.......................................................................................................... 11-8 E. Correction of an Error in Previously Issued Financial Statements................................................ 11-8 III. Income Statement ............................................................................................................................... 11-10 A. Concepts of Income..................................................................................................................... 11-10 B. Continuing Operations................................................................................................................. 11-10 C. Discontinued Operations ............................................................................................................. 11-11 D. Extraordinary Items ..................................................................................................................... 11-12 E. Format ......................................................................................................................................... 11-13 IV. Comprehensive Income ..................................................................................................................... 11-15 A. Comprehensive Income............................................................................................................... 11-15 B. Other Comprehensive Income (OCI)........................................................................................... 11-15 C. Accumulated Balance of OCI ...................................................................................................... 11-16 D. Reporting Related Income Tax.................................................................................................... 11-16 E. Format Options............................................................................................................................ 11-17 V. Interim Financial Reporting ............................................................................................................... 11-19 A. Concepts ..................................................................................................................................... 11-19 B. Continuing Operations................................................................................................................. 11-19 C. Discontinued Operations & Extraordinary Items ......................................................................... 11-21 D. Contingencies & Uncertainties .................................................................................................... 11-21 E. Accounting Changes ................................................................................................................... 11-21 F. Minimum Disclosures .................................................................................................................. 11-21 VI. Operating Segments ........................................................................................................................... 11-22 A. Management Approach Method .................................................................................................. 11-22 B. Aggregation Criteria..................................................................................................................... 11-23 C. Quantitative Thresholds............................................................................................................... 11-23 D. Disclosures .................................................................................................................................. 11-26 VII. Additional Reporting Issues .............................................................................................................. 11-27 A. Development Stage Enterprises.................................................................................................. 11-27 B. Related Party Disclosures ........................................................................................................... 11-28 C. Subsequent Events ..................................................................................................................... 11-28 11-1 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 29 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 CHAPTER 11 REPORTING THE RESULTS OF OPERATIONS I. Overview A. Accrual Accounting Accrual accounting recognizes and reports the effects of transactions and other events on the assets and liabilities of a business enterprise in the time periods to which they relate rather than only when cash is received or paid. Accrual accounting attempts to match revenues and the expenses associated with those revenues in order to determine net income for an accounting period. 1. Revenue Recognition Revenues are recognized when earned. 2. Expense Recognition Expenses are recognized and recorded as follows: a. b. Systematic and Rational Allocation In the absence of a direct association with specific revenue, some expenses are recognized and recorded by attempting to allocate expenses in a systematic and rational manner among the periods in which benefits are provided. c. 3. Associating Cause and Effect Some expenses are recognized and recorded on a presumed direct association with specific revenue. Immediate Recognition Some costs are associated with the current accounting period as expenses because (1) costs incurred during the period provide no discernible future benefits, (2) costs recorded as assets in prior periods no longer provide discernible benefits, or (3) allocating costs either on the basis of association with revenues or among several accounting periods is considered to serve no useful purpose. Accruals An accrual represents a transaction that affects the determination of income for the period but has not yet been reflected in the cash accounts of that period. a. b. 4. Accrued Revenue Accrued revenue is revenue earned but not yet collected in cash. An example of accrued revenue is accrued interest revenue earned on bonds from the last interest payment date to the end of the accounting period. Accrued Expense An accrued expense is an expense incurred but not yet paid in cash. An example of an accrued expense is salaries incurred for the last week of the accounting period that are not payable until the subsequent accounting period. Deferrals A deferral represents a transaction that has been reflected in the cash accounts of the period but has not yet affected the determination of income for that period. a. Deferred Revenue Deferred revenue is revenue collected or collectible in cash but not yet earned. An example of deferred revenue is rent collected in advance by a lessor in the last month of the accounting period, which represents the rent for the first month of the subsequent accounting period. b. Deferred/Prepaid Expense A deferred (prepaid) expense is an expense paid or payable in cash but not yet incurred. An example of a deferred (prepaid) expense is an insurance premium paid in advance in the current accounting period, which represents insurance coverage for the subsequent accounting period. 11-2 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 30 of 160 Financial Accounting & Reporting B. Updating Supplement Version 38.3 Other Comprehensive Basis of Accounting 1. Overview Financial accounting must follow generally accepted accounting principles (GAAP). An Other Comprehensive Basis of Accounting (OCBOA) is a basis of accounting not in conformity with GAAP, as follows: a. b. A basis of accounting used by an entity to file its tax return. c. The cash receipts and disbursements basis of accounting. d. 2. A basis of accounting used to comply with regulatory requirements. A definite set of criteria having substantial support, such as the price-level basis of accounting. Cash Basis In cash basis accounting, the effects of transactions and other events on the assets and liabilities of a business enterprise are recognized and reported only when cash is received or paid; while in accrual accounting, these effects are recognized and reported in the time periods to which they relate. Cash basis accounting does not attempt to match revenues and the expenses associated with those revenues. The conversion of various income statement amounts from cash basis to accrual basis is summarized in Exhibit 1. Exhibit 1 Revenue and Expense Item Effects Revenue or Expense Item Collections from sales Adjustments: 1. Increase in accounts receivable 2. Decrease in accounts receivable 3. Uncollectible accounts written off Sales revenue Collections from other revenues Adjustments: 1. Increase in revenue receivable 2. Decrease in revenue receivable 3. Increase in unearned revenue 4. Decrease in unearned revenue Revenue recognized Payments for purchases Adjustments: 1. Increase in inventory 2. Decrease in inventory 3. Increase in accounts payable 4. Decrease in accounts payable Cost of goods sold Payment for Expenses Adjustments: 1. Increase in prepaid expenses 2. Decrease in prepaid expenses 3. Increase in accrued expenses payable 4. Decrease in accrued expenses payable Expenses recognized Plus or Minus Adjustments to Derive Accrual Basis + – + Illustrative Amounts $190 7 5 $202 $184 + – – + (4) (10) $170 $ 91 – + + – (7) 9 $ 93 $ 92 – + + – (9) 8 $ 91 NOTE: This exhibit is for revenue or expense item effects, not the effects to income. 11-3 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 31 of 160 Financial Accounting & Reporting 3. C. Updating Supplement Version 38.3 Income-Tax Basis In income-tax basis accounting, the effects of events on a business enterprise are recognized when taxable income or deductible expense is recognized on the tax return. Nontaxable income and nondeductible expenses are still included in the determination of income. Definitions 1. Accounting Change A change in (a) an accounting principle, (b) an accounting estimate, or (c) the reporting entity. The correction of an error in previously issued financial statements is not an accounting change. 2. Change in Accounting Principle A change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle. 3. Change in Accounting Estimate A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. Changes in accounting estimates result from new information. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, and warranty obligations. 4. Change in Accounting Estimate Effected by a Change in Accounting Principle A change in accounting estimate that is inseparable from the effect of a related change in accounting principle. An example would be the change in the method of depreciation, amortization, or depletion for long-lived, nonfinancial assets. 5. Change in Reporting Entity A change that results in financial statements that, in effect, are those of a different reporting entity. A change in the reporting entity is limited mainly to (a) presenting consolidated or combined financial statements in place of financial statements of individual entities, (b) changing specific subsidiaries that make up the group of entities for which consolidated financial statements are presented, and (c) changing the entities included in combined financial statements. 6. Direct Effects of a Change in Accounting Principle Those recognized changes in assets or liabilities necessary to effect a change in accounting principle. An example is an adjustment to an inventory balance to effect a change in inventory valuation method. Related changes, such as an effect on deferred income tax assets or liabilities or an impairment adjustment resulting from applying the lower-of-cost-or-market test to the adjusted inventory balance, also are examples of direct effects of a change in accounting principle. 7. Error in Previously Issued Financial Statements An error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of GAAP, or oversight or misuse of facts that existed at the time the financial statements were prepared. A change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error. 8. Indirect Effects of a Change in Accounting Principle Any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively. An example of a indirect effect is a change in nondiscretionary profit sharing or royalty payment that is based on a reported amount such as revenue or net income. 9. Restatement The process of revising previously issued financial statements to reflect the correction of an error in those financial statements. 11-4 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 32 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 10. Retrospective Application The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statement of a new reporting entity as if it had existed in those prior years. (Synonymous with the term retroactive restatement) 11. Impracticable After making every reasonable effort, an entity is unable to comply because needed information is unable to be substantiated. II. Reporting Considerations A. Prior Period Adjustment A prior period adjustment consists of adjusting the financial statements of some prior period and restating those financial statements. 1. Examples Several items qualify to be treated as a prior period adjustment. They include: a. Errors of a material nature; errors, mistakes, oversights b. Misapplied GAAP 2. Requirement The prior period adjustment must be highlighted on the statement of retained earnings. It is shown as an adjustment to the opening balance of retained earnings, reported net of tax. Prior period adjustments reported net of tax deal with intra-period tax allocation. 3. Intra-Period Tax Allocation Components are reported with their related tax effect a. The three components of the income statement; (1) continuing operations, (2) discontinued operations, and (3) extraordinary items are reported on the income statement net of tax. Exhibit 2 Income Statement Components Mnemonic C D B. Discontinued Operations E b. Continuing Operations Extraordinary Items Prior period adjustments are reported on the statement of retained earnings net of tax. Changes in Accounting Principle A change in accounting principle results from the adoption of a generally accepted accounting principle (GAAP) different from the GAAP previously used for reporting purposes. The term “accounting principle” includes not only accounting principles but also the methods of applying them. Adoption of a principle to record transactions for the first time or to record the effects of transactions that were previously immaterial is not a change in accounting principle. Neither is adoption or modification of an accounting principle brought about by transactions or events that are clearly different than those previously occurring. 1. Justification Once an accounting principle is adopted, it shall be used consistently in accounting for similar events and transactions. An entity may change an accounting principle only if: a. b. The change is required by a newly issued accounting pronouncement, or The entity can justify the use of an allowable alternative accounting principle on the basis it is preferable. 11-5 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 33 of 160 Financial Accounting & Reporting 2. Updating Supplement Version 38.3 Examples Changes in accounting principle include the following. a. b. 3. A change in the method of inventory pricing, such as from LIFO to FIFO A change in the method of accounting for long-term construction contracts, such as from the completed contract method to the percentage of completion method Reporting A change in accounting principle is reported through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application requires the following: a. b. An offsetting adjustment, if needed, shall be made to the opening balance of retained earnings for that period. c. Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new principle. d. 4. The cumulative effect of the change to the new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented or earliest period to which the new accounting principle can be applied. Only the direct effects of a change in accounting principle are included in retrospective application, including any related income tax effects. Impracticability If it is impracticable to determine the cumulative effect of applying a change in accounting principle to any prior period, the new accounting principle shall be applied as if the change was made prospectively as of the earliest date possible. It shall be deemed impracticable to apply the effects of a change in accounting principle only if any of the following conditions exist: a. b. Retrospective application requires assumptions about management’s intent in a prior period that cannot be independently substantiated. c. 5. After making every reasonable effort to do so, the entity is unable to apply the requirement. Retrospective application requires significant estimates of amounts, and it is impossible to distinguish objectively information about those estimates. Disclosures in the Fiscal Period in Which a Change in Accounting Principle is Made: a. The nature and reason for the change in accounting principle and the method of applying the change. b. A description of the prior-period information that has been retrospectively adjusted, if any. c. The effect of the change on income before extraordinary items, net income, and the related per share amounts for all periods presented, either on the face of the income statement or in the notes thereto. d. The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented. e. If retrospective application to all prior periods is impracticable, disclosure of the reasons why and a description of the alternative method used to report the change. f. Presentation of the effect on financial statement subtotals and totals other than income from continuing operations and net income is not required. 11-6 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 34 of 160 Financial Accounting & Reporting C. Updating Supplement Version 38.3 Changes in Accounting Estimate Changes in an estimate used in accounting are necessary consequences of periodic presentations of financial statements. Preparing financial statements requires estimating the effects of future events. Future events and their effects cannot be perceived with certainty. Therefore, estimating requires the exercise of judgment. Accounting estimates change as new events occur, as more experience is acquired, or as additional information is obtained. 1. Change in Estimate Inseparable From Change in Principle In some cases, a change in accounting estimate and a change in accounting principle are inseparable. One example is a change in the method of depreciation affecting estimated future benefits. When the effects of the two changes cannot be separated, the change should be accounted for as a change in estimate. 2. Examples of Changes in Estimate Changes in the following items would usually require a change in accounting estimate. a. Useful lives and salvage values of depreciable assets b. Recovery periods benefited by a deferred cost c. Expected losses on receivables d. Warranty costs 3. Period of Recognition A change in accounting estimate should be accounted for in the period of change if the change only affects that period, or in the current and subsequent periods, if the change affects both, as a component of income from continuing operations. A change in estimate does not require restatement or retrospective adjustment to prior period financial statements. The effects of the change in estimate on income before extraordinary items, net income, and related per share amounts should be disclosed in the period of the change or in future periods if the change affects those periods. 4. Disclosure No disclosure is required for estimates made in the ordinary course of accounting if the effects are not material or long-term. An example is the bad debt estimate. Example 1 Change in Estimate Machinery with a cost of $450,000 is being depreciated over a 15-year life. After 10 years, information becomes available that indicates a useful life of 20 years for the machinery. Accounting for the change in depreciation estimate in the eleventh year would be as follows: Historical cost Depreciation to date ($30,000 × 10) Remaining balance Balance to be depreciated over remaining useful life ($150,000 / 10) $ 450,000 (300,000) $ 150,000 $ 15,000 To record depreciation expense in the year of the change: Depreciation Expense Accumulated Depreciation 15,000 15,000 The notes to the income statement would include the following disclosure: Note A: During the eleventh year, the estimated useful life of certain machinery was changed from 15 years to 20 years. The effect of the change was to increase net income by $15,000 (ignoring taxes). Earnings per share amounts increased $1.50. The financial statements of prior periods presented would not be restated, nor would the pro forma effects of retroactive application be reported. 11-7 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 35 of 160 Financial Accounting & Reporting D. Updating Supplement Version 38.3 Changes in Reporting Entity An accounting change that results in financial statements that are, in effect, the statements of a different reporting entity (i.e., a different group of companies comprise the reporting entity after the change). 1. 2. Examples Examples include (a) presenting consolidated or combined statements in place of statements of individual companies, (b) changing specific subsidiaries comprising the group of companies for which consolidated financial statements are presented, and (c) changing the companies included in combined financial statements. 3. E. Reporting Report the change by retrospectively applying the change to the financial statements of all prior periods presented to reflect the financial information for the new reporting entity for the periods. Do not report (1) the cumulative effect of the change on the amount of retained earnings at the beginning of the period in which the change is made or (2) pro forma effects on net income and earnings per share of retroactive application. Disclosures A description of both the nature of the change and the reason for it shall be disclosed in the period of the change. In addition, the effect of the change on income before extraordinary items, net income, other comprehensive income, and any related per-share amounts shall be disclosed for all periods presented. Correction of an Error in Previously Issued Financial Statements 1. Overview Errors in financial statements result from mathematical mistakes, mistakes in the application of accounting principles, or the oversight or misuse of facts that existed at the time the financial statements were prepared. Errors commonly found in financial statements include the following. a. b. Recording erroneous amounts for assets and equities. For example, incorrect footing of inventory totals would cause inventories to be misstated on the balance sheet. c. Failure to record prepaid and accrued expenses. d. The improper classification of assets as expenses and vice versa. The purchase price of a plant asset may be incorrectly charged to expense rather than an asset account. e. 2. Estimates based on unreasonable assumptions; for example, the use of an unrealistic depreciation rate. In addition, the change from an accounting principle that is not generally accepted to one that is generally accepted is treated as the correction of an error; for example, a change from the direct write-off method to the allowance method of accounting for uncollectible accounts. Reporting Any error in the financial statements of a prior period discovered subsequent to their issuance shall be reported as a prior-period adjustment by restating the prior period financial statements. Restatement requires that: a. The cumulative effect of the error on previous periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented. b. An offsetting adjustment, if needed, shall be made to the opening balance of retained earnings for that period. c. Financial statements for each individual prior period presented shall be adjusted to reflect correction of the period-specific effects of the error. 11-8 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 36 of 160 Financial Accounting & Reporting 3. Updating Supplement Version 38.3 Disclosures The entity shall disclose that its previously issued financial statements have been restated, along with a description of the error. They shall also disclose the following: a. b. The cumulative effect of the change on retained earnings or other appropriate components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented. c. 4. The effect of the correction on each financial statement line item and any per-share amounts affected for each prior period presented. The resulting effects (both gross and net of applicable income tax) on the net income of prior periods should be disclosed in the annual report for the year in which the adjustments are made. When financial statements for a single period only are presented, this disclosure should indicate the effects of such restatement on the balance of retained earnings at the beginning of the period and on the net income of the immediately preceding period. When financial statements for more than one period are presented, which is ordinarily the preferable procedure; the disclosure should include the effects for each of the periods included in the statements. Such disclosures should include the amounts of income tax applicable to the prior period adjustments. Disclosure of restatements in annual reports issued subsequent to the first such postrevision disclosure would ordinarily not be required. Classification of Errors Accounting errors may be classified by time of discovery or according to their effect on the balance sheet, income statement, or both. a. Occurrence and Discovery in Different Periods Errors that occur in one accounting period and are discovered in a subsequent accounting period are more involved: the cumulative effect of each error on periods prior to the period of discovery is calculated and recorded as a direct adjustment to the beginning balance of retained earnings. b. Occurrence and Discovery in Same Period Errors that occur and are discovered in the same accounting period may be corrected by reversing the incorrect entry and recording the correct one or by directly correcting the account balances with a single entry. c. Effect on Balance Sheet Only balance sheet accounts are affected, for instance, if the Inventory account is debited instead of the Equipment account or if Notes Payable is credited, instead of Accounts Payable. When the error is discovered, an entry is recorded to correct the account balances. d. Effect on Income Statement Revenue or expense classification errors will affect only the income statement for the period. If Sales Revenue is credited instead of Rent Revenue or Interest Expense is debited instead of Wage Expense, the amounts presented on the income statement for these accounts will be misstated. Net income for the period, however, will not be affected. If the error is discovered prior to the year-end closings, an entry can be recorded to correct the account balances. If the error is discovered in a subsequent period, no correction is necessary. However, the restatement of comparative financial statements is required. e. Effect on Both Statements Some errors affect both the balance sheet and the income statement, and may be classified in the following two ways: (1) Counterbalancing Errors Counterbalancing errors will “correct” themselves over two consecutive accounting periods. Generally, a counterbalancing error will cause a misstatement of net income and balance sheet accounts in one period that will be offset by an equal misstatement in the following period. Balance sheet accounts and combined net income for both periods will be stated correctly at the end of the second period (ignoring tax effects). 11-9 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 37 of 160 Financial Accounting & Reporting Example 2 Updating Supplement Version 38.3 Counterbalancing Errors A company neglects to record accrued wage expense at the end of a fiscal period. In the first year, the error would have the following effects: Income Statement Wage expense understated Net income overstated Balance Sheet Liabilities understated Retained earnings overstated In the second year, the payment of accrued wage expense will be charged to wage expense of the current year causing the following effects: Income Statement Wage expense overstated Net income understated (2) Balance Sheet Accounts are correctly stated due to the counterbalancing effect on error. Non-Counterbalancing Errors Errors that are not counterbalancing cause successive balance sheet amounts and net income to be incorrectly stated until the errors are discovered and corrected. For example, suppose that instead of capitalizing the cost of an asset, the cost is charged to expense. In the year the error occurs, expenses will be overstated and net income understated. During the life of the asset, net income will be overstated by the amount of unrecorded depreciation. Additionally, assets on the balance sheet will be understated throughout the service life of the unrecorded asset. III. Income Statement A. Concepts of Income The determination and presentation of various items on the income statement are influenced by two alternative concepts, the current operating concept and the all-inclusive concept. Proponents of the all-inclusive approach insist that the income statement should include unusual and nonrecurring items in order to measure the long-range operating performance of the enterprise. Proponents of the current operating concept emphasize the importance of normal recurring operations in evaluating the performance of the entity. They contend that the inclusion of unusual and nonrecurring items in the income statement distorts net income. The method required reflects a compromise between the all-inclusive and current-operating concepts. 1. 2. Income from discontinued operations and extraordinary items are reported separately from the results of continuing operations. 3. B. All regular items of income and expense, including items that are unusual or infrequently occurring, are included in the determination of net income. Prior period adjustments are presented as adjustments to the beginning balance of retained earnings. Continuing Operations 1. Revenues and Expenses Revenue and expense items (and gains and losses) that are considered to be of a usual and recurring nature are reported in income from continuing operations. 2. Unusual or Infrequent Items Items that are considered to be either unusual in nature or infrequent in occurrence are reported as a separate component of income from continuing operations. The nature and financial effects of this type of item should be disclosed on the face of the income statement, or alternatively, in the notes to the financial statements. These items should not be reported net of income taxes or in any other manner that would imply that they are extraordinary items. 3. Tax Provision The provision for income taxes associated with income from continuing operations should be presented as a single line item. 11-10 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 38 of 160 Financial Accounting & Reporting C. Updating Supplement Version 38.3 Discontinued Operations The results of discontinued operations are reported separately from continuing operations. Discontinued operations refers to the operations of a component of an entity that has been disposed of or is still operating, but is the subject of a formal plan for disposal. A component of an entity is a segment, reporting unit, or asset group whose operations and cash flows are clearly distinguished from the rest of the entity, operationally as well as for financial reporting purposes. Exhibit 3 Discontinued Operations: Component vs. Non-Component Disposals Component Disposals Non-Component Disposals Two companies manufacture and sell consumer products with several product groups, with different product lines and brands. For both companies, a product group is the lowest level at which operations and cash flows can be distinguished. Caring Pharmaceuticals plans to sell the beauty product group and its operations. Nesbit Household Products discontinues cosmetic brands associated with losses. Two companies operate nationwide restaurant chains, each with numerous company-owned sites. For both companies, a single restaurant is the lowest level at which operations and cash flows can be distinguished. Cluck-to-Go decides to exit its northeast region. It removes its name from the northeast restaurants and sells the buildings. New Wave Coffee sells all restaurants in its west coast region to franchisees. New Wave will receive franchise fees, provide advertising, and supply select ingredients. Two companies operate retail home appliance chains, each with numerous company-owned sites. For both companies, a single store is the lowest level at which operations and cash flows can be distinguished. Cheap Freddie’s closes stores in areas with declining populations, selling the buildings and moving remaining inventory to stores in other regions. Never-a-care, Inc., closes pairs of Never-a-care Appliances stores and opens Never-a-cloud Superstores, central to former locations, with an expanded range of products. Two sporting goods producers have golf club divisions that design, manufacture, market, and distribute golf clubs. For both companies, a division is the lowest level at which operations and cash flows can be distinguished. Committed Sports, Inc., agrees to a plan to sell the golf club division to an independent conglomerate. Never Say Die Manufacturers sells its golf club manufacturing plants. Never Say Die plans to outsource its golf club manufacturing. 1. Non-Component Assets Income from continuing operations includes gains or losses from an asset (or asset group) that is classified as held for sale, but that is below the level of a component of the entity. If disposal will not occur for more than 12 months, costs to sell are discounted to present value. 2. Income Statement The results of operations of a component of an entity are reported as part of discontinued operations, for current and prior periods (in the periods in which they occur), provided that: a. Operations Operations and cash flows have been (or will be) removed from the entity’s ongoing operations due to the disposal transaction. b. Continuing Involvement The entity ceases any significant continuing involvement in the component’s operations after the disposal transaction. 11-11 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 39 of 160 Financial Accounting & Reporting 3. Updating Supplement Version 38.3 Balance Sheet The component is valued at current fair value less cost to sell. Asset(s) that are classified as held for sale, and their related liabilities, are presented separately in the asset and liability sections of the balance sheet (not offset and presented as a single item). a. b. Expenses While classified as held for sale, the asset is not depreciated or amortized, although accrual of other related expenses, such as interest or rent, continue. c. 4. Future Operating Losses No liability for future operating losses is recognized. Expected future operating losses that other buyers and sellers would not recognize as part of the fair value less cost to sell are not indirectly recognized as part of an expected loss on the sale by reducing the book value of the asset (or asset group) to an amount less than its current fair value less cost to sell. This provision is designed to limit big bath accounting (the inclusion of losses with a questionable relation to the disposal, in order that profits in future periods appear more favorable). Future Liabilities Lease termination costs and specified employee severance plan costs related with exit or disposal activities in periods when obligations to others exists, not necessarily in the period of commitment to a plan, are required to be recognized. Contingencies Changes to the previously reported discontinued operations amounts are reported in current period statements as discontinued operations. Such adjustments may occur due to the resolution of contingencies regarding purchase price, purchaser indemnification, environmental warranty obligations, product warranty obligations, and directly-related employee benefit plan obligations. Example 3 Discontinued Operations On April 30 Empire Corporation, whose fiscal year-end is September 30, adopted a plan to discontinue the operations of Bello Division on November 30. Bello contributed a major portion of Empire’s sales volume. Empire estimated that Bello would sustain a loss of $460,000 from May 1 through September 30 and would sustain an additional loss of $220,000 from October 1 to November 30. Empire also estimated that it would realize a gain of $600,000 on the sale of Bello’s assets. At September 30, Empire determined that Bello had actually lost $1,120,000 for the fiscal year, of which $420,000 represented the loss from May 1 to September 30. Empire’s tax rate is 30%. Required: Determine the amounts that should be reported in the discontinued operations section of Empire’s income statement for the year ended September 30, for income from operations of the discontinued segment, and the gain or loss on disposal of the discontinued segment. Solution: Discontinued operations Loss from operations of discontinued Bello Division Income taxes Loss from discontinued operations D. $1,120,000 (336,000) $ 784,000 Extraordinary Items An extraordinary item should be classified separately in the income statement if it is material in relation to income before extraordinary items or to the trend of annual earnings before extraordinary items, or is material by other appropriate criteria. Items should be considered individually and not in the aggregate in determining whether an extraordinary event or transaction is material. If the item is determined to be extraordinary, it should be presented separately on the income statement net of related income tax after discontinued operations of a segment of a business (see Exhibit 1). 1. Criteria Most events and transactions affecting the operations of an enterprise are of a normal, recurring nature. For an occurrence to be classified as extraordinary it must meet both of the following criteria: 11-12 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 40 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 a. b. 2. Unusual Nature The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. Infrequency of Occurrence The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. Non-Extraordinary Gains/Losses The following gains and losses should not be reported as extraordinary items because they are usual in nature or may be expected to recur as a consequence of customary and continuing business activities. In certain circumstances, gains or losses such as a. and d., below, should be included in extraordinary items if they are the direct result of an event that meets the criteria for an extraordinary item. a. b. Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations c. Gains or losses on disposal of a segment of a business d. Other gains or losses from sale or abandonment of property, plant, or equipment used in the business e. Effects of a strike, including strikes against competitors and major suppliers f. Exhibit 4 Write-down or write-off of receivables, inventories, equipment leased to others, and intangible assets Adjustments of accruals on long-term contracts Summary of Item Placement on an Income Statement Item Criteria Examples Unusual or infrequent gains or losses Unusual or infrequent but not both Write-down or write-off of receivables, inventories, equipment leased to others, other gains or losses from the sale or abandonment or impairment of property, plant, or equipment used in the business C Changes in estimate A revision of an accounting measurement Changing the useful life of a depreciable asset from 5 to 7 years C The disposal of a component of the entity which represents separate operations and cash flows. A component that has been sold, abandoned, or spun-off. The component’s operations and cash flows must be clearly distinguished. C Both unusual and infrequent in nature Casualty gains and losses C D Discontinued operations Extraordinary items Placement D E D E D E E E. Format 1. Single-Year Presentation The following format is for the presentation of the income statement for a single year. 11-13 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 41 of 160 Financial Accounting & Reporting Exhibit 5 Updating Supplement Version 38.3 Income Statement Presentation Income from continuing operations before income taxes Provision for income taxes Income (loss) from continuing operations (after income taxes) Discontinued operations (Note X): Income (loss) from operations of discontinued Division A (including loss on disposal of $XXX) Income taxes Income from discontinued operations Income before extraordinary items Extraordinary items (less applicable income taxes of $XXX) Net income $ XXX XXX XXX $ XXX XXX XXX XXX XXX $ XXX 2. Comparative Statements The presentation of comparative financial statements enhances the usefulness of annual and other reports. Comparative statements project more relevant and meaningful information than do noncomparative statements. Comparative statements prepared on a consistent basis from one period to the next are especially valuable because they measure the difference in operating results based on the same measurement criteria. 3. Multiple-Step Format The presentation of income from continuing operations in a multiple step format emphasizes a functional or object classification of each statement item, and sets forth various intermediate levels of income. Exhibit 6 Multiple-Step Format Sales Less sales returns and allowances Net sales Beginning inventory Purchases Less purchase returns and allowances Net purchases Freight-in Goods available for sale Less ending inventory Cost of goods sold Gross margin Selling General & administrative Operating expenses Income from operations Rent Interest and dividends Gain on sale of machinery Other revenues Interest Loss on sale of investments Other expenses $ 950,000 (16,500) 933,500 $ 230,000 $590,000 (19,300) 570,700 2,000 802,700 (220,000) (582,700) 350,800 150,000 72,000 (222,000) 128,800 2,500 6,700 8,000 17,200 5,200 6,000 (11,200) 6,000 Income from continuing operations before income taxes Provision for income taxes Income from continuing operations Extraordinary item: Loss due to earthquake, less tax saving of $3,150 Net income 11-14 Copyright © 2009 by Bisk Education, Inc. All rights reserved. 134,800 (60,660) 74,140 (3,850) $ 70,290 Page 42 of 160 Financial Accounting & Reporting 4. Updating Supplement Version 38.3 Single-Step Format Income from continuing operations may be presented in a multiple step format or a single step format. Presentation of income from continuing operations in a single step format is often used for publicly issued statements. Revenues are grouped under one classification while expenses are grouped under another classification. Exhibit 7 Single-Step Format Sales (less returns and allowances of $16,500) Rent Interest and dividends Gain on sale of machinery Revenues Cost of goods sold Selling General & administrative Interest Loss on sale of investments Expenses Income from continuing operations before income taxes Provision for income taxes Income from continuing operations Extraordinary item: Loss due to earthquake, less tax saving of $3,150 Net income $ 933,500 2,500 6,700 8,000 950,700 $ 582,700 150,000 72,000 5,200 6,000 (815,900) 134,800 (60,660) 74,140 (3,850) $ 70,290 IV. Comprehensive Income A. Comprehensive Income The recognition and measurement of comprehensive income is based upon current accounting standards (GAAP). Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income is divided into net income and other comprehensive income. 1. 2. B. Components and Total Reported All components of comprehensive income must be reported in the financial statements in the period in which they are recognized. A total amount for comprehensive income must be displayed in the financial statement where the components of OCI are reported. Interim-Period Reporting An entity must report a total for comprehensive income in condensed financial statements of interim periods. Other Comprehensive Income (OCI) Items that previously were included in the equity section as a separate component of owners’ equity are required to be reported in other comprehensive income. These items continue to be determined in the same manner; GAAP has not changed regarding the nature of these items and how and when they are measured and reported. Other comprehensive income has no effect on direct adjustments to equity accounts, such as capital stock transactions and transactions related to retained earnings. 1. Classification An entity must classify items of other comprehensive income by their nature, in one of these classifications: foreign currency items, pension adjustments, unrealized gains and losses on certain investments in debt and equity securities, and gains and losses on cash flow hedging derivative instruments. Additional classifications or additional items within current classifications may result from future accounting standards. a. Foreign Currency Items Included in this classification are foreign currency translation adjustments and gains and losses on foreign currency transactions that are 11-15 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 43 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 designated as, and are effective as, economic hedges of a net investment in a foreign entity. Also included is the effective portion of gains and losses on hedging derivative instruments in a hedge of a forecasted foreign-currency-denominated transaction, and the effective portion of the gain or loss in the hedging derivative or nonderivative instrument in a hedge of a net investment in a foreign operation. b. Pension Adjustments The amounts of net gain or loss, net prior service cost or credit, and net transition asset or obligation that are expected to be recognized as components of net periodic benefit cost. c. Unrealized Gains and Losses on Certain Investments Unrealized gains and losses on certain investments in debt and equity securities including (1) (2) Subsequent decreases or increases in the fair value of AFS securities previously written down as impaired (4) 2. Unrealized holding gains and losses that result from a debt security being transferred into the AFS category from the HTM category (3) d. Unrealized holding gains and losses on available-for-sale (AFS) securities A change in the market value of a futures contract that qualifies as a hedge of an asset reported at fair value Gains and Losses on Cash Flow Hedging Derivative Instruments The effective portion of these gains and losses are reported as a component of OCI and reclassified into earnings when the hedged forecasted transaction affects earnings. Reclassification Reclassification adjustments may be displayed on the face of the financial statement in which comprehensive income is reported. Alternatively, reclassification adjustments may be shown net on the face of the financial statement and the gross changes be disclosed in the notes to the financial statements. a. Avoid Double Counting Adjustments must be made to avoid double counting in comprehensive income items that are displayed as part of net income for a period that also had been included as part of OCI in that period or earlier periods. b. Each Classification Reclassification adjustments must be determined for each classification of OCI, except minimum pension liability adjustments. Minimum pension liability adjustments must be shown net. C. Accumulated Balance of OCI An entity is required to display the accumulated balance of OCI separately from retained earnings, capital stock, and additional paid-in capital in the equity section of a statement of financial position. A descriptive title such as Accumulated Other Comprehensive Income must be used. An entity must disclose accumulated balances for each classification in that separate component of equity on the face of the statement of financial position, in the statement of changes in equity, or in the notes to the financial statements. The classifications must correspond to classifications used elsewhere in the same set of statements for components of OCI. D. Reporting Related Income Tax An entity may display components of other comprehensive income in two alternative ways. 1. Net-of-Tax Basis Each of the components of comprehensive income may be reported on a net-of-tax basis. 2. Summary Net-of-Tax Basis Each of the other comprehensive income items may be reported before tax, with one line reporting the tax provision of all of those elements. If this alternative is used, the tax provision for each individual item must be shown within the notes to the financial statements. 11-16 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 44 of 160 Financial Accounting & Reporting E. Updating Supplement Version 38.3 Format Options Comprehensive income must be displayed prominently within a financial statement in a full set of general-purpose financial statements. Comprehensive income must be shown on the face of one of the statements, not just in the notes to the financial statements. An entity may choose from several possible formats to report comprehensive income. 1. One-Statement Approach Since net income is a significant part of comprehensive income, the one-statement approach combines the statement of income and comprehensive income. The statement presents the various components of net income and then reports the elements of other comprehensive income. Although earnings per share may be shown for various income statement items, it is not required to be reported for comprehensive income. Exhibit 8 One-Statement Approach, With Tax Effect Shown Parenthetically ABC Company Statement of Income and Comprehensive Income For the year ended December 31, Year 1 Revenues Expenses Loss on sale of securities Income from Continuing Operations, before taxes Provision for taxes Income from Continuing Operations Discontinued Operations: Loss on operations of discontinued component Income taxes Loss on Discontinued Operations Income before Extraordinary Items Extraordinary Gain, net of tax Net Income Other Comprehensive Income: Foreign currency adjustments, net of tax of $6,000 Unrealized Loss on Marketable Securities: Unrealized holding loss arising during period, net of tax of $18,000 Less: reclassification adjustment, net of tax of $6,000, for loss included in net income Pension adjustment, net of tax of $4,000 Other Comprehensive Income Comprehensive Income 2. $ 450,000 (300,000) (20,000) 130,000 (54,000) 76,000 $(62,000) 7,000 (55,000) 21,000 18,000 39,000 9,000 $ (42,000) 14,000 (6,000) (25,000) $ 14,000 Two-Statement Approach The income statement and the statement of comprehensive income are separate statements in the two-statement format. The statement of comprehensive income begins with net income and then includes the other items of comprehensive income. Exhibit 9 Two-Statement Approach, With Tax Effect Shown as a Single Amount* ABC Company Statement of Income For the year ended December 31, Year 1 Revenues Expenses Loss on sale of securities Income from Continuing Operations, before taxes Provision for taxes Income from Continuing Operations 11-17 Copyright © 2009 by Bisk Education, Inc. All rights reserved. $ 450,000 (300,000) (20,000) 130,000 (54,000) 76,000 Page 45 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Discontinued Operations Loss on operations of discontinued segment Income Tax Loss on discontinued operations Income before Extraordinary Items Extraordinary Gain, net of tax Net Income $(62,000) 7,000 (55,000) $ 21,000 18,000 $ 39,000 ABC Company Statement of Comprehensive Income For the year ended December 31, Year 1 Net Income Other Comprehensive Income: Foreign currency adjustments Unrealized Loss on Marketable Securities: Unrealized holding loss arising during period Less: reclassification adjustment for loss included in net income Pension adjustment Other Comprehensive Income, before tax Income tax expense Other Comprehensive Income Comprehensive Income $ 39,000 $ 15,000 $ (60,000) 20,000 (10,000) (35,000) 10,000 (25,000) $ 14,000 * Tax effect reflected in notes 3. Statement-of-Changes-in-Equity Approach Comprehensive income may be reported on the statement of changes in equity. Exhibit 10 Statement-of-Changes-in-Equity Approach* ABC Company Statement of Changes in Equity For the year ended December 31, Year 1 Beginning balance Comprehensive income Net income Other comprehensive income, net of tax: Unrealized loss on marketable securities net of reclassification adjustment Foreign currency adjustment Pension adjustment Other comprehensive income Comprehensive income Common stock issued Dividends declared on common stock Ending balance Total $ 600,000 39,000 Comprehensive Income $ 39,000 (28,000) 39,000 (28,000) 9,000 (6,000) Retained Earnings $ 200,000 Accumulated Other Comprehensive Common Paid-in Capital Income Stock $ 165,000 $ 50,000 $ 185,000 9,000 (6,000) (25,000) $ 14,000 (25,000) 50,000 (20,000) $ 644,000 20,000 (20,000) $ 219,000 $ 140,000 30,000 $ 70,000 $ 215,000 * Net-of-tax presentation with tax amounts reflected in notes 11-18 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 46 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 V. Interim Financial Reporting A. Concepts Each interim period should be viewed as an integral part of an annual period and not as a separate, independent period. In order to maintain comparability between interim and annual financial statements, the principles and practices used to prepare the latest annual financial statements also should be used to prepare the interim statements. However, certain procedures applied to the annual statements may require modification at the interim reporting dates so that the results for the interim period may better relate to the results of operations for the annual period. At the end of each interim period, the company should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. This estimated effective tax rate should be used to provide for income taxes on a current year-to-date basis. The effective tax rate should reflect foreign tax rates, percentage depletion, and other available tax planning alternatives. 1. 2. B. Estimated Effective Tax Rate In arriving at the estimated full year tax rate, no effect should be included for the income tax related to significant unusual or extraordinary items that will be separately reported or reported net of their related income tax effects for the interim period or for the fiscal year. Nonordinary Items Unusual or infrequently occurring items (nonordinary items) should be included in determining interim period income, but should be excluded in determining the full year effective income tax rate. Continuing Operations 1. Revenues Revenues should be recognized as earned during an interim period on the same basis as followed for recognition of income for the full year. For example, revenues from long-term construction-type contracts accounted for under the percentage of completion method should be recognized in interim periods on the same basis as is followed for the full year. Losses from such contracts should be recognized in full during the interim period in which the existence of the losses becomes evident. 2. Product Costs Costs and expenses associated directly with products sold or services rendered for annual reporting purposes should be similarly treated for interim reporting purposes. Some exceptions are appropriate for valuing inventory at interim reporting dates. a. Inventory Estimation Some companies use estimated gross profit rates to estimate ending inventory and cost of goods sold during interim periods or use other methods different from those used at annual inventory dates. These companies should disclose the methods used at the interim date and any significant adjustments that result from reconciliation with the annual physical inventory. b. LIFO and Liquidation of Base Period Inventories Companies that use the LIFO method may encounter a liquidation of base period inventories at an interim date that is expected to be replaced by the end of the annual period. The inventory at the interim date should not give effect to the LIFO liquidation, and cost of sales for the interim reporting period should include the replacement cost of the liquidated LIFO base. c. Lower of Cost or Market The use of lower of cost or market may result in inventory losses that should not be deferred beyond the interim period in which the decline occurs. Recoveries of these losses in subsequent periods should be recognized as gains, but only to the extent of losses recognized in previous interim periods of the same fiscal year. Temporary market declines need not be recognized at the interim date since no loss is expected to be incurred in the fiscal year. d. Standard Costs Companies that use standard costs for valuing inventory at yearend should use the same procedures for valuing inventory at interim dates. Material and volume variances that are planned and expected to be absorbed by year-end 11-19 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 47 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 should be deferred until the end of the year. Unplanned variances should be reported in the interim period in the same manner as year-end variances. 3. Costs Other Than Product Costs Costs and expenses other than product costs should be charged to income in interim periods as incurred, or be allocated among interim periods based on an estimate of time expired, benefit received, or activity associated with the periods. Procedures adopted for assigning specific cost and expense items to an interim period should be consistent with the bases followed by the company in reporting results of operations at annual reporting dates. However, when a specific cost or expense item charged to expense for annual reporting purposes benefits more than one interim period, the cost or expense item may be allocated to those interim periods. a. b. No Arbitrary Assignment Arbitrary assignment of the amount of such costs to an interim period should not be made. c. 4. Not Identifiable to Specific Period Some costs and expenses incurred in an interim period, however, cannot be readily identified with the activities or benefits of other interim periods and should be charged to the interim period in which incurred. Gain & Loss Deferrals Gains and losses that arise in any interim period similar to those that would not be deferred at year-end should not be deferred to later interim periods within the same fiscal year. Allocation of Indirect Cost Examples The following examples may be helpful in applying the standards for allocation of costs and expenses not directly associated with revenues in interim financial statements. a. When a cost that is expensed for annual reporting purposes clearly benefits two or more interim periods (e.g., annual major repairs), each interim period should be charged for an appropriate portion of the annual cost by the use of accruals or deferrals. b. Property taxes (and similar costs such as insurance, interest, and rent) may be accrued or deferred at an annual reporting date to achieve a full year’s charge of taxes to costs and expenses. Similar procedures should be adopted at each interim reporting date to provide an appropriate cost in each period. c. Advertising costs may be deferred within a fiscal year if the benefits of an expenditure clearly extend beyond the interim period in which the expenditure is made. 5. Financial Statements Interim period financial statements should bear a reasonable portion of such year-end adjustments as inventory shrinkage, allowance for uncollectible accounts, and discretionary year-end bonuses. 6. Seasonal Variations Companies whose revenues and expenses are subject to material seasonal variations should disclose the seasonal nature of their activities, and consider supplementing their interim reports with information for twelve-month periods ended at the interim date for the current and preceding years. 7. Income Tax Provisions At the end of each interim period the company should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. That rate should be used in providing for income taxes on a current year-to-date basis. The effective tax rate should reflect anticipated investment tax credits, foreign tax rates, percentage depletion, capital gains rates, and other available tax planning alternatives. However, in arriving at this effective tax rate no effect should be included for the tax related to significant unusual or extraordinary items that will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year. a. The tax effects of losses that arise in the early portion of a fiscal year should be recognized only when the tax benefits are expected to be realized during the year or recognizable as a deferred tax asset at the end of the year. 11-20 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 48 of 160 Financial Accounting & Reporting b. Updating Supplement Version 38.3 The effect of a change in tax laws or rates on a deferred tax liability or asset shall not be apportioned among interim periods through an adjustment of the annual effective tax rate. The tax effect of a change in tax laws or rates on taxes payable or refundable for a prior year shall be recognized as of the enactment date of the change as tax expense (benefit) for the current year. C. Discontinued Operations & Extraordinary Items Extraordinary items and the gain or loss from disposal of a component of an entity and their related income tax effects should be included in the determination of net income for the interim period in which they occur. An item should be classified as extraordinary in the interim period if it is material in relation to annual net income. Extraordinary items and the gain or loss from discontinued operations should not be prorated among interim periods. D. Contingencies & Uncertainties Contingencies and other uncertainties that could be expected to affect the fairness of presentation of financial data at an interim date should be disclosed in interim reports in the same manner required for annual reports. Such disclosures should be repeated in interim and annual reports until the contingencies have been removed, resolved, or have become immaterial. E. Accounting Changes Each report of interim financial information should indicate any change in accounting principles or practices from those applied in (1) the comparable interim period of the prior annual period, (2) the preceding interim periods in the current annual period and (3) the prior annual report. Whenever possible, companies should adopt any accounting changes during the first interim period of a fiscal year. Changes in accounting principles and practices adopted after the first interim period in a fiscal year tend to obscure operating results and complicate disclosure of interim financial information. 1. 2. Change in Accounting Estimate The effect of a change in an accounting estimate, including a change in the estimated effective annual tax rate, should be accounted for in the period in which the change in estimate is made. No restatement of previously reported interim information should be made for changes in estimates, but the effect on earnings of a change in estimate made in a current interim period should be reported in the current and subsequent interim periods and continue to be reported in the interim financial information of the subsequent year for as many periods as necessary to avoid misleading comparisons. The disclosures related to changes in accounting estimate are also required. 3. F. Change in Accounting Principle Changes in an interim or annual accounting principle made in an interim period should be reported by retrospective application in the period in which the change is made. The required disclosures are also presented in this same period in which the change was made. Financial statements of subsequent periods need not repeat the required disclosures. Correction of an Error In determining materiality for the purpose of reporting the correction of an error, amounts should be related to the estimated income for the full fiscal year and also to the effect on the trend of earnings. Changes that are material with respect to an interim period but not material with respect to the estimated income for the full fiscal year or to the trend of earnings should be separately disclosed in the interim period. Minimum Disclosures Disclosure requirements apply to reporting summarized financial data to security holders of publicly traded companies. When summarized financial data are regularly reported on a quarterly basis, information with respect to the current quarter and the current year-to-date or the last-twelvemonths-to-date should be furnished together with comparable data for the preceding year. 1. Sales or gross revenues, provision for income taxes, extraordinary items, cumulative effect of a change in accounting principles, net income, and comprehensive income 2. Primary and fully diluted earnings per share data for each period presented 11-21 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 49 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 3. Seasonal revenue, costs or expenses 4. Significant changes in estimates or provisions for income taxes 5. Disposal of a segment of a business and extraordinary, unusual, or infrequently occurring items 6. Contingent items 7. Changes in accounting principles or estimates 8. Significant changes in financial position 9. Information about reportable operating segments, including revenues from external customers, intersegment revenues, a measure of segment profit or loss, material changes in total assets, a description of differences in segments or measurement of segment profit or loss, and a reconciliation of the total of segment profit or loss to consolidated income. VI. Operating Segments A. Management Approach Method General-purpose financial statements are required to include selected information reported on a single basis of segmentation using the management approach method. The management approach is based on the way that management organizes the segments within the enterprise for making operating decisions and assessing performance. The components are called operating segments. Consequently, the segments are evident from the structure of the enterprise’s internal organization, and financial statement preparers should be able to provide the required information in a costeffective and timely manner. 1. Objectives The objective is to provide information about an enterprise to help financial statement users better understand the enterprise’s performance, better assess its prospects for future net cash flows, and make more informed judgments about the enterprise as a whole. 2. Requirements An enterprise is required to report a measure of segment profit or loss, segment assets and certain related items, but not segment cash flow or segment liabilities. 3. Applicability This applies to public business enterprises; it does not apply to nonpublic enterprises or not-for-profit organizations. 4. Operating Segments Operating segments have three characteristics. Not every part of an entity is necessarily part of an operating segment. a. Revenue Producing An operating segment is a component of an enterprise with revenue producing (even if no revenue is yet earned) and expense incurring activities. b. Review by Decision Maker The operating results of an operating segment are regularly reviewed by the entity’s chief operating decision maker. c. Availability of Financial Information Discrete financial information is available for an operating segment. 5. Chief Operating Decision Maker The chief operating decision maker is identified by the function of allocating resources and assessing the performance of a segment, not necessarily by title. The chief operating decision maker may be, for example, the chief executive officer, the president, or the chief operating officer. It may be one person or it may be a group, such as the Chairman and the Board of Directors. 6. Segment Manager Generally, an operating segment has a segment manager directly accountable to the chief operating decision maker. The term segment manager is also identified by function, not necessarily by a specific title. The chief operating decision maker in 11-22 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 50 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 some cases may also be the segment manager for an operating segment. The same person may be a segment manager for more than one operating segment. 7. Reportable Segments Reportable segments include operating segments that exceed the quantitative thresholds. Operating segments that do not meet any of the quantitative thresholds may be considered reportable, and separately disclosed, if management believes information about the segment would be useful to readers of financial statements. A reportable segment may also result from aggregating two or more segments in accordance with the aggregation criteria. Exhibit 11 summarizes identifying reportable operating segments. An enterprise shall report separately information about an operating segment that meets any of the following quantitative thresholds: a. b. The absolute amount of its reported profit or loss is 10 percent or more of the greater, in absolute amount, of (1) the combined reported profit of all operating segments that did not report a loss or (2) the combined reported loss of all operating segments that did report a loss. c. B. Its reported revenue, including both sales to external customers and intersegment sales or transfers, is 10 percent or more of the combined revenue, internal and external, of all operating segments. Its assets are 10 percent or more of the combined assets of all operating segments. Aggregation Criteria Operating segments often exhibit similar long-term financial performance if they have similar economic characteristics. Two or more operating segments may be aggregated into a single operating segment if aggregation is consistent with the objective and basic principles of GAAP, if the segments have similar economic characteristics, and if the segments are similar in each of the following areas: 1. 2. The nature of the production processes 3. The type or class of customer for their products and services 4. The methods used to distribute their products or provide their services 5. C. The nature of the products and services The nature of the regulatory environment, if applicable; for example, banking, insurance, or public utilities Quantitative Thresholds 1. Segment Tests An enterprise is required to report separately information about an operating segment that meets any of the following quantitative thresholds: a. Revenue Test Its reported revenue is 10% or more of the combined revenue of all operating segments. Revenue includes both sales to external customers and intersegment sales or transfers. b. Profit (Loss) Test The absolute amount of its reported profit or loss is 10% or more of the greater, in absolute amount, of (1) (2) c. The combined reported profit of all operating segments that did not report a loss, or The combined reported loss of all operating segments that did report a loss. Assets Test Its assets are 10% or more of the combined assets of all operating segments. 11-23 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 51 of 160 Financial Accounting & Reporting Example 4 Updating Supplement Version 38.3 Quantitative Thresholds A, B, and C are operating segments of a public corporation. Pertinent information regarding sales, profit and loss, and assets of the three segments are given below. A B C Combined Elimination Sales: Unaffiliated Intersegment Total sales $ 800 40 $ 840 $ 20 500 $ 520 $ 40 $ 40 $ 860 540 $1,400 $(540) $(540) Profit(loss) $ 200 $ (300) $ 25 $ Assets $1,200 $ 150 $400 $1,750 (75) Consolidated $ 860 $ 860 $ (75) $ 1,750 Required: Determine which segments should be reported separately, based on the quantitative thresholds requirements. Solution: Revenue Test—10% of combined segment revenues equals $140 [10% × ($840 + $520 + $40)]; therefore, segments A and B meet the revenue requirement for segmental disclosure. Profit(loss) Test—The absolute amount of combined reported losses of all segments having losses exceed the combined profits of the profitable segments (i.e., $300 exceeds $225). The reported profit of segment A ($200), and the absolute amount of loss of segment B ($300) is 10% or more of the absolute amount of combined reported loss of all operating segments ($300); therefore, segments A and B meet this test. Assets Test—10% of combined assets equals $175 [10% × ($1,200 + $150 + $400]; therefore, segments A and C meet this test. All three segments meet at least one of the quantitative thresholds criteria for reportable segments; consequently, segmental disclosure should be reported for three segments. 2. Exceptions a. Combining Operating Segments An entity may combine information about operating segments not meeting the quantitative thresholds to produce a reportable segment only if the operating segments share a majority of the aggregation criteria. b. Minimum Reportable Segments If the total of external revenue reported by operating segments is less than 75% of total consolidated revenue, additional operating segments must be identified as reportable segments until at least 75% of total consolidated revenue is included in reportable segments. c. “All Other” Category Non-reportable business activities and operating segments are required to be combined and disclosed in an “all other” category separate from other reconciling items in the reconciliations. The revenue sources must be described. d. Management Judgment If management judges an operating segment to be of continuing significance even though it no longer meets the criteria for reportability, information about that segment should continue to be reported separately in the current period. e. Restatement of Prior-Period Information Information from prior periods presented for comparative purposes must be restated to reflect the newly reportable segment as a separate segment, unless it is impracticable to do so, such as when the information is not available and the cost to develop the information would be excessive. 11-24 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 52 of 160 Financial Accounting & Reporting f. Exhibit 11 Updating Supplement Version 38.3 Practical Limit Reached There may be a practical limit to the number of reportable segments beyond which information may become overly detailed. No precise limit is set, but generally an enterprise should consider whether this limit has been reached as the number of reportable segments increases above 10. Diagram for Identifying Reportable Operating Segments Identify operating segments based on management reporting system. Do some segments meet all aggregation criteria? Yes Aggregate segments if desired. No D o segments meet the quantitative thresholds? Yes No A ggregate segments if desired. Yes Do some segments meet a majority of the aggregation criteria? No D o reportable segments account for 75% of consolidated revenue? Yes No R eport additional segments if external revenue of all segments < 75% of consolidated revenue. These are reportable segments to be disclosed. A ggregate remaining into “all other” category. 11-25 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 53 of 160 Financial Accounting & Reporting D. Updating Supplement Version 38.3 Disclosures 1. General An enterprise must disclose the following general information. a. b. 2. Identification Factors Factors used to identify reportable segments, such as differences in products and services, geographic areas, or regulatory environments. Revenue Sources Types of products and services from which each reportable segment derives its revenues. Basis of Measurement a. Profit/Loss and Total Assets An enterprise shall report a measure of profit or loss and total assets for each reportable segment. These measures are generally based upon the measures as reported to, and used by, the chief operating decision maker, and may include revenues from external customers; revenues from transactions with other operating segments of the same enterprise; interest revenue; interest expense; depreciation, depletion, and amortization expense; unusual items; equity in the net income of investees accounted for by the equity method; income tax expense or benefit; extraordinary items; and significant other noncash items. b. Interest Revenue and Interest Expense An enterprise must report interest revenue separately from interest expense for each reportable segment unless a majority of the segment’s revenues are from interest. c. Investment in Equity Investees and Additions to Long-Lived Assets If the specified amounts are included in the determination of segment assets reviewed by the chief operating decision maker, the enterprise is required to disclose the amount of investment in equity method investees, and total expenditures for additions to longlived assets other than financial instruments, long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets. d. Explanation of Measurements An enterprise must provide an explanation of the measurements used, at a minimum: (1) The basis of accounting for any transactions between reportable segments (2) The nature of any differences between the measurements applied to the reportable segments and the consolidated statements (3) The nature of any changes from prior periods in the measurement methods used (4) The nature and effect of any asymmetrical allocations to segments. For example, an enterprise might allocate depreciation expense to a segment without allocating the related depreciable assets to that segment. 3. Reconciliations An enterprise is required to report reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items to corresponding enterprise amounts. All significant reconciling items must be separately identified and described. 4. Interim Period Reporting An enterprise is required to disclose information about each reportable segment in condensed financial statements of interim periods, including revenues from external customers, intersegment revenues, measures of segment profit or loss, material changes in total assets, descriptions of differences in measurement or segmentation, and a reconciliation of segments profit or loss to consolidated income. 5. Enterprise-Wide Disclosures If the following information is not provided as part of the segment information disclosed, it must also be disclosed. 11-26 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 54 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 a. Revenues from external customers for each product and service or group of similar products and services unless it is impracticable to do. b. Revenues from external customers based on geographic area, including domestic revenues and foreign revenue. c. Long-lived assets located in the enterprise’s country of domicile, and located in foreign countries. d. Information about major customers. Enterprises must disclose the total amount of revenues from each single customer that amounts to 10% or more of the enterprise’s revenues and identify the segment(s) reporting the revenues. The identity of the customer need not be disclosed. VII. Additional Reporting Issues A. Development Stage Enterprises An enterprise is in the development stage if “substantially all” of its efforts are devoted to establishing a new business and either principal operations have not begun or principal operations have begun, but revenue produced is insignificant. 1. Presentation Financial statements issued by a development stage enterprise should be presented in conformity with generally accepted accounting principles (GAAP) applicable to established operating enterprises. a. b. Generally accepted accounting principles that apply to established operating enterprises govern the recognition of revenue by a development stage enterprise and determine whether a cost incurred by a development stage enterprise is to be charged to expense when incurred or is to be capitalized or deferred. Accordingly, capitalization or deferral of costs shall be subject to the same assessment of recoverability that would be applicable in an established operating enterprise. Costs of start-up activities, including organization costs, should be expensed as incurred. c. 2. Special accounting practices that are based on a distinctive accounting for development stage enterprises are not acceptable. Financial reporting by a development stage enterprise differs from financial reporting for an established operating enterprise in regard only to the additional information. Required Statements The additional information to be included is as follows. a. Balance Sheet Cumulative net losses are reported as part of stockholders’ equity using terms such as “deficit accumulated during the development stage.” b. Income Statement Includes cumulative expenses and revenues from the inception of the development stage. Information on other comprehensive income, if any, may be combined with the income statement or presented separately. c. Statement of Cash Flows Includes cumulative amounts from date of inception. d. Statement of Stockholders’ Equity Includes the following from the date of inception: (1) (2) 3. Number of shares, warrants, etc., issued and date of issuance. Dollar amounts received for shares, etc., of each issuance. Noncash consideration received must be assigned a dollar value and must indicate the nature of the consideration and the valuation basis used. Disclosure Financial statements of a development stage enterprise should be identified as such and the nature of activities disclosed. 11-27 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 55 of 160 Financial Accounting & Reporting B. Updating Supplement Version 38.3 Related Party Disclosures Transactions between related parties include transactions among: (1) a parent company and its subsidiaries; (2) subsidiaries of a common parent; (3) an enterprise and its principal owners, management, or members of their immediate families; and (4) affiliates. 1. Examples Examples of related party transactions include a. b. Services received or furnished (e.g., accounting, management, engineering, and legal services) c. Use of property and equipment by lease or otherwise d. Borrowings, lendings, and guarantees e. Intercompany billings based on allocations of common costs f. 2. Sales, purchases, and transfers of realty and personal property Filings of consolidated tax returns Disclosures Financial statements should include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements (e.g., intercompany sales) is not required. The disclosures should include the following: a. The nature of the relationship(s) involved. b. A description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information necessary to an understanding of the effects of the transactions on the financial statements. c. The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period. d. Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement. 3. 4. C. Representations Transactions involving related parties cannot be presumed to be carried out on an arm’s length basis, as the requisite conditions of competitive, free-market dealings may not exist. Representations about transactions with related parties, if made, should not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm’s length transactions unless such representations can be substantiated. Control Relationships If the reporting enterprise and one or more other enterprises are under common ownership or management control and the existence of that control could result in operating results or financial position of the reporting enterprise significantly different from those that would have been obtained if the enterprises were autonomous, the nature of the control relationship should be disclosed even though there are no transactions between the enterprises. Subsequent Events Subsequent events are events or transactions that occur after the balance sheet date but before the financial statements are issued or are available to be issued. There are two types of subsequent events; (1) recognized and (2) nonrecognized. The following guidance is to be applied to the accounting for and disclosure of subsequent events not addressed in other generally accepted accounting principles (GAAP). 11-28 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 56 of 160 Financial Accounting & Reporting 1. Updating Supplement Version 38.3 Other GAAP If an event or transaction is within the scope of other applicable GAAP, then an entity shall follow the guidance in that applicable GAAP. The following are examples of other areas that have GAAP that prescribes the accounting and disclosures for specific subsequent events. Note this is not meant to be an exhaustive list. a. Accounting for uncertainty in income taxes b. Earnings per share c. Accounting for contingencies 2. Financial Statement Issuance Financial statements are considered issued when they are widely distributed to shareholders and other financial statement users for general use and reliance in a form or format that complies with GAAP. Financial statements are considered available to be issued when they are complete in form and format that complies with GAAP and all approvals necessary for issuance have been obtained. 3. Evaluation Period An entity that has a current expectation of widely distributing its financial statements to its shareholders and other financial statement users shall evaluate subsequent events through the date that the financial statements are issued. All other entities shall evaluate subsequent events through the date that the financial statements are available to be issued. 4. Recognized Subsequent Events An entity shall recognize in the financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. The following are examples of recognized subsequent events: a. b. 5. If the events that gave rise to litigation had taken place before the balance sheet date and that litigation is settled, after the balance sheet date but before the financial statements are issued or are available to be issued, for an amount different from the liability recorded in the accounts, then the settlement amount should be considered in estimating the amount of liability recognized in the financial statements at the balance sheet date. Subsequent events affecting the realization of assets, such as receivables and inventories or the settlement of estimated liabilities, should be recognized in the financial statements when those events represent the culmination of conditions that existed over a relatively long period of time. For example, a loss on an uncollectible trade account receivable as a result of a customer’s deteriorating financial condition leading to bankruptcy after the balance sheet date but before the financial statements are issued or are available to be issued ordinarily will be indicative of conditions existing at the balance sheet date. Thus, the effects of the customer’s bankruptcy filing shall be considered in determining the amount of uncollectible trade accounts receivable recognized in the financial statements at the balance sheet date. Nonrecognized Subsequent Events An entity shall not recognize subsequent events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after the balance sheet date but before financial statements are issued or are available to be issued. The following are examples of nonrecognized subsequent events: a. Sale of a bond or capital stock issued after the balance sheet date but before financial statements are issued or are available to be issued b. A business combination that occurs after the balance sheet date but before financial statements are issued or are available to be issued 11-29 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 57 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 c. d. Loss of plant or inventories as a result of fire or natural disaster that occurred after the balance sheet date but before financial statements are issued or are available to be issued e. Losses on receivables resulting from conditions (such as a customer’s major casualty) arising after the balance sheet date but before financial statements are issued or are available to be issued f. Changes in the fair value of assets or liabilities (financial or nonfinancial) or foreign exchange rates after the balance sheet date but before financial statements are issued or are available to be issued g. 6. Settlement of litigation when the event giving rise to the claim took place after the balance sheet date but before financial statements are issued or are available to be issued Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the balance sheet date but before financial statements are issued or are available to be issued. Disclosures a. Date through Which Subsequent Events Have Been Evaluated An entity shall disclose the date through which subsequent events have been evaluated, as well as whether that date is the date the financial statements were issued or the date the financial statements were available to be issued. b. Nonrecognized Subsequent Events Some nonrecognized subsequent events may be of such a nature that they must be disclosed to keep the financial statements from being misleading. For such events an entity shall disclose the nature of the event and an estimate of its financial effect or a statement that such an estimate cannot be made. An entity also shall consider supplementing the historical financial statements with pro forma financial data. c. Reissuance of Financial Statements An entity may need to reissue financial statements for some reason. After the original issuance of the financial statements, events or transactions may have occurred that require disclosure in the reissued financial statements to keep them from being misleading. An entity shall not recognize events occurring between the time the financial statements were issued or available to be issued and the time the financial statements were reissued unless the adjustment is required by GAAP or regulatory requirements. The entity shall disclose the date through which subsequent events have been evaluated in both the originally issued and reissued financial statements. __________________ 11-30 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 58 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Chapter 12: Pages 12-1 through 12-7. Change section III titled “Long-Term Construction Contracts (ARB 45)” to section I titled “Long-Term Constructions Contracts” and combine previous sections I and II titled “Alternative Revenue Recognition Methods” and “Revenue Recognition When Right of Return Exists (SFAS 48)”, respectively, to become section II titled ““Alternative Revenue Recognition Methods” which thus realigns the chapter as follows: I. Long-Term Construction Contracts .................................................................................................... 12-2 A. Recommendation .......................................................................................................................... 12-2 B. Percentage of Completion Method................................................................................................ 12-2 C. Completed Contract Method ......................................................................................................... 12-3 II. Alternative Revenue Recognition Methods ....................................................................................... 12-5 A. Installment ..................................................................................................................................... 12-5 B. Cost Recovery ............................................................................................................................... 12-6 C. Completion of Production .............................................................................................................. 12-7 D. When Right of Return Exists ......................................................................................................... 12-7 III. Consignments ....................................................................................................................................... 12-8 A. Overview........................................................................................................................................ 12-8 B. Computation .................................................................................................................................. 12-8 IV. Franchise Fee Income .......................................................................................................................... 12-8 A. Revenue ........................................................................................................................................ 12-8 B. Costs.............................................................................................................................................. 12-9 V. Royalties ................................................................................................................................................ 12-9 A. Accrual Basis................................................................................................................................. 12-9 B. Computation .................................................................................................................................. 12-9 I. Changing Prices.................................................................................................................................. 12-10 A. Optional ....................................................................................................................................... 12-10 B. Monetary & Nonmonetary Items.................................................................................................. 12-11 C. Presentation ................................................................................................................................ 12-12 D. Inventory and PP&E .................................................................................................................... 12-13 E. Recoverable Amount ................................................................................................................... 12-14 F. Change in Current Costs of Inventory and PP&E, Net of Inflation.............................................. 12-15 G. Income From Continuing Operations .......................................................................................... 12-15 H. Restatement of Current Cost Information Into Units of Constant Purchasing Power ................. 12-16 I. Purchasing Power Gain or Loss on Net Monetary Items ............................................................ 12-16 J. Holding Gains & Losses on Nonmonetary Assets ...................................................................... 12-17 Chapter 13: Pages 13-1. Delete section II title “SFAS 109 Overview” and rearrange the content of the first three sections into two sections titled “Basic Concepts” and “Differences”, respectively, as follows: I. Basic Concepts ..................................................................................................................................... 13-2 A. Pretax Financial Income ................................................................................................................ 13-2 B. Taxable Income ............................................................................................................................. 13-2 C. Objectives...................................................................................................................................... 13-2 D. Income Taxes Currently Payable (Refundable) ............................................................................ 13-2 E. Income Tax Expense (Benefit) ...................................................................................................... 13-3 F. Reconciliation of Pretax Financial Income & Taxable Income ...................................................... 13-4 II. Differences ............................................................................................................................................ 13-5 A. Temporary Differences .................................................................................................................. 13-5 B. Permanent Differences.................................................................................................................. 13-8 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 59 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Chapter 13: Page 13-2. Add section I.C titled “Objectives” as follows (renumber the sections that follow it): C. Objectives The objectives of accounting for income taxes are to recognize (a) the amount of taxes payable or refundable for the current year and (b) deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an enterprise’s financial statements or tax returns. To implement the objectives, the following basic principles are applied in accounting for income taxes at the date of the financial statements: 1. A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year. 2. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards. 3. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. 4. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized. Chapter 13: Pages 13-2 through 13-12. following: II. Replace section III (now section II) titled “Differences” with the Differences A. Temporary Differences A temporary difference is a difference between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount of the asset is recovered or the liability is settled. 1. Origin The tax consequences of most events recognized in the current year’s financial statements are included in determining income taxes currently payable. Because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenues, expenses, gains, and losses, differences arise between the following. a. The amount of taxable income and pretax financial income for a year b. The tax basis of assets or liabilities and their reported amounts in financial statements 2. Future Effects Because it is assumed that the reported amounts of assets and liabilities will be recovered and settled, respectively, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in a taxable or a deductible amount in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. 3. Taxable & Deductible Temporary Differences Temporary differences that will result in taxable amounts in future years when the related assets are recovered are often called taxable temporary differences. Likewise, temporary differences that will result in deductible amounts in future years when the related liabilities are settled are often called deductible temporary differences. 4. Recognition & Measurement The asset and liability method is required to be used in accounting and reporting for temporary differences. Under this method, a current or deferred tax liability or asset is recognized for the current or deferred tax consequences of all events that have been recognized in the financial statements, and the current or deferred tax consequences of an event are measured based on provisions of the enacted tax law to determine the amount of taxes payable or refundable currently or in future years. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 60 of 160 Financial Accounting & Reporting Example 5 Updating Supplement Version 38.3 Temporary Differences Pretax financial income for the current year for Zippy Corporation is $400,000, including revenue of $50,000, which will not be taxable until a future period. Deductible amounts of $30,000 on the current year tax return will be expensed on a future income statement. The tax rate is 40% for all years. There is no existing balance in any deferred tax account at the beginning of the year. Required: 1. 2. Compute taxable income for the year. Prepare the journal entry to record income taxes for the year. Solution: 1. Pretax financial income Excess of revenues over taxable amounts Excess of deductible amounts over expenses Taxable income $400,000 (50,000) (30,000) $320,000 2. Income Tax Expense—current Income Tax Expense—deferred Income Taxes Payable ($320,000 × 40%) Deferred Tax Liability [($50,000 + $30,000) × 40%] 128,000 32,000 128,000 32,000 Discussion: Because differences between pretax financial income and taxable income in the year do cause differences between pretax financial income and taxable income in some other period, there are deferred taxes to compute and record. The amount due to the government (income taxes payable) is based on the amount of taxable income. The deferred tax amount is computed in accordance with the asset and liability method. Under the liability method, the deferred tax consequences of the $80,000 ($50,000 + $30,000) future taxable amounts are calculated using enacted future tax rates (40%). The total income tax expense (provision) figure ($160,000) is the amount needed to balance the entry [current tax expense (provision) of $128,000 plus deferred tax expense (provision) of $32,000]. 5. Timing Sources Differences between taxable income and pretax financial income that result from including revenues, expenses, gains, or losses in taxable income of an earlier or later year than the year in which they are recognized in financial income (referred to as “timing differences”) create differences (sometimes accumulating over more than one year) between the tax basis of an asset or liability and its reported amount in the financial statements and, thus, are temporary differences. Example 6 Taxable After Being Included in Financial Income One example is the use of the accrual method for accounting for installment sales for computing financial income and the use of the installment (cash) method for tax purposes. This will cause an excess of the reported amount of an asset (receivable) over its tax basis that will result in a taxable amount in a future year(s) when the asset is recovered (when the cash is collected). This situation will result in future taxable amounts. Example 7 Deductible After Being Included in Financial Income Examples include accruals of items such as warranty expense and loss contingencies in computing financial income. Such items are deductible for tax purposes only when they are realized. This type of situation causes a reported amount of a liability to exceed its tax basis (zero) which will result in deductible amounts in a future year(s) when the liability is settled. This situation will result in future tax deductible amounts. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 61 of 160 Financial Accounting & Reporting Example 8 Updating Supplement Version 38.3 Taxable Before Being Included in Financial Income One example is accounting for revenue received in advance for rent or subscriptions. For tax purposes, the revenue is taxable in the period the related cash is received. The revenue is not included in the computation of financial income until the period in which it is earned. This situation causes a liability’s reported amount on the balance sheet to exceed its tax basis (zero) which will result in future tax deductible amounts when the liability is settled. This case is said to result in future tax deductible amounts because of the future sacrifices required to provide goods or services or to provide refunds to those who cancel their orders. This situation will result in future tax deductible amounts. Example 9 Deductible Before Being Included in Financial Income These situations result in future taxable amounts. Typically, temporary differences of this type accumulate and then eliminate over several years. Future temporary differences for existing depreciable assets (in use at the balance sheet date) are considered in determining the future years in which existing temporary differences result in net taxable or deductible amounts. a. b. Prepaid Expense One example is when a prepaid expense is deducted for tax purposes in the period it is paid, but deferred and deducted in the period the expense is incurred for purposes of computing financial (book) income. Depreciation Expense The most commonly cited example is where a depreciable asset is depreciated faster for tax purposes than it is depreciated for book purposes. This will cause the asset’s carrying amount to exceed its tax basis. Amounts received upon the future recovery of the asset’s carrying amount (through use or sale) will exceed its tax basis and the excess will be a taxable amount when the asset is recovered. Example 10 Multi-Year Temporary Differences An enterprise acquired a depreciable asset at the beginning of year 1. The asset has a cost of $60,000, no residual value, is being depreciated over six years using the straight-line method for financial reporting purposes, and is being depreciated over three years using the straight-line method and the one-half year convention for tax purposes. Year 1 2 3 4 5 6 Depreciation for financial reporting Depreciation for tax purposes Difference $ 10,000 $10,000 $ — 10,000 20,000 (10,000) 10,000 20,000 (10,000) 10,000 10,000 — 10,000 — 10,000 10,000 — 10,000 $ 60,000 $60,000 $ — Required: Determine the cumulative temporary difference at the end of each year and describe its impact on future tax returns. Solution: 1. At the end of year 1 there is no temporary difference. The carrying amount of the asset is $50,000 and its tax basis is $50,000 (i.e., $60,000 – $10,000). 2. At the end of year 2 the cumulative temporary difference is $10,000 and will result in a net future taxable amount of $10,000. This amount will reverse in year 5. 3. At the end of year 3 the cumulative temporary difference is $20,000 and will result in a net future taxable amount of $20,000. This amount will reverse equally in year 5 and year 6. 4. At the end of year 4 the cumulative temporary difference is $20,000 and will result in a net future taxable amount of $20,000. This amount will reverse equally in year 5 and year 6. 5. At the end of year 5 the cumulative temporary difference is $10,000 and will result in a future taxable amount of $10,000. This amount will reverse in year 6. 6. At the end of year 6 there is no more temporary difference because the asset is fully depreciated both for financial statements and tax purposes. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 62 of 160 Financial Accounting & Reporting 6. Updating Supplement Version 38.3 Other Sources Other situations that may cause temporary differences because of differences between the reported amount and the tax basis of an asset or liability. a. b. Investment Tax Credits Investment tax credits accounted for by the deferred method c. Currency Issues An increase in the tax basis of assets because of indexing whenever the local currency is the functional currency d. 7. Tax Credits A reduction in the tax basis of depreciable assets because of tax credits Business Combinations Business combinations accounted for by the acquisition method Not Linked to Particular Item Some temporary differences are deferred taxable income or tax deductions and have balances only on an income tax balance sheet and, therefore, cannot be identified with a particular asset or liability for financial reporting. There is no related, identifiable asset or liability for financial reporting, but there is a temporary difference that results from an event that has been recognized in the financial statements, and that difference will result in taxable or deductible amounts in future years. An example is a long-term contract that is accounted for by the percentage of completion method for financial reporting and by the completed contract method for tax purposes. The temporary difference (income on the contract) is deferred income for tax purposes that becomes taxable when the contract is completed. Exhibit 3 Temporary Differences REVENUES & GAINS INCLUDED FOR TAX FIRST INCLUDED IN FINANCIAL STATEMENT FIRST B. EXPENSES & LOSSES Future Deductible Amount Future Taxable Amount Future Taxable Amount Future Deductible Amount Permanent Differences Some events recognized in financial statements do not have tax consequences under the regular U.S. tax system. Certain revenues are exempt from taxation and certain expenses are not deductible. Events that do not have tax consequences do not give rise to temporary differences and, therefore, do not give rise to deferred tax assets or liabilities. These differences that will not have future tax consequences are often referred to as permanent differences. 1. Revenue Examples Permanent differences resulting from revenues that are included in the computation of financial income, but are not included in computing taxable income, include: (a) interest earned on state and municipal obligations; (b) life insurance proceeds received by an enterprise on one of its officers; and (c) dividends received by one U.S. corporation Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 63 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 from another U.S. corporation that are excluded from taxable income due to the dividendsreceived deduction (70%, 80%, or 100%). 2. Expense Examples Permanent differences resulting from expenses that are included in the computation of financial income, but are not included in computing taxable income, include: (a) expenses incurred in generating tax-exempt income; (b) premiums paid for life insurance on officers when the enterprise is the beneficiary; and (c) fines, penalties, and other costs incurred from activities that are a violation of the law. 3. Deduction Example An example of a permanent difference resulting from deductions that are allowed in computing taxable income but are not allowed in computing financial income is excess of percentage depletion (statutory allowance) over cost of natural resources. Example 11 Permanent Differences Pretax financial income for year 7 for Zippy Corporation is $300,000 including tax-exempt revenues of $40,000 and nondeductible expenses of $14,000. The tax rate for all years is 40%. Required: 1. Compute the amount of taxable income for year 7. 2. Prepare the journal entry to record income taxes for year 7. 3. Show a condensed income statement for year 7. Solution: 1. Pretax financial income Tax-exempt revenues Nondeductible expenses Taxable income 2. 3. $ 300,000 (40,000) 14,000 $ 274,000 Income Tax Expense—current Income Taxes Payable ($274,000 × 40%) Income before income taxes Current income tax expense Net income 109,600 109,600 $ 300,000 (109,600) $ 190,400 Discussion: Because differences between pretax financial income and taxable income in the year do not cause differences between pretax financial income and taxable income in any other period, there are no deferred taxes to compute and record. The amount due to the government is based on the amount of taxable income. Because there are no deferred taxes, the amount of income tax expense recorded is the same amount as income taxes payable. The effective tax rate ($109,600 / $300,000 = 36.53%) is less than the statutory rate due to an excess of taxexempt revenues ($40,000) over nondeductible expenses ($14,000). Example 12 Temporary & Permanent Differences Tigger Corporation has pretax financial income of $100,000 for year 1 (first year of operations). The following differences exist between pretax financial income and taxable income. 1. Interest on investments in tax-exempt securities amounts to $22,000. 2. Fines and violations of the law amount to $3,000. 3. An excess of accrued warranty expense over amounts paid to satisfy warranties during the year is $18,000. 4. An excess of installment sales revenue over the cash received is $31,000 (accrual basis used for financial reporting and cash basis used for tax return). 5. Premiums paid for life insurance on officers is $6,000. Tigger Corp. is the beneficiary. 6. Depreciation for books is $70,000, whereas depreciation using an accelerated method for tax purposes is $90,000. 7. Losses accrued for financial accounting purposes for litigation contingencies amounts to $16,000. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 64 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Required: a. Identify each difference between pretax financial income and taxable income as being either a permanent or temporary difference and reconcile pretax financial income with taxable income. b. Compute the net future taxable (deductible) amounts due to temporary differences existing at the end of the year. c. Assuming a tax rate for the current and future years of 40%, compute the amount of income taxes currently payable and the amount of deferred income taxes. Prepare the journal entry to record income taxes for the year. Solution a: Pretax financial income Permanent differences: Tax-exempt revenue [1] Nondeductible fines [2] Life insurance premiums [5] Temporary differences originating: Excess of warranty expense per books [3] Excess of installment revenue per books [4] Excess of depreciation per tax return [6] Excess of accrued losses per books [7] Taxable income $100,000 (22,000) 3,000 6,000 18,000 (31,000) (20,000) 16,000 $ 70,000 Solution b: Future warranty deductions [3] Future installment sale collections [4] Excess of book depreciation over tax depreciation in future [6] Future deductions for litigation [7] Net future taxable amounts $ (18,000) 31,000 20,000 (16,000) $ 17,000 Solution c: Taxable income Current tax rate Income taxes currently payable $70,000 × 40% $28,000 Net future taxable amounts Enacted future tax rate Deferred tax liability at 12/31 $17,000 × 40% $ 6,800 NOTE: Because there is a flat tax rate for all future years, deferred taxes may be computed by one aggregate calculation; the future taxable and deductible amounts that will result from the elimination of existing temporary differences need not be scheduled for the individual future years affected. NOTE: The temporary differences originating in the year that will cause future deductible amounts (accrual of warranty expense and loss contingency for book purposes) are added to pretax financial income to arrive at taxable income; temporary differences originating in the year that will cause future taxable amounts (installment sales method and accelerated depreciation for tax purposes) are deducted from pretax financial income to arrive at taxable income. Income Tax Expense—current Income Tax Expense—deferred Income Taxes Payable ($70,000 × 40%) Deferred Tax Liability ($6,800 – $0) 28,000 6,800 28,000 6,800 NOTE: The change required in the Deferred Tax Liability account is equal to its ending balance because there was a zero beginning balance. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 65 of 160 Financial Accounting & Reporting Exhibit 4 Updating Supplement Version 38.3 Summary of Temporary & Permanent Differences GAAP Financial Statements IRC Tax Return TEMP PERM NONE GROSS INCOME: Gross Sales Income Now Income Now Installment Sales Dividends Equity Method 100/80/70% Exclusion Rents & Royalties in Advance State & Muni Bond Interest Income Now Income (Later) When Rec’d Income-Sub Earnings No Exclusion Income When Earned Income Income is Dividends Excluded Forever Income When Received Never Income Life Insurance Proceeds Gain/Loss Treasury Stock Income Not Reported Never Income Not Reported Officers Compensation (Top) Expense $1,000,000 Limit Bad Debt Interest Expense Business Loan Allowance Direct Write Off Expense Expense Expense Expense All Expensed Expense Expense Non Deductible Up to Taxable Income Limit to 10% of Inc. Expense Expense ORDINARY EXPENSES: Tax Free Investment Taxable Investment Contributions Loss on Abandonment/Casualty Loss on Worthless Subsidiary Depreciation MACRS vs. S.L. Bonus Depreciation (179, etc.) Diff. Basis of Asset Purchased Goodwill Depletion % vs. S.L. % in Excess of Cost Life Insurance Exp. (Corp. Gets) Slow Depreciation Fast Depreciation Not Allowed, Must Depreciate 133k for 2009; adjusted for inflation. Use IRC Basis Amortize S/L 15 Yrs. Use GAAP Basis Gain/Loss; Tested each year for impairment Cost Over Years % of Sales Not Allowed % of Sales Expense No Deduction Profit & Pension Expense Expense Accrued No Deduction Until Paid Accrued Exp. (50% owner/family) Expense Accrued No Deduction Until Paid Net Capital Gain Income Income Research & Development Expense Exp. / Amortize / Capital. Report as Loss Not Deductible Carryover (3 Yrs. & 5 Yrs.) Not Applicable Unused Loss Allowed Shareholder Dealing Report as Loss Not Deductible Penalties Expense Not Deductible Est. Liab. Contingency/Warranty Expense-Accrued No Deduction Until Paid SPECIAL ITEMS: Net Capital Loss Federal Income Taxes Expense Not Deductible Bond Sinking Trust Fund Inc. / Exp. / Gain / Loss Inc. / Exp. / Gain / Loss Lobbying / Political Expense No Deduction Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 66 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Chapter 13: Page 13-13. Renumber previous sections IV.A.1 through 4 under the title “Recognition” to sections III.A.2 through 5 and add in a new section III.A.1 titled “Deferred Tax Liabilities & Assets” as follows: 1. Deferred Tax Liabilities & Assets Deferred tax liabilities or assets are recognized for the future tax consequences of the following: a. Temporary Differences Revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized in financial income and other events that create differences between the tax bases of assets and liabilities and their amounts for financial reporting. b. Operating Loss or Tax Credit Carrybacks For refunds of taxes paid in prior years and carryforwards to reduce taxes payable in future years. Accounting and reporting standards for the effects of operating losses and tax credit carrybacks and carryforwards require a comprehensive (as opposed to a partial) allocation approach. Chapter 16: Pages 16-1. Replace sections I titled “Translation of Foreign Currency Financial Statements” with the following two sections (renumbering the other sections): I. Functional Currency A. Introduction The financial statements of separate entities within an enterprise, which may exist and operate in different economic and currency environments, are consolidated and presented as though they were the financial statements of a single enterprise. Because it is not possible to combine, add, or subtract measurements expressed in different currencies, it is necessary to translate into a single reporting currency those assets, liabilities, revenues, expenses, gains, and losses that are measured or denominated in a foreign currency. Accordingly, the translation of the financial statements of each component entity of an enterprise should accomplish the following objectives: 1. 2. B. Provide Information Provide information that is generally compatible with the expected economic effects of a rate change on an enterprise's cash flows and equity. Reflect Financial Results and Relationships Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with U.S. generally accepted accounting principles. Measurement The assets, liabilities, and operations of a foreign entity should be measured in its functional currency. An entity’s functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash. An entity’s functional currency is basically a matter of fact. In some cases, however, the nature of a foreign entity’s operations is such that its functional currency is not clearly determinable. Example 1 Functional Currency Americana Inc., a U.S. company, owns 100% of the stock of Frenchie’s, a self-contained subsidiary incorporated in the United Kingdom. Frenchie’s records all its transactions in Pounds Sterling, even though the bulk of its operations are conducted in Germany (i.e., the Euro is the functional currency). In order to prepare its consolidated financial statements, Americana will first remeasure the Pound Sterling statements into Euros and then translate them into U.S. dollars. 1. Determining Functional Currency The functional currency of a foreign entity may be its local currency, the U.S. dollar, or another foreign currency. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 67 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 a. Local Currency Where a foreign operation is relatively self-contained (i.e., most activities are performed independently of the parent company) and integrated within one country, the entity’s functional currency will be the local currency. In this case, translation of financial statements from the functional currency into the parent’s reporting currency (e.g., the U.S. dollar) will be required. b. U.S. Dollar Where the foreign operation is, in essence, an extension of the parent’s U.S. operations (e.g., a sales branch that purchases all its inventory from the U.S. home office, in U.S. dollars), the functional currency will be the U.S. dollar. (1) If the foreign entity’s books are kept in the local currency, then remeasurement into U.S. dollars will be required. A gain or loss from remeasurement will be included in the foreign entity’s income from continuing operations. (2) If the foreign entity keeps its books in U.S. dollars, then its trial balance can be directly incorporated into the reporting entity’s financial statements. Transactions denominated in foreign currency will result in foreign currency gains and losses. The net gain (loss) will be the same as the remeasurement gain (loss). In other words, if the functional currency of the foreign entity is the U.S. dollar, the aggregate net gain or loss from exchange rate fluctuations will be the same whether the foreign entity keeps its books in the local currency or U.S. dollars. c. Another Foreign Currency A foreign entity may keep its books in the local currency (i.e., “recording currency”), yet have another foreign currency as functional currency. In this case, remeasuring of the recording currency statements into functional currency will be required. d. Consistency Once the functional currency for a foreign entity is determined, that determination shall be used consistently unless significant changes in economic facts and circumstances indicate clearly that the functional currency has changed. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 68 of 160 Financial Accounting & Reporting Exhibit 1 Updating Supplement Version 38.3 Functional Currency FUNCTIONAL CURRENCY ANOTHER FOREIGN CURRENCY LOCAL CURRENCY U.S. DOLLAR REMEASUREMENT INTO FUNCTIONAL CURRENCY TRANSLATION INTO U.S. $ FOREIGN ENTITY’S BOOKS KEPT IN U.S. $ FOREIGN CURRENCY GAIN OR LOSS IS RECORDED FOR ANY TRANSACTIONS DENOMINATED IN A FOREIGN CURRENCY TRANSLATION INTO U.S. $ FOREIGN ENTITY’S BOOKS KEPT IN LOCAL CURRENCY REMEASUREMENT INTO U.S. $ INCLUDE THE GAIN OR LOSS FROM REMEASUREMENT IN THE FOREIGN ENTITY’S BOOKS 2. C. Highly Inflationary Economies Where a foreign country’s cumulative inflation rate over the three-year period preceding the date of financial statements is approximately 100% or more, the local currency is not considered stable enough to be the functional currency. In this case, the reporting currency (e.g., the U.S. dollar) will be the functional currency, and remeasurement will be required. Economic Indicators The following economic factors should be considered both individually and collectively when determining functional currency. 1. Cash Flow Indicators a. Foreign Currency Cash flows related to the foreign entity’s individual assets and liabilities are primarily in the foreign currency and do not directly impact the parent company’s cash flows. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 69 of 160 Financial Accounting & Reporting b. 2. Updating Supplement Version 38.3 Parent’s Currency Cash flows related to the foreign entity’s individual assets and liabilities directly impact the parent’s cash flows on a current basis and are readily available for remittance to the parent company. Sales Price Indicators a. b. 3. Foreign Currency Sales prices for the foreign entity’s products are not primarily responsive on a short-term basis to changes in exchange rates but are determined more by local competition or local government regulation. Parent’s Currency Sales prices for the foreign entity’s products are primarily responsive on a short-term basis to changes in exchange rates; for example, sales prices are determined more by worldwide competition or by international prices. Sales Market Indicators a. b. 4. Foreign Currency There is an active local sales market for the foreign entity’s products, although there also might be significant amounts of exports. Parent’s Currency The sales market is mostly in the parent’s country or sales contracts are denominated in the parent’s currency. Expense Indicators a. b. 5. Foreign Currency Labor, materials, and other costs for the foreign entity’s products or services are primarily local costs, even though there also might be imports from other countries. Parent’s Currency Labor, materials, and other costs for the foreign entity’s products or services, on a continuing basis, are primarily costs for components obtained from the country in which the parent company is located. Financing Indicators a. b. 6. Foreign Currency Financing is primarily denominated in foreign currency, and funds generated by the foreign entity’s operations are sufficient to service existing and normally expected debt obligations. Parent’s Currency Financing is primarily from parent or other dollar-denominated obligations, or funds generated by the foreign entity’s operations are not sufficient to service existing and normally expected debt obligation without infusion of additional funds from the parent company. Infusion of additional funds from the parent company for expansion is not a factor, provided funds generated by the foreign entity’s expanded operations are expected to be sufficient to service that additional financing. Intercompany Transactions & Arrangements Indicators a. Foreign Currency There is a low volume of intercompany transactions, and there is not an extensive interrelationship between the operations of the foreign entity and the parent company. However, the foreign entity’s operations may rely on the parent’s or affiliates’ competitive advantages, such as patents and trademarks. b. Parent’s Currency There is a high volume of intercompany transactions and there is an extensive interrelationship between the operations of the foreign entity and the parent company. Additionally, the parent’s currency generally would be the functional currency if the foreign entity is a device or shell corporation for holding investments, obligations, intangible assets, etc., that could readily be carried on the parent’s or an affiliate’s books. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 70 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 II. Translation of Foreign Currency Statements A. Remeasurement Into Functional Currency 1. U.S. GAAP Prior to translation, the foreign currency statements must be conformed to U.S. GAAP and be measured in the functional currency of the foreign entity (otherwise, remeasurement into the functional currency is required). 2. Before Translation If an entity does not maintain its books in its functional currency, remeasuring into the functional currency is required prior to translation into the reporting currency (i.e., the U.S. dollar). If the functional currency is the same as the reporting currency, remeasurement will eliminate the need for translation (i.e., the statements will be remeasured into U.S. dollars, and thus no translation will be required). 3. Remeasurement Purpose The remeasuring process should achieve the same result as if the books had been initially recorded in the functional currency. a. This requires the remeasuring of certain accounts (nonmonetary items) at historical rates. All other accounts are remeasured at current rates. b. The remeasuring process will result in exchange gains and losses. The net gain or loss from remeasurement should be recognized in income from continuing operations for the current period. c. The following items should be remeasured at historical rates: (1) (2) Inventories carried at cost (3) Prepaid expenses such as insurance, advertising, and rent (4) Property, plant, and equipment (and its accumulated depreciation) (5) Patents, trademarks, licenses, formulas, goodwill, and other intangible assets (6) Common stock and preferred stock carried at issuance price (7) Example 2 Marketable securities carried at cost (equity securities and debt securities not intended to be held until maturity) Revenues and expenses related to nonmonetary items; for example: (a) Cost of goods sold; (b) Depreciation of property, plant, and equipment; and (c) Amortization of certain intangible items such as patents Remeasurement Into Functional Currency Figueras S.A. is a Spanish sales subsidiary formed on January 1 of the current year, and is 100 percent owned by Americana Inc. Management has determined that Figueras S.A. is, in fact, a foreign extension of Americana’s operations, and thus, its functional currency is the U.S. dollar. The following additional information is available. • • • • • No dividends were paid by Figueras S.A. during the year. Inventories are carried at weighted-average cost. Figueras’ office is located in a building purchased on May 5. Figueras’ trial balance (in Euros) is reproduced in column (1) of the trial balance. Exchange rate information for the year follows: January 1 May 5 December 31 Year’s Average 1 Euro Copyright © 2009 by Bisk Education, Inc. All rights reserved. = = = = $1.00 .98 .90 .95 Page 71 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Based on the preceding information, Figueras’ accounts have been remeasured as indicated in column (3) of the trial balance. The remeasured balance sheet and income statement are presented below. Trial Balance [Dr. (Cr.)] Assets Cash Inventory (w. avg. cost) Office building (net) Total assets (1) Euros 200,000 EUR 500,000 800,000 1,500,000 (2) Rate $ .90/EUR .95/EUR .98/EUR (3) U.S. Dollars $ 180,000 475,000 784,000 1,439,000 Liabilities Accounts payable Mortgage payable Total liabilities (300,000) (600,000) (900,000) $ .90/EUR .90/EUR (270,000) (540,000) (810,000) Equity Common stock Retained earnings Total equity (350,000) 0 (350,000) $1.00/EUR * (350,000) 0* (350,000) Operations Sales Cost of goods sold General and administrative Exchange gain (to balance) Total debits and credits (700,000) 350,000 100,000 -0 EUR $ .95/EUR .95/EUR .95/EUR (665,000) 332,500 95,000 (41,500) $ 0 * Because this was the first year of operations, the beginning RE balance is zero. Had the company been in operation for more than a year, the RE balance as remeasured at the end of the prior year would have been the amount entered in column (3). Remeasured Balance Sheet Assets Cash Inventory Office building, net $ 180,000 475,000 784,000 Liabilities Accounts payable Mortgage payable Equities Common stock Retained earnings Total assets $1,439,000 Total liabilities & equity $ 270,000 540,000 810,000 350,000 279,000* 629,000 $ 1,439,000 * Same as NI, since this was the first year of operations, and no dividends were paid. Remeasured Income Statement Sales Cost of goods sold General and administrative Exchange gain (from trial balance) Net income Copyright © 2009 by Bisk Education, Inc. All rights reserved. $ 665,000 (332,500) (95,000) 41,500 $ 279,000 Page 72 of 160 Financial Accounting & Reporting B. Updating Supplement Version 38.3 Computation 1. Rates Foreign currency financial statements should be translated by means of the following rates: a. All Assets and Liabilities Current exchange rate at the balance sheet date. b. Revenues and Expenses Conceptually, the exchange rate at the time the revenue or expense was recognized. However, due to the impracticability of this where rates change frequently, a weighted-average exchange rate for the period may be used. c. Contributed Capital Historical exchange rate. d. Retained Earnings The translated amount of retained earnings for the prior period (i.e., beginning retained earnings), plus (less) net income (loss) at the weightedaverage rate, less dividends declared during the period, at the exchange rate when declared. 2. Reporting Translation Adjustments Translation of foreign currency statements as indicated above will result in a translation adjustment. This translation adjustment is reported in other comprehensive income. It should not be included in the determination of net income. 3. Sale or Disposal of Investment in Foreign Entity The translation adjustments accumulated in other comprehensive income should be removed using a reclassification adjustment and reported as part of the gain or loss on the disposal of the investment. Example 3 Computation Americana Inc., a U.S. corporation, owns 100% of the outstanding common stock of Kaiser Ltd., a German company. Kaiser’s financial statements for the year ending December 31, year 1 are reproduced below. The statement amounts are in Euros (EUR). KAISER LTD. Balance Sheet December 31, Year 1 Assets Cash Accounts receivable Inventory Plant and equipment (net) Total assets 150,000 EUR 200,000 450,000 1,200,000 2,000,000 EUR Liabilities and Equity Accounts payable Notes payable Common stock Additional paid-in capital Retained earnings Total liabilities and equity 100,000 EUR 500,000 400,000 300,000 700,000 2,000,000 EUR KAISER LTD. Income Statement For the Year Ended December 31, Year 1 Sales Cost of goods sold Gross margin Operating expenses Net income Copyright © 2009 by Bisk Education, Inc. All rights reserved. 400,000 EUR (150,000) 250,000 (100,000) 150,000 EUR Page 73 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 The following information is also available: • • • • On August 31, Kaiser paid a 50,000 EUR dividend. Kaiser’s translated retained earnings as of January 1 was $600,000. The exchange rate when Americana acquired its investment in Kaiser was 1 EUR = U.S. $1. Exchange rate data for the year: January 1 August 31 December 31 Year’s average 1 EUR = $.95 1 EUR = .90 1 EUR = .80 1 EUR = .85 Required: Translate Kaiser’s financial statements. Solution: Assets Cash Accounts receivable Inventory Plant and equipment (net) Total assets Euros 150,000 EUR 200,000 450,000 1,200,000 2,000,000 EUR Liabilities and Equity Accounts payable Notes payable Common stock Additional paid-in capital Retained earnings* Translation adjustment (bal. fig.)** Total liabs. and equity 100,000 EUR 500,000 400,000 300,000 700,000 -2,000,000 EUR Balance Sheet Rate $ .80/EUR .80/EUR .80/EUR .80/EUR $ .80/EUR .80/EUR 1.00/EUR 1.00/EUR U.S. Dollars $ 120,000 160,000 360,000 960,000 $1,600,000 $ 80,000 400,000 400,000 300,000 682,500 (262,500) $1,600,000 * Translated retained earnings (RE) equals beginning RE as previously translated, plus net income at a weighted average rate, less dividends, at the rate in effect when declared. ** The translation adjustment is reported in other comprehensive income. Beginning RE (from information above) Net income (below) Dividends (50,000 EUR × $.90/EUR) Translated RE, Dec. 31 Sales Cost of goods sold Operating expenses Net income Euros 400,000 EUR (150,000) (100,000) 150,000 EUR Copyright © 2009 by Bisk Education, Inc. All rights reserved. $600,000 127,500 (45,000) $682,500 Income Statement Rate $ .85/EUR .85/EUR .85/EUR U.S. Dollars $340,000 (127,500) (85,000) $127,500 Page 74 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Chapter 17: Pages 17-1 through 17-25. Replace the entire text portion of the chapter titled “Consolidated Financial Statements” with the following: CHAPTER 17 CONSOLIDATED FINANCIAL STATEMENTS I. Introduction ........................................................................................................................................... 17-2 A. Purpose ......................................................................................................................................... 17-2 B. Chain of Interests........................................................................................................................... 17-2 C. Business Combinations ................................................................................................................. 17-2 II. Acquisition Method Application .......................................................................................................... 17-3 A. Indentifying the Acquirer................................................................................................................ 17-3 B. Determining the Acquisition Date .................................................................................................. 17-3 C. Recognition Principle..................................................................................................................... 17-3 D. Measurement Principle.................................................................................................................. 17-3 E. Recognizing and Measuring Goodwill or a Gain From a Bargain Purchase................................. 17-5 F. Additional Guidance ...................................................................................................................... 17-7 G. Disclosures .................................................................................................................................. 17-10 III. Subsequent Measurement and Accounting ..................................................................................... 17-11 A. General........................................................................................................................................ 17-11 B. Contingencies.............................................................................................................................. 17-11 C. Consolidation............................................................................................................................... 17-11 IV. Intercompany Transactions ............................................................................................................... 17-15 A. Intercompany Receivables, Payables & Loans........................................................................... 17-15 B. Intercompany Sales of Inventory................................................................................................. 17-15 C. Intercompany Sales of Fixed Assets ........................................................................................... 17-16 D. Intercompany Bonds.................................................................................................................... 17-17 V. Noncontrolling Interests .................................................................................................................... 17-22 A. Definition...................................................................................................................................... 17-22 B. Reporting ..................................................................................................................................... 17-22 C. Changes in a Parent’s Ownership Interest.................................................................................. 17-22 D. Disclosures .................................................................................................................................. 17-23 VI. Deconsolidation .................................................................................................................................. 17-23 A. Basis ............................................................................................................................................ 17-23 B. Recognition.................................................................................................................................. 17-23 C. Multiple Transactions................................................................................................................... 17-24 VII. Subsidiary Entity Records ................................................................................................................. 17-24 A. Traditional.................................................................................................................................... 17-24 B. Push-Down Accounting ............................................................................................................... 17-24 VIII. Combined Financial Statements ....................................................................................................... 17-25 A. Use .............................................................................................................................................. 17-25 B. Procedures .................................................................................................................................. 17-25 IX. Parent-Company Financial Statements ............................................................................................ 17-25 A. Use .............................................................................................................................................. 17-25 B. Procedures .................................................................................................................................. 17-25 17-1 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 75 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 CHAPTER 17 CONSOLIDATED FINANCIAL STATEMENTS I. Introduction A. Purpose The purpose of consolidated financial statements is to present the results of operations and the financial position of a parent company and all its subsidiaries as if the consolidated group were a single economic entity. Consolidated financial statements are considered more meaningful than separate financial statements and are usually necessary for a fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities. A controlling financial interest is usually ownership of a majority voting interest, generally ownership by one entity of more than 50 percent of the outstanding voting shares of another entity. All subsidiaries in which a parent has a controlling financial interest shall be consolidated. B. Chain of Interests On occasion, intercorporate stock ownership arrangements may indicate a chain of interests (e.g., A owns 80 percent of B, B owns 60 percent of C) the product of which (e.g., 80% × 60% = 48%) does not represent control of the lower level subsidiary. In this instance, the preparation of consolidated statements is warranted, notwithstanding the 48 percent indirect interest of A Company in C Company. The product of the percentages of stock ownership in the chain is not a determinant in establishing a minimal condition for preparation of consolidated financial statements. C. Business Combinations A business combination is a transaction or event in which an acquirer obtains control of one or more businesses. Control is defined as ownership of a majority voting interest; as a general rule ownership by one company, directly or indirectly, of over fifty percent of the outstanding voting shares of another company. Transactions sometimes referred to as “true mergers” or “mergers of equals” are also business combinations. 1. Identification An entity shall determine whether a transaction (or event) is a business combination by applying the definition above, which requires that the assets acquired and liabilities assumed constitute a business. a. b. 2. A business is defined as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. If not a business, the entity shall account for the transaction as an asset acquisition. Accounting An entity is required to account for each business combination by applying the acquisition method. The acquisition method was previously called the purchase method but has some changes to improve reporting. It applies to all business entities, including mutual entities that previously used the pooling-of-interests method of accounting for some business combinations. Applying the acquisition method requires: a. Indentifying the acquirer b. Determining the acquisition date c. Recognizing and measuring identifiable assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree d. Recognizing and measuring goodwill or a gain from a bargain purchase 17-2 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 76 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 II. Acquisition Method Application A. Indentifying the Acquirer The acquirer is the entity that obtains control of the acquiree. The acquirer is usually the entity that transfers cash or other assets, or incurs liabilities, or issues its equity interests. Other factors that may identify the acquirer are the larger size of the entities involved and the entity initiating the combination. B. Determining the Acquisition Date The acquisition date is the date on which the acquirer obtains control of the acquiree. Generally, the date on which the acquirer transfers the consideration, acquires the assets, and assumes the liabilities of the acquiree—the closing date. However, the acquirer might obtain control on a date before or after the closing date. C. Recognition Principle As of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. 1. Identifiable An asset is identifiable if it either: a. b. 2. Is capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged either individually or together with a related contract, identifiable asset, or liability, regardless of whether the entity intends to do so; or Arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. Qualifications To qualify as part of applying the acquisition method, the identifiable assets acquired and liabilities assumed must: a. Meet the definitions of assets and liabilities at the acquisition date. For example, costs the acquirer expects but is not obligated to incur in the future to effect its plan are not liabilities at the acquisition date; and b. Be part of what the acquirer and acquiree exchanged in the business combination transaction rather than the result of separate transactions. 3. 4. Classification The acquirer shall classify or designate the identifiable assets and liabilities as necessary to apply other GAAP. The acquirer shall make those classifications or designations on the basis of the contractual terms, economic conditions, its operating or accounting policies, and any other pertinent conditions as they exist at the acquisition date. 5. D. Previously Not Recognized The acquirer’s application of the recognition principle and conditions may result in some assets and liabilities that the acquiree had not previously recognized as assets or liabilities in its financial statements. For example, the acquirer recognizes the acquired intangible assets, such as brand name, a patent, or a customer relationship, that the acquiree did not recognize as assets in its financial statements because it developed them internally and charged the related costs to expense. Contingencies The acquirer shall recognize all the assets acquired and liabilities assumed that arise from contingencies related to contracts. For all other contingencies, the acquirer will assess whether it is more likely than not as of the acquisition date that the contingency gives rise to an asset or liability. If the criterion is met the acquirer will recognize the asset or liability at that date; if not met the acquirer will not recognize an asset or liability at that date Measurement Principle The acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values. 17-3 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 77 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 1. Assets with Uncertain Cash Flows (Valuation Allowances) The acquirer shall not recognize a separate valuation allowance because the effects of uncertainty about future cash flows are included in the fair value measure. For example, the acquirer is required to measure acquired receivables, including loans, at their acquisition-date fair value so the acquirer does not recognize a separate valuation allowance for the contractual cash flows that are deemed to be uncollectible at that date. 2. Assets Subject to Operating Leases in Which the Acquiree Is the Lessor The acquirer shall measure the acquisition-date fair value of an asset, such as a building or a patent or other intangible asset, that is subject to an operating lease in which the acquiree is the lessor separately from the lease contract. The acquirer separately recognizes and asset or a liability if the terms of the lease are favorable or unfavorable relative to market terms. 3. Assets That the Acquirer Intends Not to Use Fully For competitive or other reasons, the acquirer may intend not to use an acquired asset or may intend to use the asset in a way that is not its highest and best use. The acquirer must still measure the asset at fair value for its highest and best use, both initially and for purposes of subsequent impairment testing. 4. Measuring the Fair Value of a Noncontrolling Interest An acquirer will sometimes be able to measure the acquisition-date fair value of a noncontrolling interest on the basis of active market prices for the equity shares not held by the acquirer. In other situations an active market price for equity shares will not be available and the acquirer would use other valuation techniques. The fair values of the acquirer’s interest in the acquiree and the noncontrolling interest on a per-share basis might differ. The main difference is likely to be the inclusion of a control premium in the per-share fair value of the acquirer’s interest. Example 1 Noncontrolling Interest On January 1, year 1, Parent Inc., (P) acquired 80% of Subsidiary Corp.’s (S) 100,000 shares of outstanding stock for $800,000 cash. This was the first acquisition of any of S’s shares by P. Required: Determine the amount attributed to noncontrolling interest at the acquisition date for each of the following situations. a. The active market price of S’s shares on the acquisition date is $8.00 per share. b. The fair value of the noncontrolling interest was determined [given] to be $150,000. c. No active market price of S’s shares or fair value of the noncontrolling interest is provided. Solution: a. P acquired 80% of S’s 100,000 shares outstanding = 80,000 shares. With P owning 80,000 shares, that leaves 20,000 shares remaining for noncontrolling interests (100,000 – 80,000). The 20,000 shares × $8.00 active market price = $160,000 fair value attributed to the noncontrolling interest on the acquisition date. b. If the fair value of the noncontrolling interest is given, use it. There may have been some other viable valuation technique used to determine that fair value. In this case the $150,000 fair value provided would be attributed to the noncontrolling interest on the acquisition date. c. If no market price for S’s shares is provided and no fair value of the noncontrolling interest is given you must infer what the fair value of the noncontrolling interest is worth. P paid $800,000 for 80% of S’s 100,000 outstanding shares. By dividing $800,000 by 80% we can infer that the total (100%) fair value of S must be worth $1,000,000. The noncontrolling interest owns 20%; $1,000,000 × 20% = $200,000 fair value attributed to the noncontrolling interest on the acquisition date. 17-4 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 78 of 160 Financial Accounting & Reporting E. Updating Supplement Version 38.3 Recognizing and Measuring Goodwill or a Gain From a Bargain Purchase 1. Goodwill An asset representing future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. The requirement to measure the noncontrolling interest results in recognizing the goodwill attributable to the noncontrolling interest in addition to that attributable to the acquirer. The acquirer is allocated their portion first and then any remaining goodwill is attributed to the noncontrolling interest. a. Recognition Goodwill is recognized as of the acquisition date and measured as the excess of (a.(1)) over (a.(2)) below: (1) The aggregate of the consideration transferred plus the fair value of any noncontrolling interest plus, in a business combination achieved in stages, the acquisition-date fair value of the acquirer’s previously held equity interest. (2) The net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed. b. Equity Interests Only Exchanged In a business combination in which the acquirer and acquiree exchange only equity interests, the acquisition-date fair value of the acquiree’s equity interests may be more reliable than the acquisition-date fair value of the acquirer’s equity interests. If so, the acquirer shall determine the amount of goodwill by using the acquisition-date fair value of the acquiree’s equity interests instead of the acquisition-date fair value of the equity interests transferred. c. No Consideration Transferred In a business combination in which no consideration is transferred, the acquirer shall determine the amount of goodwill using the acquisition-date fair value of the acquirer’s interest in the acquiree determined using a valuation technique in place of the acquisition-date fair value of the consideration in (a.(1)) above. Example 2 Goodwill, 100% Acquisition On January 1, year 1, Parent Inc., (P) acquired all of Subsidiary Corp.’s (S) 100,000 shares of outstanding stock for $800,000 cash. This was the first acquisition of any of S’s shares by P. The net book value of S is $700,000. Required: Determine the total amount of goodwill recognized on the acquisition date for each of the following situations. a. The fair value of S’s assets and liabilities is equal to the book value. b. The fair value of S’s assets and liabilities is equal to the book value, except for land. Land is undervalued on the books by $50,000. Solution: a. The net book value of S is $700,000 and the fair value of the assets and liabilities is equal to the book value so the fair value of S is also worth $700,000. P acquired S for $800,000 cash; $800,000 cash – $700,000 fair value of S = $100,000 of total goodwill would be recognized on the acquisition date. b. The net book value of S is $700,000 and the fair value of the assets and liabilities is equal to the book value except for land, which is undervalued on the books by $50,000. Because the land is undervalued, it must first be written up to fair value before determining the amount of goodwill. The fair value of S is worth the $700,000 book value + $50,000 land = $750,000. P acquired S for $800,000 cash; $800,000 cash – $750,000 fair value of S = $50,000 of total goodwill would be recognized on the acquisition date. 17-5 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 79 of 160 Financial Accounting & Reporting Example 3 Updating Supplement Version 38.3 Goodwill with Noncontrolling Interest On January 1, year 1, Parent Inc., (P) acquired 80% of Subsidiary Corp.’s (S) 100,000 shares of outstanding stock for $750,000 cash. This was the first acquisition of any of S’s shares by P. The net book value of S is $700,000 and the fair value of S’s assets and liabilities is equal to the book value. The fair value of the noncontrolling interest is determined to be $150,000. Required: Determine the total amount of goodwill and the amount attributed to both P and the noncontrolling interest recognized on the acquisition date. Solution: The net book value of S is $700,000 and the fair value of the assets and liabilities is equal to the book value so the fair value of S is also worth $700,000. P acquired S for $750,000 cash and the fair value of the noncontrolling interest is $150,000. The $750,000 cash + $150,000 fair value of noncontrolling interest – $700,000 fair value of S = $200,000 of total goodwill recognized on the acquisition date. The goodwill is allocated to P and the noncontrolling interest as follows: Fair value of P’s 80% interest Less: Fair value of P’s share of S’s fair value ($700,000 × 80%) P’s share of goodwill $ 750,000 (560,000) $ 190,000 Total goodwill Less: P’s share of goodwill Noncontrolling interest share of goodwill $ 200,000 (190,000) $ 10,000 Note: The total goodwill is first applied to the controlling interest (P). If in this example there was only $150,000 of goodwill it all would be allocated to the controlling interest. The goodwill is not apportioned according to the ratio of ownership. For example, the controlling interest does not get 80% of $200,000, or just $160,000, and the noncontrolling interest is not allocated 20% of $200,000, or the other $40,000. 2. Bargain Purchase A business combination in which the amount in item (E.1.a.(2)) above exceeds the amount in item (E.1.a.(1)) above. a. Recognition If the excess remains after reassessing all assets and liabilities and reviewing the procedures used to measure their amounts, the acquirer shall recognize the resulting gain in earnings on the acquisition date. The gain shall be attributed to the acquirer. b. Review Before recognizing a gain on a bargain purchase, the acquirer shall reassess whether it has correctly identified all of the assets acquired and all of the liabilities assumed and shall recognize any additional assets or liabilities that are identified in that review. The acquirer shall then review the procedures used to measure the amount s required to be recognized at the acquisition date for all of the following: (1) The identifiable assets acquired and liabilities assumed (2) The noncontrolling interest in the acquiree, if any (3) For a business combination achieved in stages, the acquirer’s previously held interest in the acquiree (4) The consideration transferred. 17-6 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 80 of 160 Financial Accounting & Reporting Example 4 Updating Supplement Version 38.3 Bargain Purchase with Noncontrolling Interest On January 1, year 1, Parent Inc., (P) acquired 80% of Subsidiary Corp.’s (S) 100,000 shares of outstanding stock for $500,000 cash. This was the first acquisition of any of S’s shares by P. The net book value of S is $700,000 and the fair value of S’s assets and liabilities is equal to the book value. The fair value of the noncontrolling interest is determined to be $150,000. Required: Determine the total amount of the bargain purchase and the amount attributed to both P and the noncontrolling interest recognized on the acquisition date. Solution: The net book value of S is $700,000 and the fair value of the assets and liabilities is equal to the book value so the fair value of S is also worth $700,000. P acquired S for $500,000 cash and the fair value of the noncontrolling interest is $150,000. The $500,000 cash + $150,000 fair value of noncontrolling interest – $700,000 fair value of S = $50,000 of bargain purchase recognized on the acquisition date. The entire gain in a bargain purchase is attributed to the acquirer. Thus P recognizes a $50,000 gain and the noncontrolling interest doesn’t have any. 3. Consideration Transferred The consideration transferred in a business combination shall be measured at fair value, which shall be calculated as the sum of the acquisition-date fair values of the assets transferred by the acquirer, the liabilities acquired by the acquirer to former owners of the acquiree, and the equity interests issued by the acquirer. a. Examples Potential forms of consideration include cash, other assets, a business or a subsidiary of the acquirer, contingent consideration, common or preferred equity instruments, options, warrants, and member interests of mutual entities. b. Differences The consideration transferred may include assets or liabilities of the acquirer that have carrying amounts that differ from their fair values at the acquisition date. If so, the acquirer shall remeasure the transferred assets or liabilities to their fair values as of the acquisition date and recognize the resulting gains and losses, if any, in earnings. If the transferred assets or liabilities remain within the combined entity after the business combination the acquirer retains control of them. In that case, the acquirer shall measure those assets and liabilities at their carrying amounts immediately before the acquisition date and shall not recognize any gain or loss. c. Contingent Consideration The consideration the acquirer transfers in exchange for the acquiree includes any asset or liability resulting from a contingent consideration arrangement. The acquirer shall recognize the acquisition-date fair value of contingent consideration as part of the consideration transferred in exchange for the acquiree. (1) (2) F. The acquirer shall classify an obligation to pay contingent consideration as a liability or as equity in accordance with applicable GAAP. The acquirer shall classify as an asset a right to the return of previously transferred consideration if specified conditions are met. Additional Guidance 1. Business Combination Achieved in Stages When an acquirer obtains control of an acquiree in which it previously held an equity interest immediately before the acquisition date it is call a business combination achieved in stages. This is sometimes also referred to as a step acquisition. a. Noncontrolling Interest The acquisition method requires the acquirer to recognize the identifiable assets and liabilities, as well as the noncontrolling interest in the acquiree, at the full amounts of their fair values. 17-7 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 81 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 b. c. 2. Remeasurement The acquirer shall remeasure its previously held equity interest in the acquiree at its acquisition-date fair value and recognize the resulting gain or loss, if any, in earnings. Other Comprehensive Income (OCI) In prior reporting periods, the acquirer may have recognized changes in the value of its equity interest in the acquiree in other comprehensive income (OCI). If so, the amount recognized in OCI shall be reclassified and included in the calculation of gain or loss as of the acquisition date. Business Combination Achieved Without the Transfer of Consideration An acquirer sometimes obtains control of an acquiree without transferring consideration. a. Circumstances Such circumstances include: (1) (2) 3. Minority veto rights lapse that previously kept the acquirer from controlling an acquiree in which the acquirer held the majority voting interest. (3) b. The acquiree repurchases a sufficient number of its own shares for an existing investor, the acquirer, to obtain control. The acquirer and acquiree agree to combine businesses by contract alone. The acquirer transfers no consideration in exchange for control of an acquiree and holds no equity interests in the acquiree, either on the acquisition date or previously. Achieved by Contract Alone The acquirer shall attribute to the equity holders of the acquiree the amount of the acquiree’s net assets recognized. In other words, the equity interests in the acquirer’s held by parties other than the acquirer are a noncontrolling interest in the acquirer’s postcombination financial statements even if the result is that all of the equity interests in the acquiree are attributed to the noncontrolling interest. Measurement Period If the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the acquirer shall report provisional amounts for the items for which the accounting is incomplete. The measurement period is the period after the acquisition date during which the acquirer may adjust the provisional amounts recognized for a business combination. a. Purpose Provides the acquirer with a reasonable time period to obtain the information necessary to identify and measure the following as of the acquisition date: (1) (2) In a business combination achieved in stages, the equity interest in the acquiree previously held by the acquirer (4) c. The consideration transferred for the acquiree (or the other amount used in measuring goodwill) (3) b. The identifiable assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree The resulting goodwill recognized or the gain on a bargain purchase recognized Adjustments The acquirer shall retrospectively adjust the provisional amounts recognized at the acquisition date to reflect new information obtained about facts and circumstances that existed as of the acquisition date that, if known, would have affected the amounts recognized as of that date. Additional Assets or Liabilities The acquirer also shall recognize additional assets and liabilities if new information is obtained about facts and circumstances that existed 17-8 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 82 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 as of the acquisition date that, if known, would have resulted in the recognition of those assets and liabilities as of that date. d. e. Term The measurement period ends when the acquirer receives the information it was seeking about facts and circumstances that existed as of the acquisition date or learns that more information is not obtainable, however, it shall not exceed one year from the acquisition date. f. 4. Recognition The acquirer recognizes an increase (decrease) in the provisional amount recognized for an identifiable asset (liability) by means of a decrease (increase) in goodwill. The acquirer shall recognize any adjustments to the provisional amounts as if the accounting for the business combination had been completed at the acquisition date. Post Period After the measurement period ends, the acquirer shall not revise the accounting for the business combination but to correct an error. Determining What is Part of the Business Combination Transaction The acquirer and the acquiree may have a preexisting relationship or other arrangement before negotiations for the business combination began, or they may enter into an arrangement during the negotiations that is separate from the business combination. a. Identification The acquirer shall identify any amounts that are not part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination, that is, the amounts that are not part of the exchange for the acquiree. b. Recognition The acquirer shall recognize as part of applying the acquisition method only the consideration transferred for the acquiree and the assets acquired and liabilities assumed in the exchange for the acquiree. c. Separate Transactions A transaction entered into by or on behalf of the acquirer primarily for the benefit of acquirer or the combined entity, rather than primarily for the benefit of the acquiree (or its former owners) before the combination, is likely to be a separate transaction. The following are examples of separate transactions that are not to be included in applying the acquisition method: (1) (2) A transaction that compensates employees or former employees of the acquiree for future services (3) 5. A transaction that in effect settles preexisting relationships between the acquirer and acquiree A transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition related costs. Acquisition-Related Costs Acquisition related costs are those costs the acquirer incurs to effect a business combination. Those costs shall include finders fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. a. Recognition The acquirer shall account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. b. Exception The costs to issue debt or equity securities shall be recognized in accordance with other applicable GAAP. 17-9 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 83 of 160 Financial Accounting & Reporting 6. G. Updating Supplement Version 38.3 Income Taxes The acquirer shall recognize, as an adjustment to income tax expense in income from continuing operations (or if appropriate a direct adjustment to contributed capital), changes in the valuation allowance for acquired deferred tax assets. The acquirer shall recognize changes in the acquired tax positions in accordance with GAAP authoritative guidance on accounting for income taxes. Disclosures The notes to the financial statements of a combined entity in the period in which a material business combination is completed should include, at a minimum, the following information: 1. The name and description of the acquiree, the acquisition date, and the percentage of voting equity interests acquired 2. The primary reasons for the business combination and a description of how the acquirer obtained control of the acquiree 3. The acquisition-date fair value of the total consideration transferred and the acquisition-date fair value of each major class of consideration 4. The amounts recognized as of the acquisition date for each major class of assets acquired and liabilities assumed 5. The amounts recognized, the nature of recognized and unrecognized contingencies, and an estimate of the range of outcomes for assets and liabilities arising from contingencies 6. The amount recognized, a description and basis of determination, and an estimate of the range of outcomes for contingent consideration arrangements and indemnification assets 7. Transactions that are recognized separately from the acquisition of assets and assumptions of liabilities in the business combination 8. A qualitative description of the factors that make up the goodwill recognized and the total amount of goodwill that is expected to be deductible for tax purposes 9. In a bargain purchase: a. b. 10. The amount of any gain recognized in a bargain purchase and the line item in the income statement in which the gain is recognized A description of the reasons why the transaction resulted in a gain For each business combination in which the acquirer holds less than 100 percent of the equity interests in the acquiree: a. b. 11. The fair value of the noncontrolling interest in the acquiree at the acquisition date The valuation techniques(s) and significant inputs used to measure the fair value of the noncontrolling interest In a business combination achieved in stages: a. The acquisition-date fair value of the equity interest in the acquiree held by the acquirer immediately before the acquisition date b. The amount of any gain or loss recognized as a result of remeasuring to fair value the equity interest in the acquiree held by the acquirer before the business combination and the line item in the income statement in which that gain or loss is recognized. 17-10 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 84 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 III. Subsequent Measurement and Accounting A. General An acquirer shall subsequently measure and account for assets acquired, liabilities assumed or incurred, and equity instruments issued in a business combination in accordance with other applicable GAAP for those items, depending on their nature. B. Contingencies The acquisition method requires that an acquirer continue to report an asset or a liability arising from a contingency absent any new information about the outcome of the contingency. When new information is obtained it is evaluated and measures a liability at the higher of its acquisition-date fair value or the amount that would be recognized if applying other applicable GAAP guidance on contingencies, and measures an asset at the lower of its acquisition-date fair value or the best estimate of its future settlement amount. C. Consolidation Subsequent to a business combination, the newly affiliated companies continue to maintain their separate accounting records. Consolidated financial statements are required when a company owns more than 50% of the voting stock of another firm, with few exceptions. Exhibit 1 Accounting for Investments 0% 20% COST 100% 50% E Q U IT Y D O N O T C O N S O L ID A T E PURCH ASE C O N S O L ID A T E 1. Exceptions A majority-owned entity shall not be consolidated if control is temporary or does not rest with the majority owner. For example, if the entity is in legal reorganization or in bankruptcy or operates under foreign exchange restrictions, controls, or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent’s ability to control the entity. 2. Policy All subsidiaries—that is, all entities in which a parent has a controlling financial interest—shall be consolidated. A difference in fiscal periods of a periods of a parent and subsidiary does not justify the exclusion of the subsidiary from consolidation. Consolidation procedures must be performed every period in which financial statements are presented. Consolidated financial statements shall disclose the consolidation policy that is being followed. In most cases this is made apparent by the headings or other information in the financial statements, but in some cases a footnote is required. 3. Procedures When a subsidiary is initially consolidated during the year, the consolidated financial statements shall include the subsidiary’s revenues, expenses, gains and losses only from the date the subsidiary is initially consolidated. In the preparation of consolidated financial statements, intercompany balances and transactions shall be eliminated. The eliminations and adjustments made as part of the consolidation procedures are not entered into the books of any of the companies; these are simply worksheet entries that are never formally journalized. Consolidation procedures involve the following. a. Eliminate Capital and Investment Accounts Entries to eliminate the subsidiary’s capital accounts (except for noncontrolling interest, if any), and the parent’s investment account. Any shares of the parent held by a subsidiary shall not be treated as outstanding shares and, therefore, shall be eliminated in the consolidated financial statements and reflected as treasury shares. 17-11 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 85 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 b. c. Example 5 Eliminate Intercompany Balances This includes intercompany open account balances, security holdings, sales and purchases, interest, dividends, etc. Eliminate Intercompany Transactions Consolidated financial statements should not include gain or loss on transactions among entities in the consolidated group. Accordingly, any intercompany income or loss on assets remaining within the group shall be eliminated. If income taxes have been paid on intercompany profits on assets remaining within the consolidated group, those taxes shall be deferred or the intercompany profits to be eliminated in consolidation shall be appropriately reduced. 100% Acquisition The December 31, year 3, trial balances of Parent Inc., (P) and Subsidiary Corporation (S) are reproduced in the first two columns of the worksheet solution. P acquired its 100% interest in the common stock of S on January 1, year 3, for $120,000 cash. At the time of acquisition, S had assets with a book value of $110,000 and liabilities with a book value $15,000. The recorded amounts of all assets and liabilities of S were deemed to approximate their FV, except land, which was undervalued by $25,000 in S’s books. S had $20,000 of net income for the year and as of December 31 P had not recorded any portion of S’s net income. Required: Provide elimination entries to consolidate the financial statements of P and S. Solution: Three steps are recommended before attempting to complete the consolidation worksheet. Step 1: Determine the fair value of S at the time of the 100% stock acquisition by P. BV of assets assumed – BV of liabilities acquired +/– fair value adjustments = FV of S at acquisition $110,000 – $15,000 = BV of S $ 95,000 Fair value adjustments 25,000 FV of S, January 1, year 3 $ 120,000 Step 2: Determine amount of noncontrolling interests (NCI), if any. P acquired 100% interest so there is no NCI. $ 0 Step 3: Determine amount of goodwill or bargain purchase, if any. Purchase price Plus: FV of NCI (Step 2) Less: FV of S (Step 1) Goodwill Consolidation Worksheet, 100% Ownership Current assets Land Investment in S Liabilities C/S, $1 par (P) R/E, Dec. 31, yr 3 (P) C/S, $2 par (S) R/E, Dec 31, yr 3 (S) Trial Balance Dr. (Cr.) P S 50,000 20,000 200,000 105,000 120,000 Eliminations Dr. Cr. $ 120,000 0 (120,000) $ 0 Controlling R/E Dr. (Cr.) [1] 25,000 [2] 20,000 [1] 25,000 [3] 115,000 (70,000) (10,000) (100,000) (200,000) [2] 20,000 (20,000) [3] 20,000 (95,000) [3] 95,000 0 0 160,000 160,000 Consolidated R/E Consolidated Balance Sheet Dr. Cr. 70,000 330,000 80,000 100,000 (220,000) (220,000) 400,000 220,000 400,000 Worksheet entries: [1] To write land up to FV at time of acquisition. [2] To record net income of S accruing to P (100%). [3] To eliminate 100% of S capital account balances. 17-12 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 86 of 160 Financial Accounting & Reporting Example 6 Updating Supplement Version 38.3 100% Acquisition With Goodwill Same scenario as Example 5, except P acquired 100% interest in the common stock of S for $150,000 cash. Required: Provide elimination entries to consolidate the financial statements of P and S. Solution: Three steps are recommended before attempting to complete the consolidation worksheet. Step 1: Determine the fair value of S at the time of the 100% stock acquisition by P. BV of assets assumed – BV of liabilities acquired +/– fair value adjustments = FV of S at acquisition $110,000 – $15,000 = BV of S $ 95,000 Fair value adjustments 25,000 FV of S, January 1, year 3 $ 120,000 Step 2: Determine amount of noncontrolling interests (NCI), if any. P acquired 100% interest so there is no NCI. $ 0 Step 3: Determine amount of goodwill or bargain purchase, if any. Purchase price Plus: FV of NCI (Step 2) Less: FV of S (Step 1) Goodwill $ 150,000 0 (120,000) $ 30,000 Consolidation Worksheet, 100% Ownership Trial Balance Dr. (Cr.) P S Current assets Land Investment in S 50,000 200,000 150,000 20,000 105,000 Goodwill Liabilities C/S, $1 par (P) R/E, Dec. 31, yr 3 (P) C/S, $2 par (S) R/E, Dec 31, yr 3 (S) (70,000) (100,000) (230,000) 0 Eliminations Dr. Cr. Controlling R/E Dr. (Cr.) Consolidated Balance Sheet Dr. Cr. 70,000 330,000 [1] 25,000 [3] 20,000 [1] 25,000 [2] 30,000 [4] 115,000 [2] 30,000 30,000 (10,000) 80,000 100,000 [3] (20,000) [4] 20,000 (95,000) [4] 95,000 0 190,000 20,000 (250,000) 190,000 Consolidated R/E (250,000) 430,000 250,000 430,000 Worksheet entries: [1] To write land up to FV at time of acquisition. [2] To record the goodwill at time of acquisition. [3] To record net income of S accruing to P (100%). [4] To eliminate 100% of S capital account balances. 17-13 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 87 of 160 Financial Accounting & Reporting Example 7 Updating Supplement Version 38.3 80% Acquisition Same scenario as Example 5, except P acquired only 80% interest in S for $96,000 cash. Required: Provide elimination entries to consolidate the financial statements of P and S. Solution: Three steps are recommended before attempting to complete the consolidation worksheet. Step 1: Determine the fair value of S at the time of the 100% stock acquisition by P. BV of assets assumed – BV of liabilities acquired +/– fair value adjustments = FV of S at acquisition $110,000 – $15,000 = BV of S $ 95,000 Fair value adjustments 25,000 FV of S, January 1, year 3 $ 120,000 Step 2: Determine amount of noncontrolling interests (NCI), if any. Because no fair value of NCI was given, you must infer what the fair value would be based upon the price paid by P. 80% of X = $96,000; X = $96,000 / 0.80 = $120,000 $ 120,000 Times: NCI of 20% 0.20 Fair value of NCI $ 24,000 Step 3: Determine amount of goodwill or bargain purchase, if any. Purchase price Plus: FV of NCI (Step 2) Less: FV of S (Step 1) Goodwill $ 96,000 24,000 (120,000) $ 0 Consolidation Worksheet, 80% Ownership Trial Balance Dr. (Cr.) Current assets Land Investment in S Liabilities C/S, $1 par (P) R/E, Dec. 31, yr 3 (P) C/S, $2 par (S) R/E, Dec 31, yr 3 (S) NCI P 50,000 200,000 96,000 (70,000) (100,000) (176,000) Eliminations S Dr. Cr. 20,000 105,000 [1] 25,000 [2] 16,000 [1] 20,000 [3] 92,000 Noncontroll ing Interest Controlling R/E Dr. (Cr.) Dr. (Cr.) Consolidated Balance Sheet Dr. 70,000 330,000 (10,000) Cr. 80,000 100,000 [2] 16,000 (192,000) (20,000) [3] 20,000 (95,000) [3] 95,000 0 0 [1] 5,000 [3] 4,000 [3] 19,000 156,000 156,000 NCI Consolidated R/E (5,000) (4,000) (19,000) (28,000) (192,000) 400,000 28,000 192,000 400,000 Worksheet entries: [1] To write land up to FV at time of acquisition. (P allocated 80% of $25,000 = $20,000; rest to NCI) [2] To record net income of S accruing to P (80% × $20,000 = $16,000). [3] To eliminate 80% of S capital account balances attributed to P and record noncontrolling interest. Note: Notice that NCI at the acquisition date had a fair value of $24,000 and in the consolidated worksheet has a balance of $28,000. The difference, 428,000 – $24,000 = $4,000 is the amount of S’s income that was not attributable to P. 17-14 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 88 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 IV. Intercompany Transactions A. Intercompany Receivables, Payables & Loans 1. Receivables and Payables Originate from intercompany transactions such as the sale of inventory and fixed assets or the rendering of services. These receivables and payables appear in the affiliated company’s trial balance at the end of the period; note, however, that no asset or liability exists outside the consolidated group. Elimination of the receivable/payable simply involves a “worksheet entry” reversing the original recording. 2. Intercompany Loans These must also be eliminated from consolidated statements, in a manner similar to that used for receivables and payables. In addition, interest income and expense and interest accruals must be eliminated. Example 8 Intercompany Loans P lent $10,000 on June 1, year 1 to S, its 90% owned subsidiary. The note is to be repaid May 30, year 2, with 12% interest. Partial trial balances of P and S are reproduced below. Note receivable—S Accrued interest on note Note payable—P Accrued interest on note Sales revenue Interest revenue Expenses Interest expense P 10,000 600 S (10,000) (600) (20,000) 0 17,000 600 $ 0 (50,000) (600) 36,000 $ 0 Required: Provide the elimination entries related to the intercompany note. Also, compute consolidated net income and allocate it to controlling and noncontrolling interest. Solution: Note that whereas interest is not an expense for the consolidated entity, it is nevertheless a cost of doing business for S. It must be included in S’s net income in order to determine the noncontrolling interest in S’s net income. Notes Payable 10,000 Accrued Interest Payable 600 Notes Receivable Accrued Interest Receivable To eliminate intercompany receivable/payable and related accrued interest Interest Income 600 Interest Expense To eliminate interest income and expense on intercompany notes Sales Revenue (CR) Expenses Noncontrolling interest in net income, 10% × ($20,000 – $17,000 – $600) Controlling interest in net income B. P $(50,000) 36,000 S $(20,000) 17,000 10,000 600 600 Consolidated $ (70,000) 53,000 240 $ (16,760) Intercompany Sales of Inventory Intercompany sales of merchandise create three problems. 1. Sales and Cost of Goods Sold The sale and CGS are recorded twice: first, the seller records a sale and related CGS as the merchandise is “sold” to the affiliated buyer; secondly, the buyer resells the goods to outsiders, also recording a sale and CGS. For consolidated purposes, however, it is obvious that only one sale has occurred. 17-15 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 89 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 2. Gross Profit When one company sells merchandise to its affiliate at a price above cost, the ending inventory of the buyer contains an element of unrealized gross profit. The gross profit is not realized to the economic entity until it is sold to outsiders. The preparation of consolidated financial statements requires that unrealized gross profit be eliminated. 3. Noncontrolling Interest Noncontrolling interest in the subsidiary’s income must be based on the sales and CGS originally reported by the subsidiary. As was the case in interaffiliate interest income and expense, the noncontrolling interest income should reflect the expense incurred (or revenues obtained) in intercompany transactions. The sale, however, may not be recognized until after the goods have been sold to an outside buyer. Example 9 Intercompany Sales of Inventory Parent sells merchandise to its 90% owned Sub at 25% above cost. The following chart summarizes the transactions in intercompany sales at year-end. Beginning inventory 1/1 Sales Total Ending inventory 12/1 Cost of goods sold Parent’s sales price (= cost to Sub) $ 50,000 200,000 250,000 (75,000) $175,000 Cost $ 40,000 160,000 200,000 (60,000) $140,000 Parent’s gross profit $ 10,000 40,000 50,000 (15,000) $ 35,000 (realized) (unrealized) Required: Provide the consolidation elimination entries. Solution: (1) (2) R/E 10,000 CGS To adjust beginning R/E and CGS for the overstated beginning inventory Sales 200,000 Purchases To eliminate intercompany sales and purchases (3) CGS Inventory To eliminate unrealized gross profit in ending inventory C. 10,000 200,000 15,000 15,000 Intercompany Sales of Fixed Assets Sales of fixed assets between members of an affiliated group may result in the recognition of gain or loss by the seller, if the selling price differs from the carrying amount of the asset. Again, no gain or loss has taken place for the consolidated entity; assets have merely been transferred from one set of books to another. Additional complications result from the fact that the buyer of the asset will record it in its books at the agreed upon purchase price; subsequent depreciation charges will be based upon this purchase price, thus requiring adjustment. In summary, an interaffiliate sale of fixed assets involves the following. 1. Carrying Amount In the year of sale, restore the carrying amount of the asset to its original BV and eliminate the gain (loss) recorded by the seller. 2. Depreciation For each period, adjust depreciation expense and accumulated depreciation to reflect the original BV of the asset. 3. Retained Earnings For periods subsequent to the year of sale, R/E must be adjusted to eliminate the gain (loss) contained therein. If the parent is the seller, controlling interest R/E absorbs the entire adjustment. If a less than 100 percent owned subsidiary is the seller, the adjustment to R/E should be allocated to the controlling and noncontrolling interests on the basis of their ownership ratio. 17-16 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 90 of 160 Financial Accounting & Reporting Example 10 Updating Supplement Version 38.3 Intercompany Sale of Depreciable Assets Parent sells machinery for $1,500 to its wholly owned subsidiary. The machinery cost Parent $2,000 and accumulated depreciation at date of sale was $1,000. Parent had been depreciating the machinery on the SL method over a 10-year life. Sub continues this depreciation method. Required: Provide the elimination entries at the end of years 1 and 2. Solution: The debit to RE is $400 ($500 – $100). Thus, the yearly indirect increase in consolidated income (from decreasing depreciation expense) will cause the $500 gain to be fully recognized by the seller by the end of the fifth year, when the asset is fully depreciated. Year 1 Gain on Intercompany Sale of Assets 500 Machinery 500 Accumulated Depreciation 1,000 To eliminate gain and restore asset and accumulated depreciation accounts to their original balances Accumulated Depreciation Depreciation Expense ($500 / 5) To adjust consolidated depreciation charges 100* 100* * Gain / Life remaining to buyer = Depreciation elimination per year Year 2 D. Retained Earnings Machinery Accumulated Depreciation Depreciation Expense 400 500 800 100 Intercompany Bonds 1. Direct Sale & Purchase A direct sale and purchase of bonds between affiliates poses problems similar to the interaffiliate lending and borrowing transactions already discussed. Intercompany receivables and payables (including accrued interest) must be eliminated, as well as interest income/expense. Note that in a direct acquisition of bonds, no gain or loss results to either party, even if a premium or discount is involved, since the net carrying amount of the bond liability on the issuer’s books will always equal the bond investment amount on the purchaser’s books. Example 11 Direct Sale of Bonds Parent purchases $100,000 bonds from Sub on December 31, year 1. The bonds’ stated interest rate is 10%. Parent pays $110,000 for the bonds. The effective interest rate of the bonds is 8%. Required: Prepare the consolidation elimination entry at the date of the transaction and at December 31, year 2. Solution: On December 31, year 1, the following journal entries were made on the books of the acquirer and the issuer. Acquirer (Parent) Investment in Bonds 110,000 Cash Cash 110,000 17-17 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Issuer (Sub) 110,000 Bonds Payable Premium on Bonds 100,000 10,000 Page 91 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 The consolidation elimination entry required is Bond Premium 10,000 Bonds Payable 100,000 Investment in Bonds 110,000 During Year 2, the following journal entries would be made to record income and expenses. Acquirer Cash Issuer 10,000 Interest Income Bond Investment Interest Expense 8,800* Bond Premium 1,200 Cash 8,800* 1,200 10,000 * Interest income or expense = Effective interest rate × Net carrying amount (8% × $110,000). The consolidation elimination entries required at the end of Year 2 are as follows. Interest Income Interest Expense Bonds Payable Bond Premium Investment in Bonds 2. 8,800 8,800 100,000 8,800 108,800 Third Party A member of an affiliated group may issue its bonds to outsiders. These bonds may then be purchased from the outside parties by a second affiliate. a. For consolidated purposes, the bonds have been retired, since they are no longer held by outsiders. b. A gain or loss will typically result from the acquisition by the second affiliate of bonds originally issued by the first affiliate to outsiders. This occurs because the FV of bonds at the time of reacquisition is likely different than the carrying amount of the bond obligation on the issuer’s books. No gain or loss is recorded by individual affiliates, yet a gain or loss on retirement must be recognized at the consolidated level. c. This gain or loss will be periodically recognized by the issuer as the difference between interest expense to the issuer and interest income to the purchaser. Upon maturity of the bond issue, the entire consolidated gain (loss) realized at the time of reacquisition of the bond will have been amortized and no further adjustments will be necessary. Example 12 Bonds Originally Issued to Third Parties (face amount) P owns a 90% interest in S, acquired several years ago. P accounts for its investment in S under the equity method. No intercompany sales of fixed assets or inventories have taken place. • • • On January 1, year 1, S issued to outsiders $100,000, 8%, 10-year bonds at face amount. Interest is paid annually, on December 30. On January 1, year 3, P bought the entire bond issue, when the prevailing interest rate for that type of bond was 12%. Operating income before interest charges and revenue was as follows. Year 3 Year 4 P $55,000 60,000 S $33,000 30,000 Required: Provide elimination entries and allocate consolidated income to the noncontrolling and controlling interest for (a) year 3, and (b) year 4. Ignore income taxes. 17-18 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 92 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Solution: A gain is calculated and recognized as follows. $100,000 × P (8, 12%) $ 8,000 × PA (8, 12%) $ 40,388 39,741 $80,129 P(8, 12%) = PV of $1 in 8 years at 12%, 0.40388 PA(8, 12%) = PV of $1 annuity, 8 years at 12%, 4.96763 Carrying amount of bonds in S books Less: Price paid by P to acquire bonds Gain on retirement $ 100,000 (80,129) $ 19,871 a. The following entries would have been made by P and S during year 3 P Cash Investment in S Bonds Interest Income S 8,000 1,615 Interest Expense Cash 8,000 8,000 9,615 Elimination entries are illustrated by the following partial consolidation worksheet: P Dr. (Cr.) Invest. in S bonds ($80,129 + $1,615) Bonds payable Operating income (excluding interest) Interest income Interest expense Gain on retirement of S bonds S Dr. (Cr.) 81,744 81,744 (100,000) (55,000) (9,615) Consolidated Income Statement Dr. (Cr.) Eliminations Dr. Cr. 100,000 (33,000) (88,000) 9,615 8,000 8,000 109,615 19,871 109,615 Consolidated NI (Cr) Noncontrolling interest, 10% ($33,000 – $8,000 – $1,615 + $19,871)* Controlling interest, $55,000 + $9,615 + (90% × $43,256) (19,871) (107,871) $ 4,326 103,545 $107,871 * The entire gain on retirement is allocated to S, and interest expense is adjusted to reflect the current rate (12%). To understand the reasoning behind this, assume two transactions: (1) S retires $100,000 BV bonds at a cost of $80,129, realizing a $19,871 gain. (2) S reissues debt for $80,129 at face value. The interest rate on this debt is the prevailing rate, or 12%; therefore, interest expense for Year 3 is $8,000 + $1,615 = $9,615 (i.e., 12% × $80,129). b. The following entries would have been made by P and S during year 4. P Cash Bond Investment Interest Income ($81,744 × 12%) S 8,000 1,809 Interest Expense Cash 8,000 8,000 9,809 17-19 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 93 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 P Dr. (Cr.) Invest. in S bonds (81,744 + 1,809) Bonds payable Operating income (excluding interest) Interest income Interest expense Retained earnings, P Retained earnings, S S Dr. (Cr.) Eliminations Dr. Cr. 83,553 83,553 (100,000) (60,000) (9,809) Consolidated Income Statement Dr.(Cr.) 100,000 (30,000) (90,000) 9,809 8,000 (XXX) (XX) 109,809 8,000 16,430* 1,826* 109,809 Consolidated NI (Cr) (90,000) Noncontrolling interest, 10% × ($30,000 – $8,000 – $1,809) Controlling interest, $60,000 + $9,809 + (90% × $20,191) $ 2,019 87,981 $ 90,000 * Consolidated R/E must include the gain on retirement of the bonds ($19,871) less the amount amortized prior to year 4 ($1,615 additional interest expense charged to S in year 3, see part a, above). The remaining adjustment to R/E of $18,256 is allocated to the controlling and minority interests in proportion to their ownership percentage. Example 13 Bonds Originally Issued to Third Parties at Discount On January 1, year 1, S issued to outside parties $100,000, 8% bonds to yield 9% and due to mature on December 30, year 4. The bonds were purchased by P on January 1, year 3, when the prevailing interest rate for that type of bond was 12%. Operating income before interest charges and revenues was as follows. Year 3 4 P $80,000 90,000 S $35,000 38,000 Required: Provide the consolidation worksheet entries to eliminate the intercompany bonds and allocate consolidated net income to the minority and controlling interests for (a) year 3, and (b) year 4. Ignore income taxes. Solution: $100,000 × P (n = 4, i = 9%; 0.70843) $ 8,000 × PA (n = 4, i = 9%; 3.23975) Bond issue price, January 1, year 1 Face amount Discount, January 1, year 1 $ 70,843 25,918 96,761 100,000 $ 3,239 Table 1—S Discount Amortization Schedule Date Jan. 1, year 1 Dec. 30, year 1 Dec. 30, year 2 Dec. 30, year 3 Dec. 30, year 4 Cash payment Interest expense Amortization $8,000 8,000 8,000 8,000 $8,707 8,772 8,842 8,918* $707 772 842 918 Carrying amount $ 96,761 97,468 98,240 99,082 100,000 * $1 difference due to rounding 17-20 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 94 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 $100,000 × P (n = 2, i = 12%; 0.79720) $ 8,000 × PA (n = 2, i = 12%; 1.6900) Retirement price Carrying amount in S books (Table 1) Consolidated gain on retirement $ 79,720 13,520 93,240 98,240 $ 5,000 Table 2—P Discount Amortization Schedule Date Jan. 1, year 3 Dec. 30, year 3 Dec. 30, year 4 Cash payment Interest expense Amortization $8,000 8,000 $11,189 11,571 $3,189 3,571 Carrying amount $ 93,240 96,429 100,000 a. Year 3 Partial Consolidation Worksheet P Dr. (Cr.) Investment in S bonds (Table 2) Bonds payable Discount (Table 1) Operating income (Cr) (excluding interest) Int. income (Table 2) Int. expense (Table 1) Gain on retirement S Dr. (Cr.) Eliminations Dr. Cr. 96,429 96,429 (100,000) 918 (80,000) (11,189) Consolidated Income Statement Dr.(Cr.) 100,000 918 (35,000) (115,000) 11,189 8,842 111,189 8,842 5,000 111,189 Consolidated NI (Cr) (5,000) (120,000) Noncontrolling interest, 10% ($35,000 – $11,189* + $5,000) Controlling interest, $80,000 + $11,189 + 90% ($28,810) $ 2,881 117,119 $ 120,000 * See note following consolidated worksheet in Example 10. Computed by applying effective rate at time of purchase by P to the net payable (i.e., 12% × $93,240 = $11,189). b. Year 4 Partial Consolidation Worksheet P Dr. (Cr.) Investment in S bonds (Table 2) Bonds payable Operating income (Cr) (excluding interest) Int. income (Table 2) Int. expense (Table 1) R/E, P R/E, S S Dr. (Cr.) Eliminations Dr. Cr. 100,000 100,000 (100,000) (90,000) (11,570) Consolidated Income Statement Dr.(Cr.) 100,000 (38,000) (128,000) 11,570 8,917 (XXXX) (XX) 111,570 Consolidated NI (Cr) 8,917 2,388* 265* 111,570 (128,000) Noncontrolling interest, 10% ($38,000 – $11,570) Controlling interest, $90,000 + $11,570 + 90% ($26,430) $ 2,643 125,357 $ 128,000 17-21 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 95 of 160 Financial Accounting & Reporting * Gain on requirement of S bonds Interest income, P Interest expense, S Less: Year 3 amortization: Unamortized gain, adjust beginning R/E Updating Supplement Version 38.3 $ 5,000 $ 8,842 (11,189) Noncontrolling interest, 10% Controlling interest, 90% (2,347) $ 2,653 $ 265 2,388 $ 2,653 V. Noncontrolling Interests A. Definition A noncontrolling interest, sometimes called a minority interest, is the portion of equity in a subsidiary not attributable, directly or indirectly, to the parent. The noncontrolling interest in a subsidiary is part of the equity of the consolidated group. B. Reporting The noncontrolling interest shall be reported in the consolidated statement of financial position with equity, separately from the parent’s equity. Only a financial instrument issued by a subsidiary that is classified as equity in the subsidiary’s financial statements can be a noncontrolling interest in the consolidated financial statements. 1. 2. Net Income or Loss Revenues, expenses, gains, losses, net income or loss, and other comprehensive income shall be reported in the consolidated financial statements at the consolidated amounts, which include the amounts attributable to the owners of the parent and the noncontrolling interest. 3. C. Intercompany Income or Loss The elimination of the intercompany income or loss may be allocated between the parent and noncontrolling interests. Attributable Losses Losses attributable to the parent and the noncontrolling interest in a subsidiary may exceed their interests in the subsidiary’s equity. The excess, and any further losses attributable to the parent and the noncontrolling interest, shall be attributed to those interests. That is, the noncontrolling interest shall continue to be attributed its share of losses even if that attribution results in a deficit noncontrolling interest balance. Changes in a Parent’s Ownership Interest A parent’s ownership interest in a subsidiary might change while the parent retains its controlling financial interest in the subsidiary. 1. Examples A parent’s ownership interest in a subsidiary might change if (a) the parent purchases additional ownership interests in its subsidiary, (b) the parent sells some of its ownership interests in its subsidiary, (c) the subsidiary reacquires some of its ownership interests, or (d) the subsidiary issues additional ownership interests. 2. Reporting Changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary shall be accounted for as equity transactions (investments by owners and distributions to owners acting in their capacity as owners). Therefore, no gain or loss shall be recognized in consolidated net income or comprehensive income. The carrying amount of the noncontrolling interest shall be adjusted to reflect the change in its ownership interest in the subsidiary. Any difference between the fair value of the consideration received or paid and the amount by which the noncontrolling interest is adjusted shall be recognized in equity attributable to the parent. 3. Accumulated OCI A change in a parent’s ownership interest might occur in a subsidiary that has accumulated other comprehensive income. If that is the case, the carrying amount 17-22 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 96 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 of accumulated OCI shall be adjusted to reflect the change in the ownership interest in the subsidiary through a corresponding charge or credit to equity attributable to the parent. D. Disclosures A parent with one or more less-than-wholly-owned subsidiaries shall disclose the following for each reporting period. 1. Separately, on the face of the consolidated financial statements, the amounts of consolidated net income and consolidated comprehensive income and the related amounts of each attributable to the parent and the noncontrolling interest 2. Either in the notes or on the face of the consolidated income statement, amounts attributable to the parent for the income from continuing operations, discontinued operations, and extraordinary items, if reported in the consolidated financial statements 3. Either in the consolidated statement of changes in equity, if presented, or in the notes to consolidated financial statements, a reconciliation at the beginning and the end of the period of the carrying amount of total equity (net assets), equity (net assets) attributable to the parent, and equity (net assets) attributable to the noncontrolling interest. That reconciliation shall separately disclose net income, transactions with owners acting in their capacity as owners (showing separately contributions from and distributions to owners), and each component of other comprehensive income 4. If a subsidiary is deconsolidated, the parent shall disclose: a. The amount of any gain or loss recognized in accordance with the deconsolidation b. The portion of any gain or loss related to the remeasurement of any retained investment in the former subsidiary to its fair value c. The caption in the income statement in which the gain or loss is recognized unless separately presented on the face of the income statement. VI. Deconsolidation A. Basis A parent shall deconsolidate a subsidiary as of the date the parent ceases to have a controlling financial interest in the subsidiary. The following are examples of events that result in deconsolidation of a subsidiary. 1. 2. Contract Expiration The expiration of a contractual agreement that gave control of the subsidiary to the parent. 3. Additional Subsidiary Shares Issued The subsidiary issues shares, which reduces the parent’s ownership interest in the subsidiary so that the parent no longer has a controlling financial interest in the subsidiary. 4. B. Sale A parent sells all or part of its ownership interest in its subsidiary, and as a result, the parent no longer has a controlling financial interest in the subsidiary. Control The subsidiary becomes subject to the control of a government, court, administrator, or regulator. Recognition If a parent deconsolidates a subsidiary through a nonreciprocal transfer to owners, such as a spinoff, they shall use nonmonetary transaction accounting guidance in reporting the transaction. Otherwise, a parent shall account for the deconsolidation of a subsidiary by recognizing a gain or loss in net income attributable to the parent, measured as the difference between: 17-23 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 97 of 160 Financial Accounting & Reporting 1. Updating Supplement Version 38.3 The aggregate of: a. b. C. The fair value of any retained noncontrolling investment in the former subsidiary at the date the subsidiary is deconsolidated c. 2. The fair value of any consideration received The carrying amount of any noncontrolling interest in the former subsidiary (including any accumulated other comprehensive income attributable to the noncontrolling interest) at the date the subsidiary is deconsolidated The carrying amount of the former subsidiary’s assets and liabilities. Multiple Transactions A parent may cease to have a controlling financial interest in a subsidiary through two or more arrangements (transactions). Circumstances sometimes indicate that the multiple arrangements should be accounted for as a single transaction. In determining whether to account for the arrangements as a single transaction, a parent shall consider all of the terms and conditions of the arrangements and their economic effects. One or more of the following may indicate that the parent should account for the multiple arrangements as a single transaction. 1. Time They are entered into at the same time or in contemplation of one another. 2. Form They form a single transaction designed to achieve an overall commercial effect. 3. Dependence The occurrence of one arrangement is dependent on the occurrence of at least one other arrangement. 4. Economic Justification One arrangement considered on its own is not economically justified, but they are economically justified when considered together. An example is when one disposal is priced below market, compensated for by a subsequent disposal priced above market. VII. Subsidiary Entity Records A. Traditional Our review of business combinations has focused on (1) the recording by the parent company and (2) the required consolidation procedures. Historically, where separate incorporation is maintained, the subsidiary’s financial records are not affected by either the acquisition or the consolidation. B. Push-Down Accounting Under push-down accounting, however, the subsidiary records purchase price allocations and subsequent amortization. The subsidiary records the allocations attributed to its identifiable net assets (e.g., inventory, land, building, equipment) and goodwill with a balancing entry to an Additional Paid-In Capital account. Every year thereafter, the subsidiary recognizes depreciation expense, as appropriate, on these various allocations. 1. Simplicity Because the allocations and amortization are already entered into the records of the subsidiary, the use of push-down accounting simplifies the consolidation process. 2. Better Internal Reporting In addition, push-down accounting provides better internal reporting. Since the subsidiary’s separate figures may include additional depreciation expense resulting from the purchase, the net income reported by the subsidiary is a good representation of the impact that the acquisition has on the earnings of the business combination. 17-24 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 98 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 VIII. Combined Financial Statements A. Use There are circumstances where combined financial statements (as distinguished from consolidated statements) of commonly controlled companies are likely to be more meaningful than their separate financial statements. Combined financial statements are often prepared for a group of related companies (e.g., a group of unconsolidated subsidiaries) or a group of commonly controlled companies (e.g., one individual owns a controlling financial interest in several entities that are related in their operations). Consolidated statements are not appropriate if there is no investment by one affiliate in another to eliminate. B. Procedures Combined financial statements are prepared by combining the individual companies’ financial statement classifications into one set of financial statements. 1. Intercompany Issues Intercompany transactions, balances, and profits or losses are eliminated in the same manner as in consolidated statements. 2. Other Issues If there are problems in connection with such matters as noncontrolling interests, foreign operations, different fiscal periods, or income taxes, they are treated in the same manner as in consolidated financial statements. IX. Parent-Company Financial Statements A. Use In addition to consolidated financial statements, parent-company financial statements may be needed to indicate the position of bondholders and other creditors or preferred shareholders of the parent. Parent-company financial statements are not a valid substitute for consolidated financial statements. B. Procedures Consolidating financial statements, in which one column is used for the parent and other columns for subsidiaries is often used to effectively present the pertinent information. __________________ 17-25 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 99 of 160 Financial Accounting & Reporting Chapter 18: Updating Supplement Version 38.3 Page 18-12. Replace section II.C.5.c under “Capital Assets & Long-Term Liabilities” with the following: c. Governments generally should capitalize works of art, historical treasures, and similar assets at their historical cost or fair value at date of donation whether they are held as individual items or in a collection. Governments are encouraged, but not required, to capitalize a collection (and all additions to it) whether donated or purchased that meets all of the following. The collection is: (1) Held for public exhibition, education, or research in furtherance of public service, rather than financial gain (2) Protected, kept unencumbered, cared for, and preserved (3) Subject to an organizational policy that requires the proceeds from sales of collection items to be used to acquire other items for collections Capitalized collections or individual items that are exhaustible, such as exhibits whose useful lives are diminished by display or educational or research applications, should be depreciated over their estimated useful lives. Depreciation is not required for collections or individual items that are inexhaustible. Chapter 18: Page 18-17. Replace the first main paragraph of section II.D.6 titled “Proprietary Fund” with the following: 6. Proprietary Funds Proprietary fund financial statements should be prepared using the economic resources measurement focus and the accrual basis of accounting. Three financial statements are required: Statement of Net assets or Balance Sheet, Statement of Revenues, Expenses, and Changes in Fund Net Assets or Fund Equity; and Statement of Cash Flows. Enterprise funds have a separate fund for each major fund and combine nonmajor funds. Internal service funds also should be reported in the aggregate in a separate column after the total of all Enterprise funds. The format use for the fund statements should also be used for the corresponding government-wide statement. Chapter 18: Pages 18-27 and 18-28. following: A. Replace section III.A titled “Nonexchange Transactions” with the Nonexchange Transactions GASB 24 provides guidance for food stamps and on-behalf payments for fringe benefits and salaries. All other grants fall within the scope of GASB 33, Accounting and Financial Reporting for Nonexchange Transactions, as amended by GASB 36. One of the basic principles of GASB 33 is symmetry between expense or expenditure recognition by a provider government and revenue recognition by the recipient government. Recipient governments do not apply the criteria for derived tax revenues or imposed nonexchange revenues on transactions involving provider governments. 1. Accounting Basis NCGA and GASB pronouncements require revenue recognition using the modified accrual basis of accounting for revenues from nonexchange transactions. Revenues should generally be recognized “in the accounting period when they become available and measurable.” The term available means “collected within the current period or expected to be collected soon enough thereafter to be used to pay liabilities of the current period.” Usually, such time shall not exceed 60 days. 2. Derived Tax Revenues Derived tax revenues are assessments imposed by governments on exchange transactions and generally include sales taxes, income taxes, motor fuel taxes, and similar taxes on earnings or consumption. Assets generally are recognized in the period when the underlying exchange transaction has occurred and the resources are available. 3. Imposed Nonexchange Transactions Imposed nonexchange revenues represent assessments imposed on non-governmental entities and include property taxes and fines or Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 100 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 forfeitures. Assets are recognized when the government has an enforceable legal claim to the resources or when the resources are received, whichever occurs first. For property taxes, the date of enforceable claim is generally specified in the enabling legislation. This is often called the “lien date” or “assessment date.” a. Recipients should recognize revenues from property taxes, net of estimated refunds and estimated uncollectible amounts, in the period in which the taxes are levied, even if the enforceable legal claim arises or the due date for payment occurs in a different period. b. All other imposed nonexchange revenues should be recognized in the same period that the assets are recognized unless the enabling legislation includes time requirements. If so, revenues should be recognized in the period when the resources are required to be used or when use is first permitted. 4. Government-Mandated Nonexchange Transactions Government-mandated nonexchange transactions occur when a government at one level provides resources to a government at another level and requires that government to use the resources for a specific purpose. Intergovernmental grants fall into this category. There are often eligibility requirements, conditions established by legislation or the provider, that are required to be meet before a transaction (other than cash or other assets in advance) can occur. Until those requirements are met, the recipient does not have a receivable, the provider does not have a liability, and the recognition of revenues or expenses for resources transmitted in advance should be deferred. Recipients recognize assets and revenues when all eligibility requirements have been met and the resources are available. Providers recognize liabilities and expenses using the same criteria. Eligibility requirements include time requirements. Purpose restrictions result in restricted assets until resources are used for the specified purpose. 5. Voluntary Nonexchange Transactions Voluntary nonexchange transactions result from legislative or contractual agreements, but do not involve an exchange of equal value. Certain grants, entitlements, and donations are classified as voluntary nonexchange transactions. Both parties may or may not be governmental entities. Specific recognition criteria are the same as those for government-mandated nonexchange transactions. 6. Continuing Appropriations If distributions from a provider government are authorized by continuing appropriations (involving no further legislative action), the recipient governments can use any reasonable estimate to accrue revenues. Chapter 19: Page 19-4. Replace the second sentence of the first main paragraph of section I.B titled “General Fund” with the following: “This fund accounts for all resources that are not required to be accounted for in other funds; in essence, it accounts for all unrestricted resources.” Chapter 19: Page 19-9. Replace section I.F titled “Permanent Funds” with the following (Exhibit 6 stays): F. Permanent Funds Used to account for nonexpendable resources that may be used to generate and disperse money to benefit the reporting entity or its citizens. The name comes from the purpose of the fund; a sum of equity used to permanently generate payments to maintain some financial obligation. A fund can only be classified as a permanent fund if the money is used to report the status of a restricted financial resource. The resource is restricted in that only earnings from the resource are used and not the principal. The permanent funds [C GRIPES] use modified accrual accounting. Budgetary and encumbrance entries usually aren’t made in permanent funds. Accounting practices for permanent funds parallel those for the general fund, so few sample entries are presented. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 101 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Chapter 20: Page 20-1 through 20-12. Replace section I titled “Standard Nonprofit Accounting” with sections I and II titled ““Standard Nonprofit Accounting” and “Financial Statements”, respectively, as follows (renumbering the other sections): I. Standard Nonprofit Accounting .......................................................................................................... 20-2 A. Concepts ....................................................................................................................................... 20-2 B. Definitions...................................................................................................................................... 20-2 C. Contributions ................................................................................................................................. 20-3 D. Contributions for Others ................................................................................................................ 20-6 E. Investments ................................................................................................................................... 20-7 F. Related Organizations ................................................................................................................... 20-8 G. Mergers and Acquisitions .............................................................................................................. 20-9 II. Financial Statements .......................................................................................................................... 20-11 A. Introduction.................................................................................................................................. 20-11 B. Statement of Financial Position................................................................................................... 20-11 C. Statement of Activities ................................................................................................................. 20-12 D. Statement of Activities Alternative Two-Part Format................................................................... 20-13 E. Statement of Cash Flows ............................................................................................................ 20-14 F. Statement of Functional Expenses.............................................................................................. 20-15 G. General Disclosures .................................................................................................................... 20-16 III. Unique Accounting Features ............................................................................................................. 20-16 A. Health Care Entities..................................................................................................................... 20-16 B. Colleges & Universities................................................................................................................ 20-18 C. Voluntary Health & Welfare Organizations (VHWO) ................................................................... 20-19 D. Other Nonprofit Organizations (ONPO)....................................................................................... 20-20 IV. Appendix: Health Care Entity Fund Accounting ............................................................................ 20-21 A. Concepts ..................................................................................................................................... 20-21 B. Fund Types.................................................................................................................................. 20-21 V. Appendix: University Fund Accounting .......................................................................................... 20-23 A. Concepts ..................................................................................................................................... 20-23 B. Restricted vs. Unrestricted Current Funds .................................................................................. 20-23 C. Current Fund Unique Accounting Conventions........................................................................... 20-23 D. Current Fund Budgetary Accounts .............................................................................................. 20-24 E. Trust & Agency Funds ................................................................................................................. 20-24 F. Annuity & Life Income Funds ...................................................................................................... 20-24 G. Plant Funds ................................................................................................................................. 20-25 H. Statement of Financial Position................................................................................................... 20-26 VI. Appendix: VHWO Fund Accounting ................................................................................................ 20-27 A. Concepts ..................................................................................................................................... 20-27 B. Fund Types.................................................................................................................................. 20-27 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 102 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 CHAPTER 20 NONPROFIT ACCOUNTING I. Standard Nonprofit Accounting A. Concepts The fundamental presumption used by the FASB in developing financial reporting standards for (non-governmental) nonprofit organizations (NPO) is that the financial reporting practices of nonprofit entities should be the same as those for commercial entities. 1. 2. B. Standards There is a parallel hierarchy where non-governmental nonprofit entities are subject to the FASB rather than the GASB standards. The FASB requires nonprofit entities to provide financial statements on an entity-wide basis similar to the concept of consolidated statements for business entities. Fund Accounting Use of fund accounting for nonprofit organizations is allowed but not required. Disaggregated financial statements, common with fund accounting, are insufficient by themselves. This relegates fund statements to a supplementary role for external reporting purposes. [Expect the majority of CPA exam points on NPOs to be in areas other than fund accounting.] NPOs generally do not use budgetary and encumbrance accounting. Definitions 1. Contribution Contributions are unconditional donations of cash or other assets. Other assets include, securities, land, buildings, use of facilities or utilities, materials and supplies, intangible assets, services (within certain limited circumstances), and unconditional promises to give those items in the future. 2. Conditional Promise to Give A written or oral agreement to make a contribution that depends on the occurrence of a specified future and uncertain event to bind the promisor. A conditional promise to give is considered unconditional if the possibility that the condition will not be met is remote. 3. Unconditional Promise to Give A written or oral agreement to make a contribution that depends only on passage of time or demand by the promisee for performance. It may be difficult to determine whether donor stipulations are conditions or restrictions. In cases of ambiguous donor stipulations, a promise containing stipulations that are not clearly unconditional shall be presumed to be a conditional promise. 4. Pledge Also called promises to give. become unconditional. 5. Donor-Imposed Condition A donor stipulation that specifies a future and uncertain event whose occurrence or failure to occur gives the promisor a right of return of the assets it has transferred or releases the promisor from its obligation to transfer its assets. 6. Donor-Imposed Restriction A donor stipulation that specifies a use for the contributed asset that is more specific than broad limits resulting from the nature of the organization, the environment in which it operates, and the purposes specified in its charter. A restriction on an organization’s use of the asset contributed may be temporary or permanent. 7. Permanent Restriction A donor-imposed restriction that stipulates that resources be maintained permanently but permits the organization to use up or expend part or all of the income (or other economic benefits) derived from the donated assets. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Conditional pledges are not recorded until they Page 103 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 8. 9. Unrestricted Assets The assets from donations unrestricted by the donors, and assets formerly temporarily restricted by the donors that have since become unrestricted. Unrestricted assets include board-restricted assets. 10. Board-Restricted The governing board of an entity may earmark assets for specific purposes as long as these do not conflict with donor conditions. These assets may be designated board-restricted in the financial statements, but they remain in the unrestricted category. 11. C. Temporary Restriction A donor-imposed restriction that will lapse upon occurrence of conditions specified by the donor. The principal of a temporary endowment or donation may be used after the conditions of the restriction are fulfilled. The allowable use of the income of a temporarily restricted asset may also be restricted by the terms of the donation. Endowment Fund A fund of assets to provide support for the activities of a not-for-profit organization. Endowment funds are typically composed of donor-restricted gifts to provide a permanent source of support. However, use of the fund assets may also be temporarily restricted or unrestricted. Contributions Accounting for contributions is an issue for NPOs because for many it is a significant source of revenue. 1. Contributions Received Generally, contributions received are measured at their fair values and recognized as revenues or gains in the period received and as assets, decreases of liabilities, or expenses depending on the form of the benefits received. 2. Contributed Services Contributions of services are measured at their fair values and recognized as revenues for the period only if (a) nonfinancial assets are created or enhanced, and (b) special skills are required that would otherwise be purchased. The debit depends on the form of the benefit received. 3. Contributed Collection Items Contributed collection items are recognized as revenues or gains if collections are capitalized and not recognized as revenues or gains if collections are not capitalized. An entity need not recognize contributions of works of art, historical treasures, and similar assets if the donated items are added to collections that meet all of the following conditions: a. Are held for public exhibition, education, or research in furtherance of public service rather than financial gain b. Are protected, kept unencumbered, cared for, and preserved c. Are subject to an organizational policy that requires the proceeds from sales of collection items to be used to acquire other items for collections. 4. Classification Contributions are classified as gains when they are peripheral or incidental to the activities of the entity. However, they are classified as revenue in those circumstances in which these sources are deemed to be ongoing major or central activities by which the provider attempts to fulfill its basic function. For example, donor’s contributions are revenues if fund-raising is an ongoing major activity by which the provider attempts to fulfill its basic function. The same donations, however, would be a gain to a provider that does not actively seek contributions and receives them only occasionally. 5. Reporting NPOs must distinguish between contributions received with permanent restrictions, those received with temporary restrictions, and those received without donor-imposed restrictions. A restriction on the use of the assets contributed results either from a donor’s explicit stipulation or from circumstances surrounding the receipt of the contribution that make clear the donor’s implicit restriction on use. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 104 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 a. With Donor-Imposed Restrictions Contributions with donor-imposed restrictions are reported as restricted support; however, if those restrictions are met in the same reporting period they may be reported as unrestricted support. Restricted support increases permanently restricted net assets or temporarily restricted net assets. b. Without Donor-Imposed Restrictions Contributions without donor-imposed restrictions are reported as unrestricted support that increases unrestricted net assets. c. Expiration of Donor-Imposed Restrictions The expiration of a donor-imposed restriction on a contribution must be recognized in the period in which the restriction expires. A restriction expires when the stipulated time has elapsed, when the stipulated purpose for which the resource was restricted has been fulfilled, or both. Expirations of donor-imposed restrictions that simultaneously increase one class of net assets and decrease another (reclassifications) are reported separately from other transactions. d. Unrestricted Pledges Receipts of unconditional promises to give, or pledges, are reported as a receivable at their present value in the period in which they are made, net of an allowance for uncollectible amounts. Unrestricted pledges are reported in the statement of revenue and expenses. If part of the pledge is to be applied during some future period, that part is reported as restricted revenue. e. Restricted Pledges Receipts of unconditional promises, or pledges, to give with payments due in future periods shall be reported as restricted support unless explicit donor stipulations or circumstances make clear that the donor intended it to be used to support activities of the current period. A pledge to give in the future has an implied restriction for future use. Receipts of pledges to give cash in future years generally increase temporarily restricted net assets. f. Other Than Long-Lived Assets If unrestricted, report as operating gains or revenue or nonoperating gains depending on whether the donations constitute the entity’s ongoing major or central operations or are peripheral and incidental to the entity’s operations. If restricted, report as restricted gain or revenue. g. Restricted Long-Lived Assets Gifts of long-lived assets received without stipulations about how long the donated asset must be used shall be reported as restricted support if it is an organization’s accounting policy to imply a time restriction that expires over the useful life of the donated assets. The policy would also imply a time restriction on long-lived assets acquired with gifts of cash or other assets restricted for those acquisitions. h. Unrestricted Long-Lived Assets In the absence of a policy to imply a time restriction that expires over the useful life of long-lived donated assets and other donor-imposed restrictions on use of an asset, gifts of long-lived assets shall be reported as unrestricted support. i. Long-Lived Assets Donations of property and equipment, or of assets to acquire property and equipment, may be initially reported as restricted gain or revenue. A transfer to the unrestricted net assets is reported when the donated property or equipment is placed in service, or when the donated assets are used to acquire property and equipment. If the entity recognizes an implicit restriction in the donation (to be used for the life of the asset, for instance), then the transfer is to the restricted net assets. j. Contributed Services Contributed services are reported as both an expense and a revenue if (1) the services would otherwise be purchased; (2) the value of the services is measurable; and (3) the entity controls the employment and duties of the service donors (i.e., there is the equivalent of an employer-employee relationship). Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 105 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 k. l. 6. Noncapitalized Contributed Collections An entity that does not recognize and capitalize its collections shall report the following on the face of its statement of activities, separately from revenues, expenses, gains, and losses; costs of collection items purchased as a decrease in the appropriate class of net assets, proceeds from sale of collection items as an increase in the appropriate class of net assets, and proceeds from insurance recoveries of lost or destroyed collection items as an increase in the appropriate class of net assets. Capitalized Contributed Collections An entity that capitalizes its collections prospectively shall report proceeds from sales and insurance recoveries of items not previously capitalized separately from revenues, expenses, gains, and losses. Contributions Made Contributions made shall be recognized as expenses in the period made and as decreases of assets or increases of liabilities depending on the form of the benefits given. Exhibit 1 1. Sample Donation Entries To record gifts, bequests, and donations received: Cash (or other assets) Nonoperating Gains—(Unrestricted) Contributions Liabilities (if any are assumed) (Restricted) Revenue XX XX XX XX NOTE: Unrestricted gifts, bequests, and donations are recorded as nonoperating gains, generally. If restricted, they are recorded as permanently or temporarily restricted revenue in the appropriate donor-restricted fund. 2. To record donations (to a hospital) of pharmacy supplies and professional services: Inventory of Pharmacy Supplies Operating Expenses (functional expense accounts) Contributions—Donated Pharmacy Supplies Contributions—Donated Professional Services XX XX XX XX NOTE: Report the contributions as operating gains or revenue or nonoperating gains depending on whether the donation constitutes the entity’s major or central operations or are peripheral and incidental to the entity’s operations. 7. Disclosures a. Unconditional Promise to Give Recipients of unconditional promises to give shall disclose the amounts of promises receivable in less than one year, in one to five years, and in more than five years. They shall also disclose the amount of the allowance for uncollectible promises receivable. b. Conditional Promise to Give Recipients of conditional promises to give shall disclose the total of the amounts promised. They shall also disclose a description and amount for each group of promises having similar characteristics, such as amounts of promises conditioned on establishing new programs, completing a new building, and raising matching gifts by a specified date. c. Long-Lived Assets Entities that adopt a policy to imply a time restriction that expires over the useful life of the donated assets must disclose that accounting policy. d. Contributed Services An entity that receives contributed services shall describe the programs or activities for which those services were used, including the nature and extent of contributed services received for the period and the amount recognized as revenues for the period. Entities are encouraged to disclose the fair value of contributed services received but not recognized as revenues if that is practicable. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 106 of 160 Financial Accounting & Reporting e. 8. Updating Supplement Version 38.3 Contributed Collection Items An entity that does not recognize and capitalize its collections, or that capitalizes collections prospectively, shall describe its collections to include their relative significance and its accounting and stewardship policies for collections. If collection items not capitalized are deaccessed during the period, it also shall (1) describe those items given away, damaged, destroyed, lost, or otherwise deaccessed during the period or (2) disclose their fair value. In addition, a line item shall be shown on the face of the statement of financial position that refers to these disclosures. Intermediary Transactions When a nonprofit organization (NPO) receives assets in a nonexchange transaction from a resource provider, with the proviso that the assets be redistributed to another specific organization (or ultimate recipient) chosen by the resource provider, the NPO intermediary is functioning as an agent. However, if the NPO has some discretion as the timing, manner, and recipient of the assets, the NPO intermediary may then be either an agent for the resource provider or a donee. The degree of discretion exercised by the NPO intermediary determines the classification of the event as a donation or as an agency transaction. Exhibit 2 Some Guidelines for Separating Donations From Agency Transactions Attribute Donation Status Agency Status NPO’s assertions when requesting donations. Requests assets to provide for own activities. Requests assets to provide for others or is not much involved in requesting assets. Composition of assets Changes while NPO holds assets (Land received, cash redistributed). Assets redistributed in same composition. (Land received, land redistributed). Legal title to assets. NPO holds legal title. NPO doesn’t hold legal title. Intent of transfer. NPO commonly has programs that the assets are intended to support. NPO doesn’t commonly have programs that the assets are intended to support. Donor awareness. D. Providers unaware of ultimate recipient. Providers are aware of ultimate recipient. Type of NPO operation. NPO has programs. NPO exists to collect and redistribute assets. Contributions for Others The following applies to contributions for others and also to transactions that are not contributions because the transfers are revocable, repayable, or reciprocal. 1. Definitions a. b. 2. Recipient A not-for profit entity or charitable trust that accepts assets from donors and agrees to use those assets on behalf of, or transfer those assets to, another entity specified by the donor. This transfer of assets includes the assets, the return on investment of those assets, or both. Financially Interrelated Organizations (Entities) One entity has the ability to influence the operating and financial decisions of the other and one entity has an ongoing economic interest in the net assets of the other. Recipient A recipient that accepts assets from a donor on behalf of a specified beneficiary recognizes the fair value of those assets as a liability concurrent with the recognition of the assets. If the donor explicitly gives the recipient variance power or if the recipient and the specified beneficiary are financially interrelated entities, the recipient instead recognizes the transaction as a contribution. Four circumstances exist in which a transfer of assets by a donor is recognized by the recipient as a liability and by the donor as an asset. a. Donor May Redirect The transfer is subject to the donor’s unilateral right to redirect the use of the assets to another beneficiary. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 107 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 b. c. Donor Controls beneficiary. d. 3. Donor May Revoke The transfer is accompanied by the donor’s conditional promise to give or is otherwise revocable or repayable. Donor Benefits The donor specifies itself or its affiliate as the beneficiary and the transfer is not an equity transaction. The donor controls the recipient and specifies an unaffiliated Beneficiary A specified beneficiary recognizes rights to assets held by a recipient as an asset (either an interest in the net assets of the recipient, a beneficial interest, or a receivable) unless the donor has explicitly granted variance power to the recipient. a. Net Asset Interest If the beneficiary and the recipient are financially interrelated entities, the beneficiary recognizes an interest in the net assets of the recipient, adjusting that interest for its share of the change in the recipient’s net assets. b. Beneficiary Interest If the beneficiary has an unconditional right to specified cash flows from a charitable trust or other identifiable pool of assets, the beneficiary is required to recognize that beneficial interest, at fair value as of the transaction date and reporting dates. c. Nonrecognition If the recipient is explicitly granted variance power, the specified beneficiary doesn’t recognize an asset. d. Receivable receivable. In all other circumstances, a beneficiary recognizes its rights as a 4. 5. E. Equity Transaction If the transfer is an equity transaction and the donor specifies itself as beneficiary, the donor records an interest in the net assets of the recipient. If the donor specifies an affiliate as beneficiary, the donor records an equity transaction as a separate line item in its statement of activities, and the beneficiary records an interest in the net assets of the recipient entity. The recipient entity records an equity transaction as a separate line item in its statement of activities. Disclosures If a NPO transfers assets to a recipient and specifies itself or an affiliate as beneficiary or if it includes a ratio of fundraising expenses to amount raised in its financial statements, the NPO must make the following disclosures for each period that it presents a statement of financial position: recipient identity; whether variance power was granted to the recipient and the terms of any variance power; the distribution conditions; and the classification (as a beneficial interest or an interest in the net assets of the recipient, etc.) and aggregate amount recognized in the statement of financial position for these transfers. Investments The following applies to all investments in debt securities and to investments in equity securities that have a readily determinable market value for all nonprofit organizations. It does not apply to investments in equity securities accounted for under the equity method, or that are consolidated. 1. Applicability Fair value of equity securities is deemed to be readily determinable if any of the following conditions are met: a. Sales prices or bid-and-ask quotations are available on an exchange which is registered with the SEC or where over-the-counter quotations are officially reported. b. For securities traded in a foreign market, the market must be of breadth and scope to make it comparable to a U.S. market which meets the condition just mentioned. c. For mutual funds, the fair value per share or unit is determined and published, and represents the basis for current transactions. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 108 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 2. Valuation All applicable investments are required to be measured at fair value. Gains and losses on the investments are included in the statement of activities as increases and decreases, respectively, in unrestricted net assets unless the use of the securities is temporarily or permanently restricted. 3. Investment Income Any dividends, interest, or other investment income are to be included in the statement of activities as earned. Such amounts would be reported as adjustments to unrestricted net assets unless some restriction exists. 4. Disclosures a. b. A reconciliation of investment return to amounts reported in the statement of activities, if investment return is separated into operating and nonoperating amounts, together with a description of the policy used to determine the amount included in the measure of operations and a discussion of circumstances leading to a change in the policy. c. Aggregate carrying amount of the investment by major types. d. Basis for determining the carrying amount for investments. e. Methods and significant assumptions used to estimate the fair values of investments other than financial instruments, if those other investments are reported at fair value. f. Aggregate amount of the deficiencies for all donor-restricted endowment funds for which the fair value of the assets at the reporting date is less than the level required by donor stipulations or law. g. F. Composition of the investment return including investment income, net realized gains or losses on investments reported at other than fair value, and net gains or losses on investments reported at fair value. The nature and carrying amount of each individual investment group which represents a significant concentration of market risk. Related Organizations A foundation, auxiliary, or guild is considered to be related to a nonprofit entity if one of the following conditions is met: 1. The nonprofit entity controls the separate organization through contracts or other legal documents that provide the entity with the authority to direct the separate organization’s activities, management, and policies. 2. The nonprofit entity is considered to be the sole beneficiary of the organization because one of the three following circumstances exists: a. b. The nonprofit entity has transferred some of the resources to the organization, and substantially all of the organization’s resources are held for the benefit of the entity. c. 3. The organization has solicited funds in the name of the nonprofit entity and substantially all of the funds were intended by the contributor to be transferred to or used by the nonprofit entity. The entity has assigned certain of its functions (e.g., the operation of a dormitory) to the organization, which is operating primarily for the benefit of the entity. The nonprofit entity, upon liquidation of the group, is liable for any deficit or due the net assets of the group. transfers. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 109 of 160 Financial Accounting & Reporting G. Updating Supplement Version 38.3 Mergers and Acquisitions Because a nonprofit entity lacks the type of ownership interest that business entities have, negotiation in nonprofit mergers and acquisitions generally focus on the furtherance for the benefit of the public rather than maximizing returns for equity holders. Many mergers and acquisition by nonprofits do not involve a transfer of consideration; they are not fair value exchanges but rather reciprocal transfers. 1. Merger A merger of nonprofit entities is a combination in which the governing bodies of two or more nonprofit entities cede control of those entities to create a new nonprofit entity. The nonprofit entity resulting from a merger shall account for the merger by applying the carryover method. Under the carryover method, the combined entity’s initial set of financial statements carry forward the assets and liabilities of the combining entities, measured at their carrying amounts in the books of the combining entities at the merger date. a. Recognition An entity applying the carryover method recognizes neither additional assets or liabilities nor changes in the fair value of recognized assets and liabilities not already recognized in the combining entities’ financial statements before the merger under GAAP. If a merging entity’s separate financial statements are not prepared in accordance with GAAP, those statements shall be adjusted to GAAP before the new entity recognizes the assets and liabilities. b. Classifying or Designating Assets and Liabilities The new entity shall carry forward into the opening balances in its financial statements the merging entities’ classifications and designations unless either (1) the merger results in a modification of a contract in a manner that would change those previous classifications or designations or (2) reclassifications are necessary to conform accounting policies. c. Measurement The merging entities may have measured assets and liabilities using different methods of accounting in their separate financial statements. The new entity shall adjust the amounts of those assets and liabilities as necessary to reflect a consistent method of accounting. d. Intraentity Transactions The new entity shall eliminate the effects of any intraentity transactions on its assets, liabilities, and net assets as of the merger date. e. Presentation The entity resulting from a merger is a new reporting entity, with no activities before the date of the merger. The new entity’s initial reporting period begins with the merger date and the merger itself is not reported as activity of the initial reporting period. f. Disclosures The new entity shall disclose information that enables users of its financial statements to evaluate the nature and financial effect of the merger that resulted in its formation. It shall include, at a minimum, the following: (1) The name and description of each merging entity (2) The merger date (3) The primary reasons for the merger (4) For each merging entity, the amounts recognized as of the merger date for each major class of assets and liabilities and each class of net assets (5) For each merging entity, the nature and amounts of any significant assets or liabilities that GAAP does not require to be recognized (6) The nature and amount of any significant adjustments made to conform the individual accounting policies of the merging entities or to eliminate intraentity balances Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 110 of 160 Financial Accounting & Reporting (7) 2. Updating Supplement Version 38.3 If the new entity is a public entity, supplemental pro forma information Acquisition An acquisition by a nonprofit entity is a combination in which a nonprofit acquirer obtains control of one or more nonprofit activities or businesses and initially recognizes their assets and liabilities in the acquirer’s financial statements. The acquisition method is used to account for an acquisition by a nonprofit entity. The acquisition method used by nonprofits is essentially the same as that used by for profit entities, with the addition of some guidance on items unique to nonprofit entities and the elimination of guidance that does not apply to a nonprofit acquirer. a. Goodwill Unlike those supported predominantly by contributions and returns on investments, some nonprofit entities are more business-like in that they receive most, or even all, of their support from fees for services. In general, the more business-like a nonprofit entity, the more relevant is information about goodwill acquired to users of the entity’s financial statements. b. Contribution Received Some nonprofit entities are solely or predominantly supported by contributions and returns on investments. An acquirer that expects to be predominantly supported by contributions and returns on investments shall recognize as a separate charge in its statement of activities the amount that would otherwise be recognized as goodwill at the acquisition date. Also, many acquisitions by nonprofit entities constitute an inherent contribution received because the acquirer receives net assets without transferring consideration. The acquirer recognizes such a contribution received as a separate credit in its statement of activities on the acquisition date. c. Recognition As of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest (whether a business or another nonprofit) in the acquiree. d. Classifying or Designating Assets and Liabilities At the acquisition date, the acquirer shall classify or designate the identifiable assets acquired and liabilities assumed as necessary to subsequently apply other GAAP. Those classifications or designations shall be made on the basis of contractual terms, economic conditions, and operating or accounting policies as they exist at the acquisition date. e. Measurement The acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisitiondate fair values. f. Exceptions to Recognition and Measurement Principles The following are some exceptions particular to nonprofit entities: (1) (2) An acquirer that has an organizational policy of not capitalizing collections shall not recognize as an asset those items (works of art, historical treasures, or similar assets) that it acquires as part of an acquisition and adds to its collection (3) An acquirer shall recognize a conditional promise only if the conditions on which it depends are substantially met as of the acquisition date (4) g. The acquirer shall not recognize an acquired donor relationship as an identifiable asset separately from goodwill An acquirer shall recognize a transfer of assets with a conditional promise to contribute them as a refundable advance unless the conditions have been substantially met as of the acquisition date Presentation The financial statements of the acquirer, the combined entity, shall report an acquisition as activity of the period in which it occurs. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 111 of 160 Financial Accounting & Reporting h. Updating Supplement Version 38.3 Disclosures The acquirer shall disclose information that enables users of its financial statements to evaluate the nature and financial effect of an acquisition that occurs either during the current reporting period or after the reporting period but before the financial statements are issued or are available to be issued. It shall include, at a minimum, the following: (1) The name and a description of the acquiree (2) The acquisition date (3) If applicable, the percentage of ownership interests, such as voting equity instruments, acquired (4) The primary reasons for the acquisition and a description of how the acquirer obtained control of the acquiree (5) The acquisition-date fair value of the total consideration transferred (or if no consideration was transferred, that fact) and the acquisition-date fair value of each major class of consideration II. Financial Statements A. Introduction Nonprofit organizations are required to present at least three statements; a Statement of Financial Position, a Statement of Activities, and a Statement of Cash Flows. The statements exhibited in this section are similar to those used by a commercial entity. Some entities may choose to also disclose the fund statements. Several formats are acceptable for nonprofit entities, however, aggregated statements must be used. B. Statement of Financial Position Entities report assets, liabilities, and net assets in this statement. Entities are required to classify net assets based upon the existence or absence of donor-imposed restrictions. Thus, net assets are classified into at least three categories: permanently restricted, temporarily restricted, and unrestricted. Assets are arranged by relative liquidity. Assets restricted to a particular use assume the liquidity of that use. For instance, cash and marketable securities restricted for the purchase of property, plant, and equipment (PPE) are presented below inventories. Exhibit 3 Statement of Financial Position Name of Nonprofit Entity Statement of Financial Position December 31, Year 2 Assets: Cash Contributions Receivable Accounts Receivable Marketable Securities Inventory Prepaid Expenses Assets Restricted to Investment: PPE Property, Plant, and Equipment Long-Term Investments Total Assets $ 38 1,512 1,065 700 300 5 2,605 30,850 109,035 $ 146,110 Copyright © 2009 by Bisk Education, Inc. All rights reserved. Liabilities: Accounts Payable Grants Payable Annuity Obligation Bonds Payable Total Liabilities Net Assets Unrestricted Temporarily Restricted Permanently Restricted Total Net Assets Total Liabilities and Net Assets $ 1,285 438 842 2,750 5,315 57,614 12,171 71,010 140,795 $ 146,110 Page 112 of 160 Financial Accounting & Reporting C. Updating Supplement Version 38.3 Statement of Activities This statement is similar to a for-profit entity’s income statement. Its primary purpose is to provide relevant information about the effects of transactions and other events that change the amount and nature of net assets, the relationships of those transactions and other events to each other, and how the organization’s resources are used in providing various programs or services. It should focus on the organization as a whole and report the amount of the change in net assets for the period. 1. Sequence This statement is presented in the following sequence: Revenues and Other Additions Expenditures and Other Deductions Transfers Among Funds Net Increase (Decrease) in Net Assets Net Assets—Beginning of Year Net Assets—End of Year 2. Changes in Classes It reports the amount of change in permanently restricted net assets, temporarily restricted net assets, and unrestricted net assets for the period. 3. Revenues, Expenses, Gains and Losses The revenues, gains, and losses are classified into the three classes (unrestricted, temporarily restricted, and permanently restricted). Other events, such as expirations of donor-imposed restrictions, that simultaneously increase one class of net assets and decrease another (reclassifications) shall be reported as separate items. All expenses are reported as decreases in unrestricted net assets. 4. Gross Amounts To help explain the relationships of a not-for-profit organization’s ongoing major or central operations and activities, a statement of activities shall report the gross amounts of revenues and expenses. However, investment revenues may be reported net of related expenses, such as custodial fees and investment advisory fees, provided that the amount of the expenses is disclosed either on the face of the statement of activities or in notes to financial statements. 5. Net Amounts A statement of activities may report gains and losses as net amounts if they result from peripheral or incidental transactions or from other events and circumstances that may be largely beyond the control of the organization and its management. Information about their net amounts, used with statement of cash flows information, generally is adequate enough to understand the organization’s activities. 6. Service Efforts To help donors, creditors, and others in assessing an organization’s service efforts, including the costs of its services and how it uses resources, a statement of activities or notes to financial statements shall provide information about expenses reported by their functional classification such as major classes of program services and supporting activities. 7. Program Services These are the activities that result in goods and services being distributed to beneficiaries, customers, or members that fulfill the purposes or mission for which the organization exists. Those services are the major purpose for and the major output of the organization and often relate to several major programs. For example, a university may have programs for student instruction, research, and patient care, among others. Similarly, a health and welfare organization may have programs. 8. Supporting Activities These are the activities of a not-for-profit organization other than program services. Generally, they include management and general, fund-raising, and membership-development activities. a. Management and general activities include oversight, business management, general recordkeeping, budgeting, financing, and related administrative activities, and all Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 113 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 management and administration except for direct conduct of program services or fund-raising activities. b. Fund-raising activities include publicizing and conducting fund-raising campaigns; maintaining donor mailing lists; conducting special fund-raising events; preparing and distributing fund-raising manuals, instructions, and other materials; and conducting other activities involved with soliciting contributions from individuals, foundations, government agencies, and others. c. Membership-development activities include soliciting for prospective members and membership dues, membership relations, and similar activities. Exhibit 4 Statement of Activities Name of Nonprofit Entity Statement of Activities Year Ending December 31, Year 2 Total Revenues and Gains: Contributions Services Fees Investment Income Net Unrealized and Realized Gains on Long-Term Investments Other Net Assets Released From Restrictions: Expiration of Time Requirements Fulfilled Conditions of Equipment Acquisition Fulfilled Conditions of Program Services Total Revenues, Gains, and Other Support Expenses and Losses: Program Expenses Administration Expenses Fund-raising Expenses Loss on Sale of Equipment Actuarial Loss on Annuity Obligations Total Expenses and Losses Change in Net Assets (or change in equity) Net Assets at December 31, Year 1 Net Assets at December 31, Year 2 D. $ Unrestricted Temporarily Restricted Permanently Restricted 8,515 2,700 4,575 $ 4,320 2,700 3,225 $ 4,055 1,290 60 7,900 75 4,114 75 1,476 2,310 5,995 (5,995) 750 625 $ 21,804 $ (750) (625) (549) 15 15 $ 23,765 $ 13,700 1,210 1,075 40 15 $ 16,040 $ $ 7,725 133,070 $140,795 $ 5,779 51,835 $ 57,614 $ 140 $ 2,510 $ 13,700 1,210 1,075 40 $ 16,025 $ (564) 12,735 $ 12,171 $ 2,510 68,500 $ 71,010 Statement of Activities Alternative Two-Part Format The statement of activities may be divided into two parts. The statements exhibited in this section are what an entity using optional fund accounting might present. See Exhibits 5 and 6. 1. Statement of Unrestricted Revenues, Expenses, and Other Changes in Unrestricted Net Assets The first part of the Statement of Activities is based on the operation of the General Funds. It may also be named Statement of Operations. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 114 of 160 Financial Accounting & Reporting Exhibit 5 Updating Supplement Version 38.3 Health Care Entity Statement of Activities: Part 1 Name of Nonprofit Entity Statement of Unrestricted Revenue, Expenses, and Other Changes in Unrestricted Net Assets Year Ending December 31, Year 2 Unrestricted Revenues and Gains: Contributions $ 4,320 Service Fees 2,700 Investment Income 3,225 Net Unrealized and Realized Gains on Long-Term Investments 4,114 Investment Income 75 Net Assets Released From Restrictions: Expiration of Time Requirements 5,995 Fulfilled Conditions of Equipment Acquisition 750 Fulfilled Conditions of Program Services 625 Total Unrestricted Revenues, Gains, and Other Support $ 21,804 Expenses and Losses: Program Expenses 13,700 Administration Expenses 1,210 Fund-raising Expenses 1,075 Loss on Sale of Equipment 40 Total Expenses and Losses 16,025 Change in Unrestricted Net Assets $ 5,779 2. Statement of Changes in Net Assets This part summarizes the first part and reports the changes in restricted assets (increases and decreases in donor-restricted funds). Exhibit 6 Statement of Activities: Part 2 Name of Nonprofit Entity Statement of Changes in Net Assets Year Ending December 31, Year 2 Unrestricted Net Assets Total Unrestricted Revenues and Gains Net Assets Released From Restrictions Total Expenses and Losses Change in Unrestricted Net Assets Temporarily Restricted Net Assets Contributions Investment Income Net Unrealized and Realized Gains on Long-Term Investments Actuarial Loss on Annuity Obligations Net Assets Released From Restrictions Change in Temporarily Restricted Net Assets Permanently Restricted Net Assets (Endowment Funds) Contributions Long-Term Investment Income Net Unrealized and Realized Gains on Long-Term Investments Change in Permanently Restricted Net Assets Change in Net Assets Net Assets at December 31, Year 1 Net Assets at December 31, Year 2 E. $ 14,434 7,370 (16,025) $ 5,779 4,055 1,290 1,476 (15) (7,370) (564) 140 60 2,310 2,510 7,725 133,070 $140,795 Statement of Cash Flows The statement reports the change in cash and cash equivalents similar to commercial enterprises. The description of cash flows from financing activities is expanded to include receiving restricted resources that by donor stipulation must be used for long-term purposes. Also, interest and dividend that are donor restricted for these long-term purposes are not part of operating activities. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 115 of 160 Financial Accounting & Reporting Exhibit 7 Updating Supplement Version 38.3 Statement of Cash Flows Name of Nonprofit Entity Statement of Cash Flows Year Ending December 31, Year 4 Cash Flows From Operating Activities: Cash Received From Service Recipients Cash Received From Contributors Collections on Pledges Interest and Dividends Received Cash Paid to Vendors and Employees Cash Paid for Interest Cash Paid for Grants Net Cash Used by Operating Activities Cash Flows From Investing Activities: Cash Paid for Purchase of Investments Cash Received From Sale of Investments Cash Paid for Property, Plant, and Equipment Cash Received From Sale of Property, Plant, and Equipment Net Cash Used by Investing Activities Cash Flows From Financing Activities: Proceeds from Contributions Restricted for: Investment in Endowment Investment in Term Endowment Investment in Property, Plant, and Equipment Investment Income Restricted for Reinvestment Interest and Dividends Restricted for Reinvestment Less: Payment of Annuity Obligations Less: Payment of Notes Payable Less: Payment on Bonds Payable Net Cash Used by Financing Activities Net Increase in Cash and Cash Equivalents $ 5,220 8,030 2,766 8,570 (23,808) (382) (424) $ (28) $ (74,900) 76,100 (1,500) 250 $ (50) $ 200 70 1,210 200 300 (146) (1,140) (1,000) $ (306) $ Cash and Cash Equivalents at December 31, Year 3 Cash and Cash Equivalents at December 31, Year 4 Reconciliation of Change in Net Assets to Net Cash Used by Operating Activities Change in Net Assets Reconciling Adjustments: Plus: Depreciation Plus: Loss on Sale of Equipment Plus: Actuarial Loss on Annuity Obligations Less: Increase in Accounts and Interest Receivable Less: Increase in Contributions Receivable Plus: Decrease in Inventories and Prepaid Expenses Less: Decrease in Refundable Advance Less: Decrease in Grants Payable Plus: Increase in Accounts Payable Less: Contributions Restricted for Long-Term Investment Less: Investment Income Restricted for Long-Term Investment Less Net Unrealized and Realized Gains on Long-Term Investment Net Cash Used by Operating Activities (384) 460 $ 76 $ 15,450 $ 3,200 80 30 (460) (324) 390 (650) (424) 1,520 (2,740) (300) (15,800) $ (28) Supplemental Data for Noncash Investing and Financing Activities: Gifts of Property, Plant, and Equipment Gifts of Paid-Up Life Insurance, Cash Surrender Value Copyright © 2009 by Bisk Education, Inc. All rights reserved. $ 140 80 Page 116 of 160 Financial Accounting & Reporting F. Updating Supplement Version 38.3 Statement of Functional Expenses The Statement of Functional Expenses is required only for Voluntary Health and Welfare Organizations (VHWO). This details the expenses on the Statement of Activities by functional and natural (or object) classification. 1. Functional Classification A method of grouping expenses according to the purpose for which costs are incurred. The primary functional classifications are program services and supporting activities, as described in the Statement of Activities section. 2. Natural Classification Regular items such as salaries, rent, electricity, interest expense, depreciation, awards and grants to others, and professional fees. 3. Presentation The expenses and classifications must be presented in a matrix format. Exhibit 8 VHWO Statement of Functional Expenses (Heading) Program Services Support Services Research Community Services Total Management and General Fund Raising Total Salaries Employee Benefits Payroll Taxes Professional Fees Contractual Services Supplies Telephone . . . Miscellaneous Total Total Expenses Before Deprec. Depreciation XX XX XX XX XX XX XX . . . XX XX XX XX XX XX XX XX XX . . . XX XX XX XX XX XX XX XX XX . . . XX XX XX XX XX XX XX XX XX . . . XX XX XX XX XX XX XX XX XX . . . XX XX XX XX XX XX XX XX XX . . . XX XX XX XX XX XX XX XX XX . . . XX XX . XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX Total Expenses G. Education Grand Total XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX . . General Disclosures 1. Fundraising Among other things, the NPO is required to disclose a ratio of fundraising expenses to amounts raised, and also how it computes that ratio, in its financial statements. 2. Depreciation An entity shall disclose (a) depreciation expense for the period, (b) depreciable asset balances by nature or function of asset, (c) total accumulated depreciation or accumulated depreciation for the major classes of assets, and (d) the depreciation method or methods used for each major class of assets. 3. Depreciation Exception Depreciation should not be recognized on individual pieces of artwork or antiquities. Artwork or antiquities is deemed to have those characteristics only if verifiable evidence exists that the asset has cultural, aesthetic, or historical value that is worth preserving perpetually and the holder has the technological and financial ability to protect and preserve, essentially undiminished, the service potential of the asset and is doing so. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 117 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 2008 RELEASED AICPA QUESTIONS AND ANSWERS In September 2008, the AICPA released fifty multiple-choice questions and one simulation relating to the FAR section of the CPA examination. These questions and their unofficial answers are reproduced here, along with the exclusive Bisk Education explanations. The multiple-choice questions in Problems 1 and 2 were labeled moderate and hard, respectively, by the AICPA examiners. Problem 3 is the one simulation that was disclosed. The AICPA did not state if these questions ever appeared on any exam, whether they were assigned points or merely being pre-tested and earned no points if they did appear on an exam, or if they were now obsolete for some reason. These questions are intended only as a study aid and should not be used to predict the content of future exams. It is extremely unlikely that released questions will appear on future examinations. These questions have been reproduced as received from the AICPA examiners. If candidates encounter what they believe are errors or ambiguities in questions during their actual exams, they should bring them to the attention of the examiners in accordance with the procedures outlined on the AICPA’s CPA Examination website. Problem 1 MULTIPLE-CHOICE QUESTIONS (50 to 63 minutes) 1. According to the FASB conceptual framework, certain assets are reported in financial statements at the amount of cash or its equivalent that would have to be paid if the same or equivalent assets were acquired currently. What is the name of the reporting concept? a. Replacement cost b. Current market value c. Historical cost d. Net realizable value (R/08, FAR, 0947F, #1, 8556) 2. To be relevant, information should have which of the following? a. Verifiability b. Feedback value c. Understandability d. Costs and benefits (R/08, FAR, C04367F, #2, 8557) 3. Which of the following items is not classified as “other comprehensive income”? a. Extraordinary gains from extinguishment of debt b. Foreign currency translation adjustments c. Minimum pension liability equity adjustment for a defined-benefit pension plan d. Unrealized gains for the year on available-forsale marketable securities (R/08, FAR, 0858F, #3, 8558) 4. A company’s year-end balance sheet is shown below: Assets Cash Accounts receivable Inventory Property, plant and equipment (net) $ 300,000 350,000 600,000 2,000,000 $3,250,000 Liabilities and shareholder equity Current liabilities Long-term liabilities Common stock Retained earnings $ 700,000 600,000 800,000 1,150,000 $3,250,000 What is the current ratio as of December 31? a. 1.79 b. 0.93 c. 0.67 d. 0.43 (R/08, FAR, A1457F, #4, 8559) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 118 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 5. TGR Enterprises provided the following information from its statement of financial position for the year ended December 31, year 1: Cash Accounts receivable Inventories Prepaid expenses Accounts payable Accrued liabilities January 1 $ 10,000 120,000 200,000 20,000 175,000 25,000 December 31 $ 50,000 100,000 160,000 10,000 120,000 30,000 TGR’s sales and cost of sales for year 1 were $1,400,000 and $840,000, respectively. What is the accounts receivable turnover, in days? a. 26.1 b. 28.7 c. 31.3 d. 41.7 (R/08, FAR, A0678F, #5, 8560) 6. Which inventory costing method would a company that wishes to maximize profits in a period of rising prices use? a. FIFO b. Dollar-value LIFO c. Weighted average d. Moving average (R/08, FAR, 0022F, #6, 8561) 7. At the end of the year, Ian Co. determined its inventory to be $258,000 on a FIFO (first in, first out) basis. The current replacement cost of this inventory was $230,000. Ian estimates that it could sell the inventory for $275,000 at a disposal cost of $14,000. If Ian’s normal profit margin for its inventory was $10,000, what would be its net carrying value? a. $244,000 b. $251,000 c. $258,000 d. $261,000 (R/08, FAR, A0240F, #7, 8562) 8. The following costs pertain to Den Co.’s purchase of inventory: 700 units of product A Freight-in Cost of materials and labor incurred to bring product A to saleable condition Insurance cost during transit of purchased goods Total $3,750 175 900 100 $4,925 What amount should Den record as the cost of inventory as a result of this purchase? a. $3,925 b. $4,650 c. $4,825 d. $4,925 (R/08, FAR, 0677F, #8, 8563) 9. A manufacturing firm purchased used equipment for $135,000. The original owners estimated that the residual value of the equipment was $10,000. The carrying amount of the equipment was $120,000 when ownership transferred. The new owners estimate that the expected remaining useful life of the equipment was 10 years, with a salvage value of $15,000. What amount represents the depreciable base used by the new owners? a. $105,000 b. $110,000 c. $120,000 d. $125,000 (R/08, FAR, A0645F, #9, 8564) 10. Anchor Co. owns 40% of Main Co.’s common stock outstanding and 75% of Main’s noncumulative preferred stock outstanding. Anchor exercises significant influence over Main’s operations. During the current period, Main declared dividends of $200,000 on its common stock and $100,000 on its noncumulative preferred stock. What amount of dividend income should Anchor report on its income statement for the current period related to its investment in Main? a. $ 75,000 b. $ 80,000 c. $ 120,000 d. $ 225,000 (R/08, FAR, 1568F, #10, 8565) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 119 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 11. At the beginning of the current year, Hayworth Co. sold equipment with a two-year service contract for a single payment of $20,000. The fair value of the equipment was $18,000. Hayworth recorded this transaction with a debit of $20,000 to cash and a credit of $20,000 to sales revenue. Which of the following statements is correct regarding Hayworth’s current-year financial statements? a. The financial statements are correct. b. Net income will be overstated. c. Total assets will be overstated. d. Total liabilities will be overstated. (R/08, FAR, A1420F, #11, 8566) 15. On January 2, 2003, Raft Corp. discovered that it had incorrectly expensed a $210,000 machine purchased on January 2, 2000. Raft estimated the machine’s original useful life to be 10 years and its salvage value at $10,000. Raft uses the straight-line method of depreciation and is subject to a 30% tax rate. In its December 31, 2003, financial statements, what amount should Raft report as a prior period adjustment? a. $102,900 b. $105,000 c. $165,900 d. $168,000 (R/08, FAR, 0439F, #15, 8570) 12. On January 1, a company issued a $50,000 face value, 8% five-year bond for $46,139 that will yield 10%. Interest is payable on June 30 and December 31. What is the bond carrying amount on December 31 of the current year? a. $46,139 b. $46,446 c. $46,768 d. $47,106 (R/08, FAR, A1726F, #12, 8567) 16. Which of the following describes the appropriate reporting treatment for a change in accounting estimate? a. In the period of change with no future consideration b. By reporting pro forma amounts for prior periods c. By restating amounts reported in financial statements of prior periods d. In the period of change and future periods if the change affects both (R/08, FAR, C01221F, #16, 8571) 13. What type of bonds in a particular bond issuance will not all mature on the same date? a. Debenture bonds b. Serial bonds c. Term bonds d. Sinking fund bonds (R/08, FAR, 1363F, #13, 8568) 14. In 2002, Spirit, Inc. determined that the 12-year estimated useful life of a machine purchased for $48,000 in January 1997 should be extended by three years. The machine is being depreciated using the straight-line method and has no salvage value. What amount of depreciation expense should Spirit report in its financial statements for the year ending December 31, 2002? a. $2,800 b. $3,200 c. $4,200 d. $4,800 (R/08, FAR, 0657F, #14, 8569) 17. On January 2, of the current year, Peace Co. paid $310,000 to purchase 75% of the voting shares of Surge Co. Peace reported retained earnings of $80,000, and Surge reported contributed capital of $300,000 and retained earnings of $100,000. The purchase differential was attributed to depreciable assets with a remaining useful life of 10 years. Peace used the equity method in accounting for its investment in Surge. Surge reported net income of $20,000 and paid dividends of $8,000 during the current year. Peace reported income, exclusive of its income from Surge, of $30,000 and paid dividends of $15,000 during the current year. What amount will Peace report as dividends declared and paid in its current year’s consolidated statement of retained earnings? a. $ 8,000 b. $ 15,000 c. $ 21,000 d. $ 23,000 (R/08, FAR, C02270F, #17, 8572) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 120 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 18. A corporation issues quarterly interim financial statements and uses the lower cost or market method to value its inventory in its annual financial statements. Which of the following statements is correct regarding how the corporation should value its inventory in its interim financial statements? a. Inventory losses generally should be recognized in the interim statements. b. Temporary market declines should be recognized in the interim statements. c. Only the cost method of valuation should be used. d. Gains from valuations in previous interim periods should be fully recognized. (R/08, FAR, A2005F, #18, 8573) 19. Steam Co. acquired equipment under a capital lease for six years. Minimum lease payments were $60,000 payable annually at year-end. The interest rate was 5% with an annuity factor for six years of 5.0757. The present value of the payments was equal to the fair market value of the equipment. What amount should Steam report as interest expense at the end of the first year of the lease? a. $0 b. $ 3,000 c. $ 15,227 d. $ 18,000 (R/08, FAR, 1274F, #19, 8574) 20. Which of the following expenditures qualifies for asset capitalization? a. Cost of materials used in prototype testing b. Costs of testing a prototype and modifying its design c. Salaries of engineering staff developing a new product d. Legal costs associated with obtaining a patent on a new product (R/08, FAR, A0472F, #20, 8575) 22. Powell City purchased a piece of equipment to be used by a department financed by the general fund. How should Powell report the acquisition in the general fund? a. As an expenditure b. Capitalize, depreciation is optional c. Capitalize, depreciation is required d. Capitalize, depreciation is not permitted (R/08, FAR, 0751G, #22, 8577) 23. Hann School, a nongovernmental not-for-profit organization, spent $1 million of temporarily restricted cash to acquire land and building. How should this be reported in the statement of activities? a. Increase in unrestricted net assets b. Increase in temporarily restricted net assets c. Increase in permanently restricted net assets d. Decrease in permanently restricted net assets (R/08, FAR, A0147N, #23, 8578) 24. Which of the following comprise functional expense categories for a nongovernmental not-forprofit organization? a. Program services, management and general, and fund-raising b. Membership dues, fund-raising, and management and general c. Grant expenses, program services, and membership development d. Membership development, professional fees, and program services (R/08, FAR, A0367N, #24, 8579) 25. Settam, a nongovernmental not-for-profit organization, received a donation of stock with donorstipulated requirements as follows: Shares valued at $8,000,000 are to be sold with the proceeds used for renovation. Shares valued at $2,000,000 are to be retained with the dividends used to support current operations. 21. What is the measurement focus and the basis of accounting for the government-wide financial statements? a. b. c. d. Measurement focus Current financial resources Economic resources Current financial resources Economic resources Basis of accounting Modified accrual Modified accrual Accrual Accrual What amount should Settam include as unrestricted net assets as a result of this donation? a. $0 b. $ 2,000,000 c. $ 8,000,000 d. $ 10,000,000 (R/08, FAR, 0983G, #25, 8580) (R/08, FAR, A0008G, #21, 8576) __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 121 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Problem 2 ADDITIONAL MULTIPLE-CHOICE QUESTIONS (50 to 63 minutes) 26. Which of the following statements is correct regarding reporting comprehensive income? a. Accumulated other comprehensive income is reported in the stockholders’ equity section of the balance sheet. b. A separate statement of comprehensive income is required. c. Comprehensive income must include all changes in stockholders’ equity for the period. d. Comprehensive income is reported in the yearend statements but not in the interim statements. (R/08, FAR, A1931F, #26, 8581) 27. How should the amortization of bond discount on long-term debt be reported in a statement of cash flows prepared using the indirect method? a. As a financing activities inflow b. As a financing activities outflow c. In operating activities as a deduction from income d. In operating activities as an addition to income (R/08, FAR, 0501F, #27, 8582) 28. Sanni Co. had $150,000 in cash-basis pretax income for the year. At the current year end, accounts receivable decreased by $20,000 and accounts payable increased by $16,000 from their previous year-end balances. Compared to the accrual-basis method of accounting, Sanni’s cashbasis pretax income is a. Higher by $4,000 b. Lower by $4,000 c. Higher by $36,000 d. Lower by $36,000 (R/08, FAR, A0554F, #28, 8583) 30. The following information was taken from Baxter Department Store’s financial statements: Inventory at January 1 Inventory at December 31 Net sales Net purchases $ 100,000 300,000 2,000,000 700,000 What was Baxter’s inventory turnover for the year ending December 31? a. 2.5 b. 3.5 c. 5 d. 10 (R/08, FAR, 1553F, #30, 8585) 31. Smith Co. has a checking account at Small Bank and an interest-bearing savings account at Big Bank. On December 31, year 1, the bank reconciliations for Smith are as follows: Big Bank Bank balance Deposit in transit Book balance Small Bank Bank balance Outstanding checks Book balance $150,000 5,000 155,000 $ 1,500 (8,500) (7,000) What amount should be classified as cash on Smith’s balance sheet at December 31, year 1? a. $148,000 b. $151,000 c. $155,000 d. $156,000 (R/08, FAR, A0526F, #31, 8586) 29. Redwood Co.’s financial statements had the following information at year end: Cash Accounts receivable Allowance for uncollectible accounts Inventory Short-term marketable securities Prepaid rent Current liabilities Long-term debt $ 60,000 180,000 8,000 240,000 90,000 18,000 400,000 220,000 What was Redwood’s quick ratio? a. 0.81 to 1 b. 0.83 to 1 c. 0.94 to 1 d. 1.46 to 1 (R/08, FAR, 1373F, #29, 8584) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 122 of 160 Financial Accounting & Reporting 32. Seafood Trading Co. commenced operations during the year as a large importer and exporter of seafood. The imports were all from one country overseas. The export sales were conducted as drop shipments and were merely transshipped at Seattle. Seafood Trading reported the following data: Purchases during the year $12.0 million Shipping costs from overseas 1.5 million Shipping costs to export customers 1.0 million Inventory at year end 3.0 million What amount of shipping costs should be included in Seafood Trading’s year-end inventory valuation? a. $0 b. $250,000 c. $375,000 d. $625,000 (R/08, FAR, C02967F, #32, 8587) 33. Fireworks, Inc. had an explosion in its plant that destroyed most of its inventory. Its records show that beginning inventory was $40,000. Fireworks made purchases of $480,000 and sales of $620,000 during the year. Its normal gross profit percentage is 25%. It can sell some of its damaged inventory for $5,000. The insurance company will reimburse Fireworks for 70% of its loss. What amount should Fireworks report as loss from the explosion? a. $50,000 b. $35,000 c. $18,000 d. $15,000 (R/08, FAR, A0224F, #33, 8588) 34. A depreciable asset has an estimated 15% salvage value. Under which of the following methods, properly applied, would the accumulated depreciation equal the original cost at the end of the asset’s estimated useful life? a. b. c. d. Straight-line Yes Yes No No Double-declining balance Yes No Yes No (R/08, FAR, 0962F, #34, 8589) Updating Supplement Version 38.3 35. On December 31, 2003, Moon, Inc. authorized Luna Co. to operate as a franchisee for an initial franchise fee of $100,000. Luna paid $40,000 on signing the agreement and signed an interestfree note to pay the balance in three annual installments of $20,000 each, beginning December 31, 2004. On December 31, 2003, the present value of the note, appropriately discounted, is $48,000. Services for the initial fee will be performed in 2004. In its December 31, 2003, balance sheet, what amount should Moon report as unearned franchise fees? a. $0 b. $ 48,000 c. $ 88,000 d. $ 100,000 (R/08, FAR, 0039F, #35, 8590) 36. On July 28, Vent Corp. sold $500,000 of 4%, eight-year subordinated debentures for $450,000. The purchasers were issued 2,000 detachable warrants, each of which was for one share of $5 par common stock at $12 per share. Shortly after issuance, the warrants sold at a market price of $10 each. What amount of discount on the debentures should Vent record at issuance? a. $50,000 b. $60,000 c. $70,000 d. $74,000 (R/08, FAR, 0041F, #36, 8591) 37. Which of the following statements characterizes convertible debt? a. The holder of the debt must be repaid with shares of the issuer’s stock. b. No value is assigned to the conversion feature when convertible debt is issued. c. The transaction should be recorded as the issuance of stock. d. The issuer’s stock price is less than market value when the debt is converted. (R/08, FAR, A0042F, #37, 8592) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 123 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 38. The following is the stockholders’ equity section of Harbor Co.’s balance sheet at December 31: Common stock $10 par, 100,000 shares authorized, 50,000 shares issued of which 5,000 have been reacquired, and are held in treasury Additional paid-in capital common stock Retained earnings Subtotal Less treasury stock Total stockholders’ equity $ 450,000 1,100,000 800,000 $2,350,000 (150,000) $2,200,000 Harbor has insignificant amounts of convertible securities, stock warrants, and stock options. What is the book value per share of Harbor’s common stock? a. $31 b. $44 c. $46 d. $49 (R/08, FAR, 1413F, #38, 8593) 39. Sayon Co. issues 200,000 shares of $5 par value common stock to acquire Trask Co. in a purchase-business combination. The market value of Sayon’s common stock is $12. Legal and consulting fees incurred in relationship to the purchase are $110,000. Registration and issuance costs for the common stock are $35,000. What should be recorded in Sayon’s additional paid-in capital account for this business combination? a. $1,545,000 b. $1,400,000 c. $1,365,000 d. $1,255,000 (R/08, FAR, A0725F, #39, 8594) 40. A corporation entered into a purchase commitment to buy inventory. At the end of the accounting period, the current market value of the inventory was less than the fixed purchase price, by a material amount. Which of the following accounting treatments is most appropriate? a. Describe the nature of the contract in a note to the financial statements, recognize a loss in the income statement, and recognize a liability for the accrued loss b. Describe the nature of the contract and the estimated amount of the loss in a note to the financial statements, but do not recognize a loss in the income statement c. Describe the nature of the contract in a note to the financial statements, recognize a loss in the income statement, and recognize a reduction in inventory equal to the amount of the loss by use of a valuation account d. Neither describe the purchase obligation, nor recognize a loss on the income statement or balance sheet (R/08, FAR, A1264F, #40, 8595) 41. The following information is relevant to the computation of Chan Co.’s earnings per share to be disclosed on Chan’s income statement for the year ending December 31: Net income for 2002 is $600,000. $5,000,000 face value 10-year convertible bonds outstanding on January 1. The bonds were issued four years ago at a discount which is being amortized in the amount of $20,000 per year. The stated rate of interest on the bonds is 9%, and the bonds were issued to yield 10%. Each $1,000 bond is convertible into 20 shares of Chan’s common stock. Chan’s corporate income tax rate is 25%. Chan has no preferred stock outstanding, and no other convertible securities. What amount should be used as the numerator in the fraction used to compute Chan’s diluted earnings per share assuming that the bonds are dilutive securities? a. $ 130,000 b. $ 247,500 c. $ 952,500 d. $ 1,070,000 (R/08, FAR, 1421F, #41, 8596) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 124 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 42. Which of the following is the characteristic of a perfect hedge? a. No possibility of future gain or loss b. No possibility of future gain only c. No possibility of future loss only d. The possibility of future gain and no future loss (R/08, FAR, C04481F, #42, 8597) 43. Gordon Ltd., a 100% owned British subsidiary of a U.S. parent company, reports its financial statements in local currency, the British pound. A local newspaper published the following U.S. exchange rates to the British pound at year end: Current rate Historical rate (acquisition) Average rate Inventory (FIFO) $1.50 1.70 1.55 1.60 Which currency rate should Gordon use to convert its income statement to U.S. dollars at year end? a. 1.50 b. 1.55 c. 1.60 d. 1.70 (R/08, FAR, 1282F, #43, 8598) 44. On January 16, Tree Co. paid $60,000 in property taxes on its factory for the current calendar year. On April 2, Tree paid $240,000 for unanticipated major repairs to its factory equipment. The repairs will benefit operations for the remainder of the calendar year. What amount of these expenses should Tree include in its third quarter interim financial statements for the three months ended September 30? a. $0 b. $15,000 c. $75,000 d. $95,000 (R/08, FAR, 0341F, #44, 8599) 45. Stam Co. incurred the following research and development project costs during the current year: Equipment purchased for current and future projects Equipment purchased for current projects only Research and development salaries for current projects Legal fees to obtain patent Material and labor costs for prototype product $100,000 200,000 400,000 50,000 600,000 The equipment has a five-year useful life and is depreciated using the straight-line method. What amount should Stam recognize as research and development expense at year end? a. $ 450,000 b. $ 1,000,000 c. $ 1,220,000 d. $ 1,350,000 (R/08, FAR, 1262F, #45, 8600) 46. A state had general obligation bonds outstanding that required payment of interest on July 1 and January 1 of each year. State law allowed for the general fund to make debt payments without the use of a fiscal agent. The fiscal year ended June 30. Which of the following accounts would have decreased when the state paid the interest due on July 1? a. Interest expenditures b. Interest payable c. Interest expense d. Fund balance (R/08, FAR, A0034G, #46, 8601) 47. On March 1, Wag City issued $1,000,000, ten-year, 6% general obligation bonds at par with no bond issue costs. The bonds pay interest September 1 and March 1. What amount of interest expense and bond interest payable should Wag report in its government-wide financial statements at the close of the fiscal year on December 31? a. Interest expense, $50,000; interest payable, $20,000 b. Interest expense, $50,000; interest payable, $0 c. Interest expense, $60,000; interest payable, $10,000 d. Interest expense, $30,000; interest payable, $0 (R/08, FAR, A0090G, #47, 8602) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 125 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 49. How should unconditional pledges received by a nongovernmental not-for-profit organization that will be collected over more than one year be reported? a. Long-term pledges receivable, valued at the expected collection amount b. Pledges receivable, valued at their present values c. Deferred revenue, valued at present value d. Pledges receivable, valued at the amount pledged (R/08, FAR, A0126N, #49, 8604) 48. All of the following statements regarding notes to the basic financial statements of governmental entities are true except a. The notes contain disclosures related to required supplementary information. b. Some notes presented by governments are identical to notes presented in business financial statements. c. Notes that are considered essential to the basic financial statements need to be presented. d. It is acceptable to present notes in a very extensive format. (R/08, FAR, A0088G, #48, 8603) 50. How should a nongovernmental, not-for-profit organization report donor-restricted cash contributions for long-term purposes in its statement of cash flows? a. Operating activity inflow b. Investing activity inflow c. Financing activity inflow d. As a noncash transaction (R/08, FAR, A0158N, #50, 8605) __________________ Problem 3 SIMULATION (30 to 45 minutes) Situation Bond Issue Price Interest Expense Balance Sheet On January 2, 2003, the Lyndhurst Company, Inc. a privately-held company, issued $1,000,000, fiveyear, 10.00% bonds, dated January 2, 2003. The bonds provided for semi-annual interest payments to be made on June 30 and December 31 of each year. Terms of the bond indenture allowed the company to call the bonds at 102 after one year. The bonds were issued when the market interest rate was 8.00%. Lyndhurst Company, Inc. uses the effective interest method for amortizing bond discounts and premiums. The bonds are term bonds that mature on December 31, 2007. Lyndhurst Company, Inc.’s fiscal year for financial reporting purposes is December 31. The company called the bonds at 102 on June 30, 2004. Situation Bond Issue Price Interest Expense (R/08, FAR, P3, amended, 8606) Balance Sheet Use the following spreadsheet to calculate the present values of the principal and interest cash flows related to the bonds, and the resulting bond issue price. For each shaded cell in rows 2 and 3, columns B, through F, select the appropriate value or formula from the choices listed below that column. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 126 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 For column E, use the compound interest tables in Appendix D to find the appropriate time value factors. Calculate the bond issue price, based on your selections, and enter it in cell F4. Round the result of any calculations to the nearest dollar. (Formula symbol definitions: * = multiplied by; / = divided by) A B C D E F 1 Payment Type Compounding Period(2) Interest Rate Payment Amount Factor Present Value 2 Principal 3 Interest 4 Bond Issue Price $ Choices for Cells B2 & B3 1 2 5 7 10 Situation Bond Issue Price Choices for Cells D2 & D3 $ 40,000 $ 50,000 $ 80,000 $ 100,000 $1,000,000 $1,040,000 $1,050,000 Interest Expense Choices for Cell E2 0.385543 0.463194 0.613913 0.620921 0.675564 0.680583 0.783526 0.821927 Choices for Cell F2 (B2*D2)/E2 C2*D2 D2*E2 D2/E2 (D2/B2)*C2 Choices for Cell E3 3.790787 3.992710 4.329477 4.451822 6.144567 6.710082 7.721735 8.110896 Choices for Cells C2 & C3 0.040 0.050 0.080 0.100 Choices for Cell F3 (B3*D3)/E3 C3*D3 D3*E3 D3/E3 (D3/B3)*C3 Balance Sheet Complete the bond amortization table for the original Lyndhurst Company, Inc. bonds (issued 1/2/2003) through the term of the bonds in the following way: 1 2 3 4 5 The face amount of the bonds issued appears in cell G2 of the spreadsheet below. Insert your calculation of the bond issue price (from the previous tab) in cell F2. Calculate the amount of the unamortized (discount) or premium and insert it in cell E2. Finish completing the bond amortization schedule in rows A through F. Round the result of any calculations to the nearest dollar. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 127 of 160 Financial Accounting & Reporting A 1 Date 2 01/01/03 3 4 5 6 7 8 9 10 11 12 B Updating Supplement Version 38.3 D E F Increase (Decrease) Unamortized Carrying (Discount) Amount Interest Interest in Carrying Payment Expense Amount of Bonds or Premium of Bonds Situation C Bond Issue Price Interest Expense G H Face Amount Interest of Bonds rates (%) $1,000,000 Bond 10.00 Market 8.00 Balance Sheet Use the values in the amortization table on the previous tab to complete the liabilities section of Lyndhurst Company, Inc.’s December 31, 2003, balance sheet and excerpts from the income statement for the year ending December 31, 2003. Insert the appropriate values in the shaded cells below. Lyndhurst Company, Inc. Balance Sheet December 31, 2003 I Liabilities: Accounts payable and other liabilities Bonds payable Lyndhurst Company, Inc. 5 6 7 8 9 10 11 12 Income Statement 13 Year ended December 31, 2003 14 15 16 17 18 19 $ 150,000 Unamortized premium/discount Total liabilities Sales Expenses before interest and taxes Interest expense Net income before taxes Copyright © 2009 by Bisk Education, Inc. All rights reserved. 1,000,000 500,000 Page 128 of 160 Financial Accounting & Reporting Gain/Loss Updating Supplement Version 38.3 Communication Research Lyndhurst Company, Inc. called the 10.00%, $1,000,000 bonds on June 30, 2004, paying bondholders the 102 call price. Enter the appropriate values in the shaded cells below and calculate the gain or loss on this early retirement of the debt. Indicate whether the value in column C represents a gain or a loss by entering “Gain” or “Loss” in column D. 1 A Carrying Amount of Debt B Payment Due at Call Date C Amount of Gain or (Loss) D Indicate “Gain” or “Loss” 2 Gain/Loss Communication Research Write a memo to the company’s CEO explaining under what market conditions the company’s bonds would be issued at a premium. REMINDER: On the actual exam your response will be graded for both technical content and writing skills. Technical content will be evaluated for information that is helpful to the intended reader and clearly relevant to the issue. Writing skills will be evaluated for development, organization, and the appropriate expression of ideas in professional correspondence. Use a standard business memo or letter format with a clear beginning, middle, and end. Do not convey information in the form of a table, bullet point list, or other abbreviated presentation. Gain/Loss Communication Research Lyndhurst Company, Inc. issued convertible bonds in the past and is considering a cash incentive to the bondholders as an inducement to convert the debt into equity shares. How should Lyndhurst Company, Inc. account for these incentive payments to its bondholders? REMINDER: On the actual exam you will use a research database to find the correct authoritative literature and then select from a variety of choices dependent upon your research. Please see the AICPA’s tutorial and sample tests on The Uniform CPA Examination website (www.cpa-exam.org). Paragraph Reference Answer: _______________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 129 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Solution 1 MULTIPLE-CHOICE ANSWERS 1. (a) This reporting concept is replacement cost. It is defined as the price of a new, similar item after allowance for use and depreciation. Current market value is the hypothetical selling price that could be obtained in an arm’s-length transaction. Historical cost is the acquisition cost less depreciation or amortization to date. Net realizable value is the net amount expected to be received in cash. (Chapter 1-2-3, CBT Skill: Understanding, CSO: 1.1.2) 2. (b) Relevance and reliability are the two primary decision specific factors that make accounting information useful for decision making. To be relevant, information must be timely and must have either predictive or feedback value. Verifiability is a trait associated with reliability. Understandability is a user-specific quality characteristic. Costs and benefits are to be considered when determining the kind of information to be provided. Information is only valuable to the extent that the cost of obtaining and analyzing it is less than the benefits derived from its use. (Chapter 1-6-3, CBT Skill: Understanding, CSO: 1.1.2) 3. (a) Extraordinary gains from extinguishment of debt is not classified as other comprehensive income. Foreign currency translation adjustments, pension liability adjustments for a defined benefit pension plan, and unrealized gains on available-for-sale marketable securities are all classified as other comprehensive income. (Chapter 1-2-2, CBT Skill: Understanding, CSO: 1.2.3) 4. (a) The current ratio is a primary test of the overall solvency of the enterprise and its ability to meet current obligations from current assets. It is derived by dividing the current assets by the current liabilities. Current assets include the $300,000 in cash, $350,000 in accounts receivable, and $600,000 in inventory for a total of $1,250,000. The current liabilities are given as $700,000. [$1,250,000/ $700,000 = 1.79] (Chapter 15-2-2, CBT Skill: Analysis, CSO: 1.4.0) 5. (b) The accounts receivable turnover in days tests the average number of days to collect receivables and is computed by taking the number of business days used in a year over the accounts receivable turnover. The accounts receivable turnover is the net credit sales over the average net accounts receivable. The number 360 is commonly used as the number of business days in a year because it is easily divisible by 12 to get a monthly number. Some analysts prefer to use 365, 300, or 250 as the number of business days in the year. The net credit sales of $1,400,000 over the average net receivables of $110,000 equals approximately 12.72. Using 365 days divided by 12.72 equals approximately 28.7. This question is an example of how you may have to try the different number of business days used to get to one of the answer choices. (Chapter 15-2-3, CBT Skill: Analysis, CSO: 1.4.0) 6. (a) The FIFO inventory costing method assumes that the goods first acquired are the first sold and, as such, would maximize profits in a period of rising prices. Dollar-value LIFO is based on the dollar value of inventory pools of similar items and the last items acquired would be the first sold. Weighted average and moving average inventory costing methods use an average and thus would not lead to maximizing profits in a period of rising prices. (Chapter 3-2-3, CBT Skill: Judgment, CSO: 2.3.0) 7. (b) Ian would report its inventory at the lower of cost or market. The market means current replacement cost except the market cannot exceed the net realizable value, known as the ceiling, or be less than the net realizable value minus normal profit, known as the floor. Net realizable value is the estimated selling price less reasonable costs of completion and disposal. The ceiling would be $261,000 ($275,000 selling price – $14,000 disposal costs) and the floor would be $251,000 ($275,000 selling price – $14,000 disposal costs – $10,000 normal profit margin). The replacement cost is only $230,000, so the market would be the minimum amount of $251,000. Comparing the lower of cost ($258,000) or market ($251,000) shows the market is lower. So Ian’s inventory would be carried at $251,000. (Chapter 3-2-4, CBT Skill: Analysis, CSO: 2.3.0) 8. (d) The cost of merchandise inventory is net of any discounts but includes freight-in, taxes, insurance while in transit, warehousing costs, and similar charges paid to bring the article to its existing condition and location. The cost of the inventory would be the $3,750 purchase price, plus the $175 freight-in charge, plus the $900 costs of materials and labor to bring it to saleable condition, plus the $100 insurance cost during transit for a total of $4,925. (Chapter 3-2-2, CBT Skill: Analysis, CSO: 2.3.0) 9. (c) The asset would be recorded at $135,000, its acquisition cost to the new owners. The salvage value would be the $15,000 estimated by the new owners. The carrying amount and residual value of the previous owners does not Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 130 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 matter to the new owners. The depreciable base would be $120,000; the $135,000 acquisition cost less the $15,000 estimated salvage value. (Chapter 4-3-1, CBT Skill: Analysis, CSO: 2.4.0) 10. (a) Anchor would report $75,000 in dividend income on its income statement for the current period related to its investment in Main. The $75,000 comes from the 75% of $100,000 dividend that Anchor would receive on the noncumulative preferred stock. Anchor would also recognize $80,000, 40% of the $200,000 common stock dividend, but not on the income statement. Because Anchor exercises significant influence over Main’s operations, Anchor would use the equity method to account for its common stock investment in Main. Anchor would credit the Investment account since the distribution reduces the owner’s equity of Main. (Chapter 2-3-5, CBT Skill: Analysis, CSO: 2.5.0) 11. (b) Of the $20,000 Hayworth received, $18,000 should have been for sales revenue from the equipment and $2,000 should have been allocated to the two-year service contract. Because only one year has passed, Hayworth has only earned $1,000 from that service contract and still has a liability for the next year. Recording the transaction the way Hayworth did means net income will be overstated, the financial statements are not correct, total assets are not affected, and total liabilities will be understated. (Chapter 7-1-3, CBT Skill: Analysis, CSO: 2.8.0) 12. (c) In determining the carrying amount of bonds, an adjustment is made for premium or discount amortization to the date of sale. Amortization of a bond premium decreases interest expense and the carrying amount of the bond, while the amortization of a bond discount increases the issuer’s interest expense and carrying amount of the bond. Bonds payable carrying amount, 1/1 Effective interest rate (10% × 6/12) Interest expense, 1/1- 6/30 Interest payment [$50,000 × (8% × 6/12)] Amortization of discount, 1/2 - 6/30 Bonds payable carrying amount, 1/1 Bonds payable carrying amount, 6/30 Effective interest rate (10% × 6/12) Interest expense, 7/1 - 12/31 Interest payment [$50,000 × (8% × 6/12)] Amortization of discount, 7/1 - 12/31 Bonds payable carrying amount, 6/30 Bonds payable carrying amount, 12/31 $46,139 × 5% 2,307 (2,000) 307 46,139 46,446 × 5% 2,322 (2,000) 322 46,446 $46,768 $46,139 + $307 + $322 = $46,768 (Chapter 6-3-3, CBT Skill: Analysis, CSO: 2.9.0) 13. (b) Serial bonds are a set of bonds issued at the same time but having a different maturity date; thus providing a series of installments for repayment of principal. A debenture bond is just an unsecured bond. A term bond is an issue of bonds that all have the same maturity date. Most corporate bonds are term bonds. Sinking fund bonds require the debtor to periodically set aside sums to give assurance to investors and would mature normally on a set date. (Chapter 6-4-1, CBT Skill: Analysis, CSO: 2.9.0) 14. (a) Changing the estimated useful life of a machine is considered a change in accounting estimate and accounted for in the current and subsequent periods. The machine had been depreciated a total of $20,000 thus far, 5 years at $4,000 per year ($48,000 / 12 years straight-line = $4,000 per year). The original amount of $48,000 less the $20,000 depreciated so far equals $28,000 worth of useful life. Extending the useful life three years means it now has 10 years of useful life left (12 years originally less the 5 years gone by plus 3 more years). So the depreciation expense is $2,800 ($28,000 / 10) per year. (Chapter 11-4-2, CBT Skill: Analysis, CSO: 3.1.0) 15. (b) Raft Corp. should have only expensed the depreciation expense of $60,000 over the previous 3 years [($210,000 cost less $10,000 salvage value) / 10 years useful life = $20,000 per year]. The difference of what was expensed ($210,000) and what should have been expensed ($60,000) is $150,000. The $150,000 times the 30% tax rate = $45,000. Therefore, $150,000 less $45,000 equals a prior period adjustment of $105,000. (Chapter 11-4-4, CBT Skill: Analysis, CSO: 3.1.0) 16. (d) A change in accounting estimate is reported in the period of change and future periods if the change affects both. There are no pro forma reports for prior periods, and amounts reported in financial statements of prior periods are not restated. (Chapter 11-4-2, CBT Skill: Understanding, CSO: 3.1.0) 17. (b) Peace will report just the $15,000 in dividends they paid during the year as dividends declared and paid in its current year’s consolidated statement of retained earnings. The 75% portion of the $8,000 in dividends paid by Surge will be treated by Peace as a reduction in the carrying amount of the investment in Surge. (Chapter 17-3-3, CBT Skill: Analysis, CSO: 3.2.0) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 131 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 18. (a) The use of lower of cost or market may result in inventory losses that should not be deferred beyond the interim period in which the decline occurs. Recoveries of these losses in subsequent periods should be recognized as gains, but only to the extent of losses recognized in previous interim periods of the same fiscal year. Temporary market declines need not be recognized at the interim date since no loss is expected to be incurred in the fiscal year. The cost method of valuation need not be the only method used. (Chapter 11-5-2, CBT Skill: Judgment, CSO: 3.12.0) 19. (c) You must first calculate the present value of the minimum lease payments. The present value of the minimum lease payments is the minimum lease payment amount of $60,000 times the annuity factor of 5.0757 equaling $304,542. Because no payment is made until the end of the year, you would take that amount of $304,542 times the interest rate of 5% and get interest expense of $15,227 at the end of the first year of the lease. (Chapter 8-4-2, CBT Skill: Analysis, CSO: 3.13.0) 20. (d) The external acquisition costs of a patent, which includes the legal costs associated with obtaining a patent on a new product, qualifies for asset capitalization. Cost of materials used in prototype testing, costs of testing a prototype and modifying its design, and salaries of engineering staff developing a new product are all examples of research and development costs. These research and development costs are not capitalized, but instead expensed in the year in which incurred. (Chapter 5-2-1, CBT Skill: Understanding, CSO: 3.16.0) 21. (d) Government-wide financial statements aggregate information for all governmental and business-type activities. GASB 34 requires an economic resources measurement focus and accrual basis of accounting for all amounts in the government-wide financial statements. (Chapter 182-1, CBT Skill: Understanding, CSO: 4.1.1) 22. (a) The modified accrual basis of accounting is used in the governmental-type fund statements such as the general fund. Under the modified accrual basis of accounting, fixed assets are expenditures and not capitalized. (Chapter 181-5, CBT Skill: Understanding, CSO: 4.1.2) 23. (a) Unrestricted assets are assets from donations unrestricted by the donor and assets formerly temporarily restricted by the donors that have since become unrestricted. The $1 million in cash which was temporarily restricted has now been used for its purpose. This results in an increase in unrestricted net assets. There would not be an increase, but instead there would be a decrease, in temporarily restricted net assets. There would be no effect, increase or decrease, in permanently restricted assets. (Chapter 20-1-2, CBT Skill: Judgment, CSO: 5.1.2) 24. (a) There are two primary functional expense classifications; program services and support services. Program services include research, education, and community services. Support services categories are management and general, and fund-raising. Membership dues, grant expenses, membership development, and professional fees are not functional expense categories for a nongovernmental not-for-profit organization. (Chapter 20-2-3, CBT Skill: Understanding, CSO: 5.1.4) 25. (a) None of the shares would be included as unrestricted net assets. The shares valued at $8,000,000 would be a temporarily restricted net asset with the allowable use of the income being restricted by the terms of the donation. The shares valued at $2,000,000 would be a permanently restricted net asset. (Chapter 20-1-2, CBT Skill: Analysis, CSO: 5.2.4) __________________ Solution 2 ADDITIONAL MULTIPLE-CHOICE ANSWERS 26. (a) An entity is required to display the accumulated balance of other comprehensive income separately from retained earnings, capital stock, and additional paid-in capital in the stockholders’ equity section of a statement of financial position (balance sheet). No separate statement of comprehensive income is required, comprehensive income doesn’t need to include all changes in stockholders’ equity for the period, and comprehensive income is reported in the interim financial statements. (Chapter 11-3-3, CBT Skill: Judgment, CSO: 1.2.3) 27. (d) The amortization of bond discount on long-term debt is reported as an addition to income in the operating activities section of a statement of cash flows prepared using the indirect method. (Chapter 14-3-6, CBT Skill: Analysis, CSO: 1.2.4) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 132 of 160 Financial Accounting & Reporting 28. (c) Compared to the accrual basis of accounting, Sanni’s cash-basis pretax income is higher by $36,000. Accounts receivable decreasing by $20,000 would require a reduction of $20,000 to derive the accrual basis. Accounts payable increasing by $16,000 would require a reduction of $16,000 to derive the accrual basis. (Chapter 11-49, CBT Skill: Understanding, CSO: 1.3.0) 29. (a) The quick ratio, also known as the acidtest ratio, provides a test of immediate solvency. It is derived by dividing the sum of cash, marketable securities, and net receivables by the current liabilities. [($60,000 + $90,000 + ($180,000 – $8,000)) / $400,000 = 0.805] Rounding the 0.805 to two decimal places gets the quick ratio of 0.81 to 1. (Chapter 15-2-2, CBT Skill: Analysis, CSO: 1.4.0) 30. (a) The inventory turnover indicates the number of times inventory was acquired and sold during the period. It is derived by dividing the cost of goods sold by the average inventory. The cost of goods sold is the net purchases of $700,000 less the increase in inventory of $200,000 for a total of $500,000. The average inventory is generally determined by adding the beginning inventory of $100,000 plus ending inventory of $300,000 and dividing by two for a total of $200,000. The $500,000 / $200,000 yields a 2.5 inventory turnover. (Chapter 15-2-3, CBT Skill: Analysis, CSO: 1.4.0) 31. (c) Smith would classify the $150,000 bank balance and $5,000 deposit in transit for Big Bank as cash on the balance sheet. The bank balance of $1,500 in Small Bank is negated by the $8,500 in outstanding checks. Overdrafts in accounts with no available cash in another account at the same bank to offset are classified as current liabilities. They are not deducted from the total amount of cash at another bank. (Chapter 2-2-2, CBT Skill: Analysis, CSO: 2.1.0) 32. (c) Merchandise inventory should include freight-in, taxes, insurance while in transit, warehousing costs, and similar charges paid by the purchaser to bring the merchandise to its existing condition and location. Thus, the $1.5 million in shipping costs from overseas should be included in the inventory valuation. The shipping costs to export customers are a selling expense and should not be included in the cost of inventory. Seafood purchased $12 million in inventory during the year and has $3 million remaining in inventory at year end. The $12 million divided by $3 million means one-quarter of the inventory is still remaining. Thus, one-quarter of the $1.5 million, or $375,000, in shipping costs from overseas should be included in Updating Supplement Version 38.3 the year-end inventory valuation. CBT Skill: Analysis, CSO: 2.3.0) (Chapter 3-2-2, 33. (d) The gross margin method of inventory estimation is used to estimate inventory losses from theft and casualties. First, calculate the goods available for sale, which is the beginning inventory of $40,000 plus purchases of $480,000 for a total of $520,000. Next, figure the estimated cost of goods sold, which is the net sale of $620,000 less the gross margin of $155,000 ($620,000 × 25%) for a total of $465,000. Subtracting the $465,000 estimated cost of goods sold from the $520,000 goods available for sale leaves $55,000 in estimated ending inventory. Now, subtract the $5,000 worth of damaged inventory Fireworks can sell and that leaves a $50,000 loss from the explosion. The insurance company reimburses Fireworks for 70% ($50,000 × 70% = $35,000) of that loss. Fireworks would report only $15,000 ($50,000 – $35,000) as loss from the explosion. (Chapter 3-3-1, CBT Skill: Analysis, CSO: 2.3.0) 34. (d) Under neither the straight-line method or the double-declining balance method of depreciation would the accumulated depreciation equal the original cost at the end of the asset’s estimated useful life. The straight-line method depreciates the cost less salvage value evenly over the estimated useful life of the asset. The doubledeclining balance method uses a rate of depreciation twice that of the straight-line rate, but the asset cannot be depreciated below the salvage value. (Chapter 4-3-1, CBT Skill: Understanding, CSO: 2.4.0) 35. (c) Initial franchise fees from franchise sales ordinarily must be recognized when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor. Because services for the initial fee won’t be performed until 2004, any amounts recognized on December 31, 2003 would be reported as unearned franchise fees. Moon would report the $40,000 cash and $48,000 present value of the note for a total of $88,000 as unearned franchise fees. Remember that notes receivable are recorded at their present value. Any discount or premium should be amortized over the life of the note. (Chapter 12-5-1, CBT Skill: Analysis, CSO: 2.8.0) 36. (c) When bonds are issued with detachable stock warrants there must be an allocation of the proceeds between the warrants and the debt security based on relative fair values. Vent would credit Cash $450,000, credit Bond Payable Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 133 of 160 Financial Accounting & Reporting $500,000, and credit APIC-Stock Warrants for their fair value of $20,000 (2,000 detachable warrants at the market price of $10). The entry needs a $70,000 debit to balance and that is the discount on the debentures. (Chapter 6-4-3, CBT Skill: Analysis, CSO: 2.9.0) 37. (b) Convertible debt securities are those debt securities which are convertible into common stock of the issuer or an affiliated company at a specified price at the option of the holder and which are sold at a price or have a value at issuance not significantly in excess of the face amount. The terms of such securities generally include (1) an interest rate which is lower than the issuer could establish for nonconvertible debt, (2) an initial conversion price which is greater than the market value of the common stock at time of issuance, and (3) a conversion price which does not decrease except pursuant to antidilution provisions. No proceeds from the debt issue are to be assigned to the conversion feature (even though the convertible bonds may sell for substantially more than similar nonconvertible bonds). The reason for no allocation to equity is that the debt cannot be separated from the conversion feature, as would be the case with detachable stock warrants. The holder of the debt need not be repaid with shares of the issuer’s stock and the transaction should not be recorded as the issuance of stock. (Chapter 6-4-2, CBT Skill: Understanding, CSO: 2.10.0) 38. (d) Book value per common share is used to measure the amount that common stockholders would receive if all assets were sold at their carrying values and all creditors were paid. It is derived by dividing the common stockholders’ equity by the number of common shares outstanding. The number of common shares outstanding is the 50,000 shares issued less the 5,000 shares that have been reacquired and are held in treasury. Thus, $2,200,000 / 45,000 = $48.89 book value per share of common, rounded to the nearest dollar is $49. (Chapter 15-2-4, CBT Skill: Analysis, CSO: 2.11.0) 39. (c) In a purchase-business combination, if the purchaser issues its own equity securities as part of the consideration the securities must be credited to additional paid-in capital based on their fair value. Costs of registering and issuing equity securities are a reduction of the fair value of the securities in additional paid-in capital. Direct acquisition costs incurred (e.g., finders fees, legal and consulting fees) must be capitalized as part of the total purchase price. Any indirect and general expenses related to the acquisition are expensed as incurred. The market value of Sayon’s common stock is $7 more Updating Supplement Version 38.3 than the par value ($12 – $5 = $7). The $7 times 200,000 shares equals $1,400,000 Sayon would initially record, but then it must subtract the $35,000 registration and issuance costs for a total amount of $1,365,000 that should be recorded in Sayon’s additional paid-in capital account. The $110,000 in legal and consulting fees would be capitalized as part of the total purchase price, but would not affect the additional paid-in capital account. Under the acquisition method, as described in FAS 141(R), these legal and consulting fees would be considered acquisition-related costs which are expensed in the periods in which the costs are incurred. (Chapter 17-3-2, CBT Skill: Analysis, CSO: 3.2.0) 40. (a) When there is a firm commitment to purchase goods in a future period at a set price, an enforceable contract exists. Any loss resulting from a drop in the market value of such goods should be recognized in the current period. There should be a note in the financial statements describing the nature of the contract. The journal entry would be a debit to Loss on Purchase Commitment and a credit to Allowance for Loss on Purchase Commitment. (Chapter 3-2-2, CBT Skill: Understanding, CSO: 3.3.0) 41. (c) Diluted earnings per share is the amount of earnings for the period available to each share of common stock outstanding during the reporting period and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during the reporting period. Earnings per share calculations have the income available to common shareholders in the numerator and the weighted average number of shares outstanding in the denominator. The income available to common stockholders starts with the net income of $600,000. There is no preferred stock outstanding, so there is no need to worry about any deduction for preferred dividends. The if-converted method is applied to the convertible bonds in assuming they are dilutive. The conversion means the company would not have the interest expense for the debt and it should be added back to income to arrive at income available to common stockholders. The interest for the year would be the face value of the bonds times the stated interest rate plus any amortization of the discount. [($5,000,000 × 9%) + $20,000 = $470,000] Taking in the effect of taxes would reduce the interest expense by 25%. [25% × $470,000 = $117,500; $470,000 – $117,500 = $352,500] Adding the $352,500 interest expense to the $600,000 net income results in $952,500 of income available to common stockholders in the numerator of the diluted Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 134 of 160 Financial Accounting & Reporting earnings per share computation. (Chapter 15-3-3, CBT Skill: Analysis, CSO: 3.5.0) 42. (a) Hedging is a risk management strategy to protect against the possibility of loss, such as from price fluctuations. Generally, the strategy involves counterbalancing transactions in which a loss on one financial instrument or cash flow stream would be offset by a gain on the related derivative. A perfect hedge would result in no possibility of future gain or loss. (Chapter 2-5-1, CBT Skill: Understanding, CSO: 3.8.0) 43. (b) The foreign currency income statement should conceptually use the exchange rate at the time the revenue or expense was recognized. However, due to the impracticability of this where rates change frequently, a weighted-average exchange rate for the period may be used. The current exchange rate would be used for all assets and liabilities at the balance sheet date. The historical exchange rate is used for contributed capital. There is no inventory (FIFO) exchange rate used in the financial statements. (Chapter 16-1-3, CBT Skill: Analysis, CSO: 3.9.0) 44. (d) For interim financial reporting, costs and expenses other than product costs should be charged to income in interim periods as incurred or be allocated among interim periods based on an estimate of time expired, benefit received, or activity associated with the periods. The $60,000 in property taxes is for the entire calendar year and would be allocated evenly as $15,000 of expenses for each quarter. The $240,000 for major repairs happened on April 2 and will benefit operations for just the remainder of the year. The $240,000 divided by the three remaining quarters equals $80,000 in expenses for each of those three quarters. The $15,000 plus $80,000 equals $95,000 in expenses to be reported in the third quarter of the interim financial statements for the three months ended September 30. (Chapter 11-5-2, CBT Skill: Analysis, CSO: 3.12.0) 45. (c) Future economic benefits deriving from research and development (R &D) activities, if any, are uncertain in their amount and timing. Due to these uncertainties, most R&D costs are required to be charged to expense the year in which incurred. However, any materials, equipment, facilities, or intangibles purchased that have alternative future uses should be recorded as assets. Assets recorded for R&D costs with alternative future uses should be amortized over their useful lives by periodic charges to R&D expense. Stam should recognize only the amortization amount of $20,000 as R&D expense for Updating Supplement Version 38.3 the $100,000 worth of equipment purchased for current and future projects. Stam should also recognize the $200,000 of equipment purchased for current projects only, the $400,000 of R&D salaries for current projects, and the $600,000 of material and labor costs for a prototype product as R& D expense at year end for a total of $1,220,000. The legal fees to obtain a patent would not be included in R&D expense. Only R&D costs incurred to internally develop a patent would be expensed as incurred. (Chapter 5-2-2, CBT Skill: Analysis, CSO: 3.16.0) 46. (d) The general fund is used to account for most routine operations of the governmental entity. This fund accounts for all resources that are not required to be accounted for in other funds; in essence, it accounts for all unrestricted resources. The general fund uses modified accrual accounting. A fund balance is the difference between governmental fund assets and liabilities reported on the balance sheet. When the state paid the interest due, it would have reduced the amount of assets (cash) and as such decreased fund balance. (Chapter 19-1-2, CBT Skill: Understanding, CSO: 4.1.2) 47. (a) The government-wide financial statements use normal accrual accounting. The bond interest should be the $1,000,000 times 0.03 (because the 6% interest is paid every 6 months) for a total of $30,000 on each due date. The interest expense would be the $30,000 for the period March 1 to September 1 plus $20,000 for the four month period September 1 to December 31 ($30,000 × 4/6 = $20,000) for a total of $50,000. Because the $20,000 for the last four months will not be paid until the next March 1, it would be the interest payable at the close of the fiscal year on December 31. (Chapter 18-2-1, CBT Skill: Analysis, CSO: 4.2.1) 48. (a) The notes to the basic financial statements of governmental entities do not contain disclosures related to required supplementary information. The Management’s Discussion and Analysis (MD&A) is the required supplementary information in the government’s general purpose external report and it is presented before the financial statements. Some notes presented by governments are identical to notes presented in business financial statements. Notes that are considered essential to the basic financial statements need to be presented and it is acceptable to present them in a very extensive format. (Chapter 18-2-3, CBT Skill: Understanding, CSO: 4.2.6) 49. (b) Unconditional pledges are reported as a receivable at their present values in the period in Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 135 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 which they are made, net of an allowance for uncollectible amounts. They are not recorded as long-term, deferred revenue, or at the full amount pledged. (Chapter 20-1-4, CBT Skill: Understanding, CSO: 5.2.1) the cash and cash equivalents similar to commercial enterprises. The description of cash flows is expanded to include donor-restricted cash contributions that must be used for long-term purposes. (Chapter 20-1-3, CBT Skill: Understanding, CSO: 5.1.3) 50. (c) The statement of cash flows for a nongovernmental not-for-profit organization reports __________________ Solution 3 SIMULATION SOLUTION Bond Issue Price A B C D E 1 Payment Type Compounding Period(s) Interest Rate Payment Amount Factor Present Value 2 Principal 10 0.04 $1,000,000 0.675564 $ 675,564 3 Interest 10 0.04 $ 8.110896 $ 405,545 4 Bond Issue Price 50,000 F $1,081,109 Explanations: Column B, rows 2 & 3: They are five-year bonds with semi-annual interest payments. Multiplying 5 years by 2 times per year = 10 compounding periods for both principal and interest. Column C, rows 2 & 3: Lyndhurst Company, Inc. uses the effective interest method. The bonds were issued when the market interest rate was 8.00%. With semi-annual interest payments, only half the 8.00% would be allocated to both principal and interest for each period. (0.08 / 2 = 0.04) Column D, row 2: The principal payment amount is the $1,000,000 face amount of the bond. Column D, row 3: The interest payment amount is the face amount of the bond times the stated interest amount per period. With semi-annual interest payments, half the stated 10.00% would be paid each period. (0.10 / 2 = 0.05, then 0.05 × $1,000,000 = $50,000) Column E, row 2: The factor used for the principal is the present value of $1 for 10 periods at 4% = 06.75664 Column E, row 3: The factor used for the interest is the present value of an annuity of $1 in arrears (because no payment was made at the beginning) for 10 periods at 4% = 8.110896 Column F, row 2: D2*E2 = $1,000,000 × 0.675564 = $675,564 Column F, row 3: D3*E3 = $50,000 × 8.110896 = $405,545 Column F, row 3: The bond issue price is the present value of the principal plus present value of the interest. ($675,564 + $405,545 = $1,081,109) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 136 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Interest Expense A B C D E Increase (Decrease) Unamortized Interest Interest in Carrying (Discount) 1 Date Payment Expense Amount of Bonds or Premium 2 01/02/03 $81,109 3 06/30/03 $50,000 $43,244 ($6,756) $74,353 4 12/31/03 $50,000 $42,974 ($7,026) $67,327 5 06/30/04 $50,000 $42,693 ($7,307) $60,020 6 12/31/04 $50,000 $42,401 ($7,599) $52,421 7 06/30/05 $50,000 $42,097 ($7.903) $44,518 8 12/31/05 $50,000 $41,781 ($8,219) $36,299 9 06/30/06 $50,000 $41,452 ($8,548) $27,751 10 12/31/06 $50,000 $41,110 ($8,890) $18,861 11 06/30/07 $50,000 $40,754 ($9,246) $9,615 12 12/31/07 $50,000 $40,385 ($9,615) $0 F G H Carrying Face Interest Amount Amount of Bonds of Bonds rates (%) Bond $1,081,109 $1,000,000 $1,074,353 10.00 Market $1,067,327 $1,060,020 8.00 $1,052,421 $1,044,518 $1,036,299 $1,027,751 $1,018,861 $1,009,615 $1,000,000 Explanations: Column A, rows 3 - 12: The dates will be June 30 and December 31 of each of the five years. Column B, rows 3 - 12: The $50,000 interest payment will be the same for each period. Column C, rows 3 - 12: To calculate interest expense, multiply the carrying amount of the bonds form the pervious period by the 0.04 interest rate. For example, row 3 would be $1,081,109 × 0.04 = $43,244. Column D, rows 3 - 12: The change in carrying amount of bonds is the difference between the interest payment and interest expense. If the interest payment is greater than interest expense there is a decrease in the carrying amount of bonds. If the interest payment is less than interest expense there is an increase in the carrying amount of the bonds. For example, row 3 would be $50,000 – $43,244 = a $6,756 decrease. Column E, row 2: The unamortized (discount) or premium is the difference between the carrying amount of the bonds and the face amount of the bonds. If the carrying amount of the bonds is greater than the face amount there is an unamortized premium. If the carrying amount of the bonds is less than the face amount there is an unamortized discount. In this case, $1,081,109 – $1,000,000 = an $81,109 premium. Column E, rows 3 - 12: There are two ways to calculate the unamortized premium. One is to take that amount from the previous period and increase or decrease it by the increase (decrease) in carrying amount of bonds. For example, row 3 would be $81,109 – $6,756 = $74,353. The other is to simply take the carrying amount of the bonds and subtract the face amount. For example, row 3 would be $1,074,353 – $1,000,000 = $74,353. Column F, row 2: The carrying amount of the bonds starts at the bond issue price of $1,081,109. Column F, rows 3 - 12: The carrying amount of the bonds is calculated by applying the increase or decrease in carrying amount of the bonds to the carrying amount of bonds from the previous period. For example, row 3 would be $1,081,109 – $6,756 = $1,074,353. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 137 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Balance Sheet Bonds payable = $1,000,000; the face amount of the bonds. Unamortized premium/discount = $67,327; the amount at December 31, 2003 (cell E4 of amortization table). Total liabilities = $1,217,327; the sum of $150,000 + $1,000,000 + $67,327. Interest expense = $86,218; the $43,244 from June 30, 2003 plus the $42,974 from December 31, 2003. Net income before taxes = $431,782; the $1,000,000 in sales – $500,000 expenses – $86,218 interest expense. Gain/Loss 1 2 A Carrying Amount of Debt $1,060,020 B Payment Due at Call Date $1,020,000 C Amount of Gain or (Loss) $40,020 D Indicate “Gain” or “Loss” Gain Carrying amount of debt = $1,060,020; the amount at June 30, 2004 (cell F5 of amortization table). Payment due at call date = $1,020,000; the face amount times the call price % ($1,000,000 × 1.02). Amount of gain or (loss) = $40,020; the difference between the carrying amount of debt and payment due at call date. This amount is a gain because the amount paid was less than the carrying amount of debt on the books. Communication To: CEO, Lyndhurst Company Re: Issuing Bonds at a Premium Bonds are contractual agreements wherein the issuer promises to pay the purchaser a principal amount at a designated future date. In addition, the issuer makes periodic interest payments based on the face amount of the bond and the stated rate of interest. The market price of the bond is equal to the present value of the bond’s interest and principal payments, discounted using the market interest rate for that type of bond. The market interest rate takes into consideration the stated (face) interest rate of the bonds, the credit worthiness of the debtor, the maturity date of the bonds, and other factors. When market conditions are such that the stated interest rate of the bonds is higher than the current market interest rate for similar securities, the bonds may be issued at a premium. A bond premium is the amount in excess of the bond face value (sometimes called par value or maturity value) at which a bond is issued. Premiums on bonds held as a long-term investment must be amortized from date of acquisition to maturity date. Research FAS 84, Par. 3 3. When convertible debt is converted to equity securities of the debtor pursuant to an inducement offer described in paragraph 2 of this Statement, the debtor enterprise shall recognize an expense equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of securities issuable pursuant to the original conversion terms. The expense shall not be reported as an extraordinary item. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 138 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 2009 RELEASED AICPA QUESTIONS AND ANSWERS In April 2009, the AICPA released fifty multiple-choice questions and one simulation relating to the FAR section of the CPA examination. These questions and their unofficial answers are reproduced here, along with the exclusive Bisk Education explanations. The multiple-choice questions in Problems 1 and 2 were labeled moderate and hard, respectively, by the AICPA examiners. Problem 3 is the one simulation that was disclosed. The AICPA did not state if these questions ever appeared on any exam, whether they were assigned points or merely being pre-tested and earned no points if they did appear on an exam, or if they were now obsolete for some reason. These questions are intended only as a study aid and should not be used to predict the content of future exams. It is extremely unlikely that released questions will appear on future examinations. These questions have been reproduced as received from the AICPA examiners. If candidates encounter what they believe are errors or ambiguities in questions during their actual exams, they should bring them to the attention of the examiners in accordance with the procedures outlined on the AICPA’s CPA Examination website. Problem 1: Moderate 1. For the year ended December 31, Ion Corp. had cash inflows of $25,000 from the purchases, sales, and maturities of held-to-maturity securities and $40,000 from the purchases, sales, and maturities of available-for-sale securities. What amount of net cash from investing activities should Ion report in its cash flow statement? a. $0 b. $25,000 c. $40,000 d. $65,000 (R/09, FAR, 0432F, #1, 8751) 2. Harland County received a $2,000,000 capital grant to be equally distributed among its five municipalities. The grant is to finance the construction of capital assets. Harland had no administrative or direct financial involvement in the construction. In which fund should Harland record the receipt of cash? a. Agency fund b. General fund c. Special revenue fund d. Private purpose trust fund (R/09, FAR, 0745G, #2, 8752) 3. Which of the following funds should be reported as part of local government's governmental activities column in its government-wide statements? a. Debt service b. Agency c. Private-purpose trust d. Pension trust (R/09, FAR, 1224G, #3, 8753) 4. Young Corp. purchased equipment by making a down payment of $4,000 and issuing a note payable for $18,000. A payment of $6,000 is to be made at the end of each year for three years. The applicable rate of interest is 8%. The present value of an ordinary annuity factor for three years at 8% is 2.58, and the present value for the future amount of a single sum of one dollar for three years at 8% is .735. Shipping charges for the equipment were $2,000, and installation charges were $3,500. What is the capitalized cost of the equipment? a. $19,480 b. $21,480 c. $24,980 d. $27,500 (R/09, FAR, A0168F, #4, 8754) 5. Jordan Co. had the following gains during the current period: Gain on disposal of business segment $500,000 Foreign currency translation gain 100,000 What amount of extraordinary gain should be presented on Jordan’s income statement for the current period? a. $0 b. $100,000 c. $500,000 d. $600,000 (R/09, FAR, 1758F, #5, 8755) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 139 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 6. A foreign subsidiary's functional currency is its local currency, which has not experienced significant inflation. The weighted average exchange rate for the current year would be the appropriate exchange rate for translating Salaries expense Yes Yes No No Sales to external customers Yes No Yes No (R/09, FAR, 1278F, #6, 8756) 7. Asp Co. appropriately uses the installment method of revenue recognition to account for its credit sales. The following information was abstracted from Asp's December 31, 2002, financial statements: 2002 Sales $1,500,000 Accounts receivable: 2002 sales 900,000 2001 sales 540,000 Deferred gross profit: 2002 sales 252,000 2001 sales 108,000 2001 $1,000,000 600,000 120,000 What was Asp's gross profit percentage for 2002 sales? a. 20% b. 25% c. 28% d. 40% (R/09, FAR, 0521F, #7, 8757) 8. Brass Co. reported income before income tax expense of $60,000 for 2000. Brass had no permanent or temporary timing differences for tax purposes. Brass has an effective tax rate of 30% and a $40,000 net operating loss carryforward from 1999. What is the maximum income tax benefit that Brass can realize from the loss carryforward for 2000? a. $12,000 b. $18,000 c. $20,000 d. $40,000 (R/09, FAR, 0468F, #8, 8758) 9. A company reports the following information as of December 31: Sales revenue Cost of goods sold Operating expenses Unrealized holding gain on availablefor-sale securities, net of tax $800,000 600,000 90,000 30,000 What amount should the company report as comprehensive income as of December 31? a. $ 30,000 b. $ 110,000 c. $ 140,000 d. $ 200,000 (R/09, FAR, A1468F, #9, 8759) 10. Ajax Corp. has an effective tax rate of 30%. On January 1, 2000, Ajax purchased equipment for $100,000. The equipment has a useful life of 10 years. What amount of current tax benefit will Ajax realize during 2000 by using the 150% declining balance method of depreciation for tax purposes instead of the straight-line method? a. $1,500 b. $3,000 c. $4,500 d. $5,000 (R/09, FAR, 0467F, #10, 8760) 11. Carr, Inc. purchased equipment for $100,000 on January 1, 2002. The equipment had an estimated 10-year useful life and a $15,000 salvage value. Carr uses the 200% declining balance depreciation method. In its 2003 income statement, what amount should Carr report as depreciation expense for the equipment? a. $13,600 b. $16,000 c. $17,000 d. $20,000 (R/09, FAR, 0416F, #11, 8761) 12. Which of the following characteristics relates to both accounting relevance and reliability? a. Verifiability b. Timeliness c. Neutrality d. Comparability (R/09, FAR, A0199F, #12, 8762) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 140 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 13. Lion Co.'s income statement for its first year of operations shows pretax income of $6,000,000. In addition, the following differences existed between Lion's tax return and records: Tax return Uncollectible accounts expense $220,000 Depreciation expense 860,000 Tax-exempt interest revenue — Accounting records $250,000 570,000 50,000 16. During the current year, Onal Co. purchased 10,000 shares of its own stock at $7 per share. The stock was originally issued at $6. The firm sold 5,000 of the treasury shares for $10 per share. The firm uses the cost method to account for treasury stock. What amount should Onal report in its income statement for these transactions? a. $0 b. $ 5,000 gain c. $10,000 loss d. $15,000 gain (R/09, FAR, A0093F, #16, 8766) Lion's current year tax rate is 30% and the enacted rate for future years is 40%. What amount should Lion report as deferred tax expense in its income statement for the year? a. $148,000 b. $124,000 c. $104,000 d. $ 78,000 (R/09, FAR, 0768F, #13, 8763) 17. A nongovernmental not-for-profit organization’s statement of activities is similar to which of the following for-profit financial statements? a. Balance sheet b. Statement of cash flows c. Statement of retained earnings d. Income statement (R/09, FAR, A0104N, #17, 8767) 14. Rue Co.'s allowance for uncollectible accounts had a credit balance of $12,000 at December 31, 2002. During 2003, Rue wrote-off uncollectible accounts of $48,000. The aging of accounts receivable indicated that a $50,000 allowance for uncollectible accounts was required at December 31, 2003. What amount of uncollectible accounts expense should Rue report for 2003? a. $48,000 b. $50,000 c. $60,000 d. $86,000 (R/09, FAR, 0174F, #14, 8764) 18. After an impairment loss is recognized, the adjusted carrying amount of the intangible asset shall be its new accounting basis. Which of the following statements about subsequent reversal of a previously recognized impairment loss is correct? a. It is prohibited. b. It is required when the reversal is considered permanent. c. It must be disclosed in the notes to the financial statements. d. It is encouraged, but not required. (R/09, FAR, PC216, #18, 8768) 15. A company has the following accrual-basis balances at the end of its first year of operation: 19. Tang City received land from a donor who stipulated that the land must remain intact, but any income generated from the property may be used for general government services. In which fund should Tang City record the donated land? a. Special revenue b. Permanent c. Private-purpose trust d. Agency (R/09, FAR, C02392F, #19, 8769) Unearned consulting fees Consulting fees receivable Consulting fee revenue $ 2,000 3,500 25,000 The company's cash-basis consulting revenue is what amount? a. $19,500 b. $23,500 c. $26,500 d. $30,500 (R/09, FAR, A1987F, #15, 8765) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 141 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 20. When would a company use the installment sales method of revenue recognition? a. When collectibility of installment accounts receivable is reasonably predictable b. When repossessions of merchandise sold on the installment plan may result in a future gain or loss c. When installment sales are material, and there is no reasonable basis for estimating collectibility d. When collection expenses and bad debts on installment accounts receivable are deemed to be immaterial (R/09, FAR, A0310F, #20, 8770) 23. How should a nongovernmental not-for-profit organization report depreciation expense in its statement of activities? a. It should not be included. b. It should be included as a decrease in unrestricted net assets. c. It should be included as an increase in temporarily restricted net assets. d. It should be reclassified from unrestricted net assets to temporarily restricted net assets, depending on donor-imposed restrictions on the assets. (R/09, FAR, C04822F, #23, 8773) 21. On January 1, Feld traded a delivery truck and paid $10,000 cash for a tow truck owned by Baker. The delivery truck had an original cost of $140,000, accumulated depreciation of $80,000, and an estimated fair value of $90,000. Feld estimated the fair value of Baker's tow truck to be $100,000. The transaction had commercial substance. What amount of gain should be recognized by Feld? a. $0 b. $ 3,000 c. $ 10,000 d. $ 30,000 (R/09, FAR, A2238F, #21, 8771) 24. Willem Co. reported the following liabilities at December 31, 2001: 22. Which of the following is reported as interest expense? a. Pension cost interest b. Amortization of discount of a note c. Deferred compensation plan interest d. Interest incurred to finance a software development for internal use (R/09, FAR, C04494F, #22, 8772) Accounts payable-trade Short-term borrowings Mortgage payable, current portion $100,000 Other bank loan, matures June 30, 2002 $ 750,000 400,000 3,500,000 1,000,000 The $1,000,000 bank loan was refinanced with a 20year loan on January 15, 2002, with the first principal payment due January 15, 2003. Willem's audited financial statements were issued February 28, 2002. What amount should Willem report as current liabilities at December 31, 2001? a. $ 850,000 b. $1,150,000 c. $1,250,000 d. $2,250,000 (R/09, FAR, 1175F, #24, 8774) 25. Arkin Corp. is a nongovernmental not-forprofit organization involved in research. Arkin's statement of functional expenses should classify which of the following as support services? a. Salaries of staff researchers involved in research b. Salaries of fundraisers for funds used in research c. Costs of equipment involved in research d. Costs of laboratory supplies used in research (R/09, FAR, A0341N, #25, 8775) __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 142 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Problem 2: Hard 26. Ian Co. is calculating earnings per share amounts for inclusion in the Ian's annual report to shareholders. Ian has obtained the following information from the controller's office as well as shareholder services: Net income from January 1 to December 31 Number of outstanding shares: January 1 to March 31 April 1 to May 31 June 1 to December 31 $125,000 15,000 12,500 17,000 In addition, Ian has issued 10,000 incentive stock options with an exercise price of $30 to its employees and a year-end market price of $25 per share. What amount is Ian's diluted earnings per share for the year ended December 31? a. $4.63 b. $4.85 c. $7.35 d. $7.94 (R/09, FAR, C02303F, #26, 8776) 27. Green Co. had the following equity transactions at December 31: Cash proceeds from sale of investment in Blue Co. (carrying value – $60,000) Dividends received on Grey Co. stock Common stock purchased from Brown Co. 29. When the allowance method of recognizing uncollectible accounts is used, how would the collection of an account previously written off affect accounts receivable and the allowance for uncollectible accounts? $75,000 10,500 38,000 What amount should Green recognize as net cash from investing activities in its statement of cash flows at December 31? a. $37,000 b. $47,500 c. $75,000 d. $85,500 (R/09, FAR, 1366F, #27, 8777) a. b. c. d. Accounts receivable Increase Increase No effect No effect Allowance for uncollectible accounts Decrease No effect Decrease Increase (R/09, FAR, 0384F, #29, 8779) 30. During 2004, a former employee of Dane Co. began a suit against Dane for wrongful termination in November 2003. After considering all of the facts, Dane's legal counsel believes that the former employee will prevail and will probably receive damages of between $1,000,000 and $1,500,000, with $1,300,000 being the most likely amount. Dane's financial statements for the year ended December 31, 2003, will not be issued until February 2004. In its December 31, 2003, balance sheet, what amount should Dane report as a liability with respect to the suit? a. $0 b. $1,000,000 c. $1,300,000 d. $1,500,000 (R/09, FAR, A0548F, #30, 8780) 31. Which format must an enterprise fund use to report cash flow operating activities in the statement of cash flows? a. Indirect method, beginning with operating income b. Indirect method, beginning with change in net assets c. Direct method d. Either direct or indirect method (R/09, FAR, 1119G, #31, 8781) 28. A company has a long-lived asset with a carrying value of $120,000, expected future cash flows of $130,000, present value of expected future cash flows of $100,000, and a market value of $105,000. What amount of impairment loss should be reported? a. $0 b. $5,000 c. $15,000 d. $20,000 (R/09, FAR, A2154F, #28, 8778) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 143 of 160 Financial Accounting & Reporting 32. Nack City received a donation of a valuable painting. Nack planned to add the painting to its collection and display it in the protected exhibition area of city hall. Nack had a policy that if such donated art works were sold, the proceeds would be used to acquire other items for its collections. Which of the following would be correct regarding the donated painting? a. Must be capitalized and depreciated b. Must be capitalized but not depreciated c. May be capitalized, but it is not required, and it must be depreciated d. May be capitalized, but it is not required, and depreciation is not required (R/09, FAR, C03149F, #32, 8782) 33. Which of the following not-for-profit entities is required to prepare a statement of functional expense? a. An art museum b. A shelter for the homeless c. A private foundation d. A public golf course (R/09, FAR, A0297N, #33, 8783) 34. On January 1, Stunt Corp. had outstanding convertible bonds with a face value of $1,000,000 and an unamortized discount of $100,000. On that date, the bonds were converted into 100,000 shares of $1 par stock. The market value on the date of conversion was $12 per share. The transaction will be accounted for with the book value method. By what amount will Stunt's stockholders' equity increase as a result of the bond conversion? a. $ 100,000 b. $ 900,000 c. $1,000,000 d. $1,200,000 (R/09, FAR, A1245F, #34, 8784) 35. During the current year, Wythe County levied $2,000,000 property taxes, 1% of which is expected to be uncollectible. During the year, the county collected $1,800,000 and wrote off $15,000 as uncollectible. What amount should Wythe County report as property tax revenue in its governmentwide statement of activities for the current year? a. $1,800,000 b. $1,980,000 c. $1,985,000 d. $2,000,000 (R/09, FAR, 1160G, #35, 8785) Updating Supplement Version 38.3 36. On December 1 of the current year, Bann Co. entered into an option contract to purchase 2,000 shares of Norta Co. stock for $40 per share (the same as the current market price) by the end of the next two months. The time value of the option contract is $600. At the end of December, Norta's stock was selling for $43, and the time value of the option is now $400. If Bann does not exercise its option until January of the subsequent year, which of the following changes would reflect the proper accounting treatment for this transaction on Bann's December 31, year-end financial statements? a. The option value will be disclosed in the footnotes only. b. Other comprehensive income will increase by $6,000. c. Net income will increase by $5,800. d. Current assets will decrease by $200. (R/09, FAR, A0729F, #36, 8786) 37. Gridiron University is a private university. A successful alumnus has recently donated $1,000,000 to Gridiron for the purpose of funding a "center for the study of sports ethics." This donation is conditional upon the university raising matching funds within the next 12 months. The university administrators estimate that they have a 50% chance of raising the additional money. How should this donation be accounted for? a. As a temporarily restricted support b. As unrestricted support c. As a refundable advance d. As a memorandum entry reported in the footnotes (R/09, FAR, A0063N, #37, 8787) 38. A company has outstanding accounts payable of $30,000 and a short-term construction loan in the amount of $100,000 at year end. The loan was refinanced through issuance of long-term bonds after year end but before issuance of financial statements. How should these liabilities be recorded in the balance sheet? a. Long-term liabilities of $130,000 b. Current liabilities of $130,000 c. Current liabilities of $30,000, long-term liabilities of $100,000 d. Current liabilities of $130,000, with required footnote disclosure of the refinancing of the loan (R/09, FAR, A1175F, #38, 8788) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 144 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 39. During the current fiscal year, Foxx, a nongovernmental not-for-profit organization, received unrestricted pledges of $300,000. Of the pledged amount, $200,000 was designated by donors for use during the current year, and $100,000 was designated for next year. Five percent of the pledges are expected to be uncollectible. What amount should Foxx report as restricted support (contributions) in the statement of activities for the current year? a. $200,000 b. $190,000 c. $100,000 d. $ 95,000 (R/09, FAR, A0139N, #39, 8789) 40. A company has the following liabilities at year end: Mortgage note payable; $16,000 due within 12 months Short-term debt that the company is refinancing with long-term debt Deferred tax liability arising from depreciation $355,000 175,000 42. After three profitable years, Dodd Co. decided to offer a bonus to its branch manager, Cone, of 25% of income over $100,000 earned by his branch. For the year 2002, income for Cone's branch was $160,000 before income taxes and Cone's bonus. Cone's bonus is computed on income in excess of $100,000 after deducting the bonus, but before deducting taxes. What is Cone's bonus for the year 2002? a. $12,000 b. $15,000 c. $25,000 d. $32,000 (R/09, FAR, 1414F, #42, 8792) 43. Wall Co. sells a product under a two-year warranty. The estimated cost of warranty repairs is 2% of net sales. During Wall's first two years in business, it made the following sales and incurred the following warranty repair costs: Year 1 Total sales Total repair costs incurred $250,000 4,500 Year 2 Total sales Total repair costs incurred $300,000 5,000 25,000 What amount should the company include in the current liability section of the balance sheet? a. $0 b. $ 16,000 c. $ 41,000 d. $ 191,000 (R/09, FAR, A1456F, #40, 8790) 41. On October 1 of the current year, a U.S. company sold merchandise on account to a British company for 2,000 pounds (exchange rate, 1 pound = $1.43). At the company's December 31 fiscal year end, the exchange rate was 1 pound = $1.45. The exchange rate was 1 pound = $1.50 on collection in January of the subsequent year. What amount would the company recognize as a gain(loss) from foreign currency translation when the receivable is collected? a. $0 b. $ 100 c. $ 140 d. $(140) (R/09, FAR, A0347F, #41, 8791) What amount should Wall report as warranty expense for year 2? a. $1,000 b. $5,000 c. $5,900 d. $6,000 (R/09, FAR, C02166F, #43, 8793) 44. A company issued a bond with a stated rate of interest that is less than the effective interest rate on the date of issuance. The bond was issued on one of the interest payment dates. What should the company report on the first interest payment date? a. An interest expense that is less than the cash payment made to bondholders b. An interest expense that is greater than the cash payment made to bondholders c. A debit to the unamortized bond discount d. A debit to the unamortized bond premium (R/09, FAR, A2170F, #44, 8794) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 145 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 45. Tam Co. reported the following items in its year-end financial statements: Capital expenditures Capital lease payments Income taxes paid Dividends paid Net interest payments $1,000,000 125,000 325,000 200,000 220,000 What amount should Tam report as supplemental disclosures in its statement of cash flows prepared using the indirect method? a. $ 545,000 b. $ 745,000 c. $1,125,000 d. $1,870,000 (R/09, FAR, 1237F, #45, 8795) 46. Which of the following statements describes the proper accounting for losses when nonmonetary assets are exchanged for other nonmonetary assets? a. A loss is recognized immediately, because assets received should not be valued at more than their cash equivalent price. b. A loss is deferred so that the asset received in the exchange is properly valued. c. A loss, if any, which is unrelated to the determination of the amount of the asset received should be recorded. d. A loss can occur only when assets are sold or disposed of in a monetary transaction. (R/09, FAR, PC677, #46, 8796) 47. How should a company report its decision to change from a cash-basis of accounting to accrualbasis of accounting? a. As a change in accounting principle, requiring the cumulative effect of the change (net of tax) to be reported in the income statement b. Prospectively, with no amounts restated and no cumulative adjustment c. As an extraordinary item (net of tax) d. As a prior-period adjustment (net of tax), by adjusting the beginning balance of retained earnings (R/09, FAR, A0671F, #47, 8797) 48. Baker Co. began its operations during the current year. The following is Baker’s balance sheet at December 31: Baker Co. BALANCE SHEET Assets Cash Accounts receivable Total assets $ 192,000 82,000 $ 274,000 Liabilities and stockholders’ equity Accounts payable $ 24,000 Common stock 200,000 Retained earnings 50,000 Total liabilities and stockholders’ equity $ 274,000 Baker’s net income for the current year was $78,000 and dividends of $28,000 were declared and paid. Common stock was issued for $200,000. What amount should Baker report as cash provided by operating activities in its statement of cash flows for the current year? a. $ 20,000 b. $ 50,000 c. $192,000 d. $ 250,000 (R/09, FAR, 1664F, #48, 8798) 49. Which of the following is a characteristic of a capital lease? a. The lease term is substantially less than the estimated economic life of the leased property. b. The lease contains a bargain-purchase option. c. The present value of the minimum lease payments at the beginning of the lease term is 75% or more of the fair value of the property at the inception of the lease. d. The future obligation does not appear in the balance sheet of the lessee. (R/09, FAR, C00674F, #49, 8799) 50. A company issues bonds at 98, with a maturity value of $50,000. The entry the company uses to record the original issue should include which of the following? a. A debit to bond discount of $1,000 b. A credit to bonds payable of $49,000 c. A credit to bond premium of $1,000 d. A debit to bonds payable of $50,000 (R/09, FAR, A1550F, #50, 8800) __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 146 of 160 Financial Accounting & Reporting Deferred Tax Worksheet Situation Updating Supplement Version 38.3 Balance Sheet Deferred Taxes Communication Stanhope, Inc., a C corporation, is a distributor of personal electronics and has reported a net income for each year since inception. Its taxable income has consistently resulted in an effective tax rate of 33%. (Ignore state income taxes.) You have been assigned to compute the company’s deferred portion of federal income taxes for inclusion in its financial statements for year 2 and to provide the company’s controller with a schedule that supports your computation. Your schedule should identify deductible and taxable temporary differences and components of the deferred tax computations. The controller has provided you with the following reconciliation of Stanhope’s pretax accounting income to taxable income for year 2 and the additional information shown below. Use this information to answer the subsequent questions. Stanhope, Inc. Reconciliation of Pretax Accounting Income to Taxable Income Year ended December 31, year 2 Pretax accounting income Expenses recorded on books this year not deductible for tax purposes: Meals and entertainment expenses Bad debts expense provision $678,000 12,000 15,000 Subtotal 27,000 705,000 Income recorded on books this year not subject to tax: Tax-exempt interest income Unrealized gain (loss) on trading securities 15,000 8,000 Deductions on tax return not charged against book income this year: Depreciation expense Bad debts written off and charged against allowance account 63,000 5,000 Taxable income 91,000 $614,000 1. The Allowance for doubtful accounts (bad debts) as of December 31, year 1, was $11,000. During year 2, uncollectible accounts totaling $5,000 were written off and charged against the allowance account. A provision for bad debts of $15,000 was charged to operations at the end of the year to result in an Allowance for doubtful accounts balance at December 31, year 2, of $21,000. 2. At the end of the year, there were net unrealized gains on trading securities of $8,000. There were no unrealized gains/losses on trading securities at the beginning of the year. 3. The company uses straight-line depreciation for financial reporting (GAAP) purposes and accelerated methods for income tax purposes. Balances and activity in the accumulated depreciation account for GAAP and income tax purposes are summarized below: Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 147 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 GAAP Difference 1,314,000 2,018,000 704,000 196,000 Accumulated depreciation, December 31, year 1 Tax 259,000 63,000 1,510,000 2,277,000 767,000 Year 2 depreciation expense Accumulated depreciation, December 31, year 2 (R/09, FAR, P3, amended, 8749) Deferred Tax Worksheet Situation Balance Sheet Deferred Taxes Communication Use the information contained in the Situation to prepare the deferred tax computations and supporting components by completing the following worksheet. • In column A, select a line item that will result in a temporary difference. • In column B, enter the total temporary difference that would result in a deferred tax asset or liability. • Enter the total deferred tax asset or liability in the appropriate column, C or D, based on the temporary difference you recorded in column B. Round all answers to the nearest whole dollar. Stanhope, Inc. Worksheet for Deferred Income Taxes Year ended December 31, year 2 A 1 B C D Description of temporary differences Temporary differences Deferred tax assets Deferred tax liabilities 2 3 4 5 6 7 8 9 Totals Selection list for description of temporary differences Accumulated depreciation, excess of tax over GAAP Unrealized gain (loss) on trading securities Accumulated depreciation, excess of GAAP over tax Meals and entertainment expenses Allowance for doubtful accounts Tax-exempt interest income Bad debts expense provision Bad debts written off Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 148 of 160 Financial Accounting & Reporting Deferred Tax Worksheet Situation Updating Supplement Version 38.3 Balance Sheet Deferred Taxes Communication Use the information from your completed worksheet for deferred income taxes (Deferred Tax Worksheet tab) to prepare the applicable line items for Stanhope, Inc.’s balance sheet as of December 31, year 2. If there is no balance in a particular account, enter a value of zero (0). Assets: Deferred taxes, current asset Deferred taxes, noncurrent asset Liabilities: Deferred taxes, current liability Deferred taxes, noncurrent liability Situation Deferred Tax Worksheet Balance Sheet Deferred Taxes Communication The engagement partner asked you to explain to the vice president of Stanhope, Inc. why accounting for deferred income taxes is required by GAAP. Write a memorandum to the vice president that explains the general nature of deferred income taxes. The memorandum should include an explanation of the different objectives of income tax and financial reporting, as well as an explanation of temporary differences. REMINDER: On the actual exam your response will be graded for both technical content and writing skills. Technical content will be evaluated for information that is helpful to the intended reader and clearly relevant to the issue. Writing skills will be evaluated for development, organization, and the appropriate expression of ideas in professional correspondence. Use a standard business memo or letter format with a clear beginning, middle, and end. Do not convey information in the form of a table, bullet point list, or other abbreviated presentation. Research The management of Stanhope, Inc. inquired whether changes in tax laws and rates during the current year would affect the computation of Stanhope’s deferred tax liabilities and deferred tax assets. Find authoritative guidance that responds to this inquiry. REMINDER: On the actual exam you will use a research database to find the correct authoritative literature and then select from a variety of choices dependent upon your research. Please see the AICPA’s tutorial and sample tests on The Uniform CPA Examination website (www.cpa-exam.org). Paragraph Reference Answer: _______________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 149 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Solution 1 MULTIPLE-CHOICE ANSWERS (Moderate) 1. (d) Cash flows from investing activities includes purchases, sales, and maturities of debt and equity securities; excluding those acquired specifically for resale. This would include availablefor-sale and held-to-maturity securities. ($25,000 + $40,000 = $65,000) (Chapter 14-2-2, CBT Skill: Analysis, CSO: 1.2.4) 2. (a) Harland should record the receipt of cash received from the capital grant in the agency fund. Agency funds are used to account for the custodial activities of a government serving as an agent for other governments, private organizations, or individuals. Harland is serving as an agent for its five municipalities. The general fund is used to account for most routine operations of the governmental entity. General fund revenues primarily consist of taxes, licenses, fines, and interest. The special revenue fund is used to account for revenues that are externally restricted or designated by the legislative body for specific general government purposes other than capital projects. Private purpose trust funds are used to account for fiduciary responsibilities and activities in managing other trust arrangements that benefit individuals, private organizations, or other governments. (Chapter 19-3-5, CBT Skill: Judgment, CSO: 4.1.2) 3. (a) The debt service fund should be reported as part of local government’s governmental activities column in its government-wide statements. Reporting capital assets and long-term liabilities is required in the government-wide statements. Agency, private purpose trust, and pension trust funds are all fiduciary funds. Fiduciary activities are not included in the government-wide statements because the assets and liabilities cannot be used to support the government’s own programs. (Chapter 18-2-3, CBT Skill: Understanding, CSO: 4.2.1) 4. (c) Assets are to be recorded at their acquisition cost. Acquisition cost is defined as the cash price, or its equivalent, plus all the costs reasonably necessary to bring it to the location and to make it ready for its intended use. The cash price, or its equivalent, would be the $4,000 down payment plus the $15,480 present value of the $6,000 payments, an ordinary annuity, (2.58 × $6,000). Add to that price of $19,480 the $2,000 in shipping charges to get the equipment to its location and the $3,500 of installation charges to get it ready for its intended use. (Chapter 4-2-1, CBT Skill: Analysis, CSO: 2.4.0) 5. (a) Gains on disposal of a business segment and foreign currency translations are in most cases considered normal events and transactions affecting operations. For an occurrence of an underlying event or transaction to be classified as extraordinary it must meet both of the following criteria: 1) unusual in nature in that it possesses a high degree of abnormality and be of the type clearly unrelated to, or incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates and 2) infrequent in occurrence in that it be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. The scenario does not indicate anything that would classify the gains as extraordinary. (Chapter 11-2-3, CBT Skill: Analysis, CSO: 3.7.0) 6. (a) Foreign currency financial statements should be translated by means of the following rates: all assets and liabilities at the current exchange rate at the balance sheet date; revenues and expenses at the exchange rate at the time the revenue or expense was recognized, however due to the impracticability of this where rates change frequently, a weighted-average exchange rate for the period may be used; contributed capital at the historical exchange rate; and retained earnings at the translated amount of retained earnings for the prior period, plus (less net income(loss) at the weighted-average rate, less dividends declared during the period at the exchange rate when declared. The weighted average exchange rate would be an appropriate exchange rate for salaries expense and sales to external customers. (Chapter 16-1-3, CBT Skill: Understanding, CSO: 3.9.0) 7. (c) The installment method is an exception of normal GAAP revenue recognition and not allowed unless certain circumstances exist such that collection of sales is not reasonably assured. The installment method allows revenue to be deferred and recognized each year in proportion to the receivables collected that year. Income recognized generally equals cash collected multiplied by the gross profit percentage applicable to those sales. Receivable accounts and gross profit accounts must be kept separately for each year because the gross profit rate will often vary from year to year. The gross profit percentage can be computed by either dividing the realized gross profit by collections or dividing the deferred gross profit by receivables for a particular year. The $252,000 deferred gross profit in 2002 divided by the $900,000 accounts receivable Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 150 of 160 Financial Accounting & Reporting in 2002 equals a gross profit percentage of 28% for 2002 sales. (Chapter 12-1-1, CBT Skill: Analysis, CSO: 2.8.0) 8. (a) Future realization of the tax benefit of an existing deductible temporary difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character within the carryback, carryforward period available under law. Whatever amount is allowed is multiplied by the effective tax rate to come up with the tax benefit realized. Brass had $60,000 reported income which was sufficient income to cover the entire $40,000 net operating loss carryforward. With an effective tax rate of 30%, Brass can realize an income tax benefit of $12,000 ($40,000 × 30%). (Chapter 13-4-1, CBT Skill: Analysis, CSO: 3.10.0) 9. (c) Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income is divided into net income and other comprehensive income (OCI). It would include $110,000 from net income ($800,000 – $600,000 – $90,000) and $30,000 from OCI (the unrealized holding gain on available-for-sale securities). (Chapter 11-3-2, CBT Skill: Analysis, CSO: 1.2.3) 10. (a) Using the straight-line method of depreciation, Ajax would have a depreciation expense of $10,000 ($100,000 purchase price / 10 years). The current tax benefit would be $3,000 ($10,000 depreciation expense × 30% effective tax rate). Using the 150% declining balance method of depreciation, Ajax would have a depreciation expense of $15,000 ($100,000 purchase price / 10 years × 150%). The current tax benefit would be $4,500 ($15,000 depreciation expense × 30% effective tax rate). The amount of tax benefit realized by using the 150% declining method instead of the straight-line method would be the difference ($4,500 – $3,000). (Chapter 13-1-4, CBT Skill: Analysis, CSO: 3.10.0) 11. (b) The straight-line (SL) depreciation method is a fixed charge method where an equal amount of depreciable cost is allocated to each period. The SL formula is (historical cost – salvage value) / estimated useful life. The 200% declining balance depreciation method, also known as doubledeclining balance (DDB), uses a rate of depreciation twice the SL rate applied to the book value (i.e., declining balance) of the asset to obtain the depreciation expense for the period. The salvage value is not used in the calculation except as a lower bound for the asset’s book value. The DDB formula Updating Supplement Version 38.3 is (2 / estimated useful life) × (historical cost – accumulated depreciation). 2002: (2/10) × ($100,000 – 0) = $20,000 2003: (2/10) × ($100,000 – $20,000) = $16,000 (Chapter 4-3-1, CBT Skill: Analysis, CSO: 2.4.0) 12. (d) Comparability, which includes consistency, is a secondary quality that interacts with both relevance and reliability to contribute to the usefulness of information. Information about a particular enterprise gains greatly in usefulness if it can be compared with similar information about other enterprises and with similar information about the same enterprise for some other period or some other point in time. Verifiability is a characteristic of reliability only in that information can be said to be verifiable when a large number of independent observers derive similar results using the same measurement methods. Timeliness is a characteristic of relevance only in that information is timely if it is available to a decision maker before it loses its capacity to influence decisions. Neutrality is a characteristic of reliability only in that the information is free from bias towards a predetermined result. (Chapter 1-5-2, CBT Skill: Understanding, CSO: 1.1.2) 13. (c) Deferred tax liabilities or assets are recognized for the future tax consequences of, among other things, revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized. The difference in uncollectible accounts expense between the tax return and the accounting records would result is a $30,000 deferred tax asset. The difference in depreciation expense between the tax return and the accounting records would result in a $290,000 deferred tax liability. The difference in tax-exempt interest revenue between the tax return and the accounting records results in no tax asset or liability because the revenue was tax exempt. This results in a net future tax liability of $260,000. The $260,000 times the future tax rate of 40% equals $104,000. (Chapter 13-2-2, CBT Skill: Analysis, CSO: 3.10.0) 14. (d) Under the aging of accounts receivable method, after the desired ending balance of the allowance group is determined, the amount of uncollectible accounts (bad debt) expense recognized is the difference between the existing balance in the allowance account and the desired ending balance. The allowance account started the year with a credit balance of $12,000. The write-offs during the year would have been a credit to Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 151 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 accounts receivable and a debit to allowance for uncollectible accounts of $48,000 thus bringing the allowance account to a $36,000 debit balance at year-end. To get the allowance account to the desired $50,000 credit balance there would need to be a credit to allowance for uncollectible accounts and debit to uncollectible accounts expense for $86,000. (Chapter 2-6-2, CBT Skill: Analysis, CSO: 2.2.0) 18. (a) An impairment loss is recognized if the carrying amount of an intangible asset is not recoverable and its carrying amount exceeds its fair value. After an impairment loss is recognized, the adjusted carrying amount of the asset is its new accounting basis. Subsequent reversal of a previously recognized impairment loss is prohibited. (Chapter 5-1-3, CBT Skill: Understanding, CSO: 2.6.0) 15. (b) In cash-basis accounting, the effects of transactions and other events on the assets and liabilities of a business enterprise are recognized and reported only when cash is received or paid; while in accrual accounting, these effects are recognized and reported in the time periods to which they relate. Cash-basis accounting does not attempt to match revenues and the expenses associated with those revenues. The unearned consulting fees amount means the company received cash for services they have not yet performed so it wouldn’t be counted in consulting fee revenue. The consulting fees receivable amount means the company has earned the revenue but has not yet received the cash. The cash-basis consulting revenue would be the $25,000 consulting fee revenue plus the $2,000 unearned consulting fees less the $3,500 consulting fees receivable for a total of $23,500. (Chapter 11-4-9, CBT Skill: Analysis, CSO: 1.3.0) 19. (b) A permanent fund is used to account for nonexpendable resources that may be used for the government’s programs to generate and disperse money, such as the land in this situation, to benefit the reporting entity or its citizens. The name of the fund comes from the purpose of the fund: a sum of equity used to permanently generate payments to maintain some financial obligation. A fund can only be classified as a permanent fund if the money is used to report the status of a restricted financial resource. The resource is restricted in the sense that only earnings from the resource are used and not the principal. A special revenue fund is used to account for revenues that are externally restricted or designated by the legislative body for specific general government purposes other than capital projects. Private-purpose trust funds are used to account for fiduciary responsibilities and activities in managing trust arrangements that benefit individuals, private organizations, or other governments. An agency fund is used to account for the custodial activities of a government serving as an agent for other governments, private organizations, or individuals. Agency funds are purely custodial. (Chapter 19-1-6, CBT Skill: Understanding, CSO: 4.1.2) 16. (a) Treasury stock is the corporation’s common or preferred stock that has been reacquired by purchase, by settlement of an obligation to the corporation, or through donation. The cost method views the purchase and subsequent disposition of stock as one transaction. The treasury stock is recorded (debited), carried, and reissued at the acquisition cost. If the stock is reissued at a price in excess of the acquisition cost, such as in this situation, the excess is credited to an appropriately titled paid-in capital account. There are no gains or losses reported in the income statement for these transactions. (Chapter 10-5-2, CBT Skill: Analysis, CSO: 2.11.0) 17. (d) A nongovernmental not-for-profit organization’s statement of activities is similar to a for-profit entity’s income statement. The change in net assets is reported in the statement of activities. The revenues, gains, and losses are classified into three groups: unrestricted, temporarily restricted, and permanently restricted. All expenses are reported as decreases in unrestricted net assets. (Chapter 20-1-3, CBT Skill: Understanding, CSO: 5.1.2) 20. (c) The installment method is an exception of normal GAAP revenue recognition and not allowed unless certain circumstances exist such that collection of sales is not reasonably assured. This method is permitted when receivables are collected over an extended period of time and, because of the terms of transactions or other conditions, there is no reasonable basis for estimating the degree of collectibility. The installment method allows revenue to be deferred and recognized each year in proportion to the receivables collected that year. (Chapter 12-1-1, CBT Skill: Understanding, CSO: 2.8.0) 21. (d) In general, accounting for nonmonetary transactions (those involving nonmonetary assets or liabilities) should be based on the fair values (FV) of the assets involved. The acquisition is recorded at the FV of the asset surrendered or the FV of the asset received, whichever is more clearly Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 152 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 determinable, and gains or losses should be recognized. Nonmonetary exchanges should be based on recorded amounts, rather than FV, of the exchanged assets if any of the following apply: 1) neither the FV of the assets received nor FV of the assets surrendered is reasonably determinable, or 2) the transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers, or 3) the exchange lacks commercial substance. This situation does not fall into any category warranting the exchange to be based on recorded amounts so it would be based on FV. Feld would realize a gain of $30,000 on this transaction. The entry would be: Equipment (tow truck FV) 100,000 Accumulated Depreciation 80,000 Cash 10,000 Equipment (delivery truck) 140,000 Gain 30,000 (Chapter 4-2-1, CBT Skill: Analysis, CSO: 3.14.0) 22. (b) Amortization of a bond premium decreases interest expense and the carrying amount of the bond for the issuer, while the amortization of a bond discount increases the issuer’s interest expense and the carrying amount of the bond. Pension cost interest is part of net pension expense. Deferred compensation plan interest is part of compensation expense. Interest incurred to finance a software development for internal use is capitalized as part of the cost of the software. (Chapter 6-3-3, CBT Skill: Understanding, CSO: 3.11.0) 23. (b) A nongovernmental not-for-profit organization’s statement of activities is similar to a for-profit entity’s income statement. The change in net assets is reported in the statement of activities. The revenues, gains, and losses are classified into three groups: unrestricted, temporarily restricted, and permanently restricted. All expenses, which would include depreciation expense, are reported as decreases in unrestricted net assets. (Chapter 20-13, CBT Skill: Understanding, CSO: 5.1.2) 24. (c) The term current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. Short-term obligations are those scheduled to mature within one year or operating cycle, whichever is longer, and generally are classified as current liabilities. However, if they are to be refinanced on a long-term basis they will be appropriately classified as longterm liabilities. Exclusion from current liabilities requires two conditions be met; 1) the enterprise must intend to refinance the obligation on a longterm basis, and 2) the enterprise must have the ability to consummate the financing. A refinancing that occurs after the balance sheet date but before the issuance of the balance sheet is evidence of intent and ability. The $1,000,000 bank loan would not be reported as part of current liabilities because it was refinanced on a long-term basis. The accounts payable-trade, short-term borrowings, and current portion of mortgage payable would be reported as current liabilities ($750,000 + $100,000 + $400,000 = $1,250,000). (Chapter 7-2-4, CBT Skill: Analysis, CSO: 1.2.2) 25. (b) The statement of functional expenses provides information about expenses reported by their functional classifications, such as major classes of program services and support services, as well as information about expenses by their natural classification, such as salaries, rent, electricity, interest expense, depreciation awards and grants to others, and professional fees, in a matrix format. Program services are the activities that result in goods and services being distributed to beneficiaries, customers, or members that fulfill the purposes or mission for which the organization exists. Those services are the major purpose for and the major output of the organization and often relate to several major programs. Examples include research, education, and community services, among others. Support services are all activities of a not-for-profit organization other than program services. Generally, they include management and general, fund-raising, and membership-development activities. The salaries of fundraisers, even though the funds raised may be used in research, are classified as support services. (Chapter 20-1-3, CBT Skill: Understanding, CSO: 5.1.4) __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 153 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Solution 2 MULTIPLE-CHOICE ANSWERS (Hard) 26. (d) Calculating diluted earnings per share (EPS) is a two step process. The first step is to compute basic EPS and the second is to determine the per share effect of each dilutive security. Basic EPS is computed by dividing income available to shareholders (IAC) by the weighted average number of shares outstanding during the period. Shares Outstanding 15,000 12,500 17,000 Totals Months Outstanding 3/12 2/12 7/12 12/12 Weighted Average 3,750 2,083.333 9,916.667 15,750 Basic EPS would be $125,000 / 15,750 = $7.94. The incentive stock options are potentially dilutive securities. A security is only dilutive if the inclusion of the security in the computation of EPS results in a smaller EPS or increases the loss per share. If the average market price is higher than the exercise price the options are dilutive. If the average market price is less than the exercise price the options are anti-dilutive. Since the market price of $25 is less than the exercise price of $30 these options are antidilutive and have no per share effect. The diluted EPS is the same as basic EPS. (Chapter 15-3-3, CBT Skill: Analysis, CSO: 3.5.0) 27. (a) Cash flows from investing activities include 1) making and collecting loans (excluding those acquired specifically for resale), 2) acquiring and disposing of property, plant and equipment, and other productive assets, and 3) purchases, sales, and maturities of debt and equity securities (excluding those acquired specifically for resale). The sale of investment in Blue Co. would be an investing activity cash inflow of $75,000 and the common stock purchase from Brown Co. would be an investing activity cash outflow of $38,000. The $75,000 cash in less $38,000 cash out equals net $37,000 cash from investing activities. Dividends received on stock are classified as cash flows from operating activities. (Chapter 14-2-2, CBT Skill: Analysis, CSO: 1.2.4) 28. (c) An impairment loss shall be recognized only if the carrying amount of a long-lived asset, or asset group, is not recoverable and exceeds its fair value. The carrying amount (book value) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. The amount of an impairment loss is the difference between an asset’s book and fair value. The $120,000 carrying value of the company’s long-lived does not exceed the $130,000 undiscounted future cash flows expected to result from the asset so there is no impairment loss. (Chapter 4-4-1, CBT Skill: Analysis, CSO: 2.4.0) 29. (d) Journal entries to record the collection of an account previously written off as uncollectible are as follows: Accounts Receivable—Joe XX Doe Cash XX To reopen account to balance when written off. Cash XX Accounts Receivable—Joe Doe XX To record receipt of cash payment of receivable. These entries would increase cash and allowance for uncollectible accounts. They would have no net effect on net accounts receivable, net income, current assets, or working capital. (Chapter 2-6-2, CBT Skill: Understanding, CSO: 2.2.0) 30. (c) Contingent liabilities arise from events or circumstances occurring before the balance sheet date, the resolution of which is contingent on a future event or circumstance. Pending or threatened litigation is one example of a contingent liability. The accounting treatment depends on the likelihood that future events will confirm the contingent loss and whether the amount can be reasonably estimated. Where the likelihood of confirmation of a loss is considered probable and the loss can be reasonable estimated, the estimated loss should be accrued by a charge to income and the nature of the contingency should be disclosed. If, however, only a range of possible loss can be estimated, with no amount in the range better than any other, the minimum amount in the range should be accrued. The wrongful termination event took place in 2003 and because a loss from it is considered probable it should be reported in the December 31, 2003, balance sheet. The most likely amount (reasonably estimated) would be reported. (Chapter 7-1-6, CBT Skill: Analysis, CSO: 3.3.0) 31. (c) An enterprise fund is one of the governmental proprietary funds. Governments should present a statement of cash flows for proprietary funds based on the provisions of GASB statements. The GASB states the direct method of presenting cash flows from operating activities (including a reconciliation of operating cash flows to operating income) should be used. (Chapter 18-2-5, CBT Skill: Judgment, CSO: 4.2.4) Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 154 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 32. (d) Governments are encouraged, but not required, to capitalize a collection of works of art or historical treasures (and all additions to that collection) whether donated or purchased that meets all of the following conditions. The collection is 1) held for public exhibition, education, or research in furtherance of public service rather than financial gain, 2) protected, kept encumbered, cared for, and preserved, and 3) subject to an organizational policy that requires the proceeds from sales of collection items to be used to acquire other items for collections. Capitalized collections or individual items that are exhaustible, such as exhibits whose useful lives are diminished by display or educational or research applications, should be depreciated over their estimated useful lives. Depreciation is not required for collections or individual items that are inexhaustible. (Chapter 18-2-3, CBT Skill: Understanding, CSO: 4.1.2) 33. (b) A statement of functional expenses is required only for voluntary health and welfare organizations (VHWOs). VHWOs offer free or low cost services to the general public or to certain segments of society, and are supported primarily by public contributions. A shelter for the homeless would be considered a VHWO. A private foundation is not public. An art museum and a public golf course charge fees. (Chapter 20-2-3, CBT Skill: Understanding, CSO: 5.1.4) 34. (b) Convertible bonds provide the bondholder the option of converting the bond to capital stock, typically common stock. Using the book value method, the conversion of the bonds into common stock is generally recorded by crediting the paid-in capital accounts for the carrying amount of the debt at the date of the conversion, less any cost associated with the conversion. The carrying amount of the bonds on the date of conversion is the $1,000,000 face value less the $100,000 unamortized discount. The market value is not considered when using the book value method. The journal entry: Bonds Payable 1,000,000 Bond Discount 100,000 Common Stock (100,000 × $1 par) 100,000 APIC (to balance) 800,000 The $100,000 credit to common stock and $800,000 credit to APIC would increase stockholders’ equity $900,000. (Chapter 6-4-2, CBT Skill: Analysis, CSO: 2.11.0) 35. (b) represent Imposed nonexchange assessments imposed revenues on non- governmental entities and include property taxes and fines or forfeitures. Governments should recognize revenues from property taxes, net of estimated refunds and estimated uncollectible amounts, in the period for which the taxes are levied, even if the enforceable legal claim arises or the due date for payment occurs in a different period. All other imposed nonexchange revenues should be recognized in the same period that the assets are recognized unless the enabling legislation includes time requirements. If so, revenues should be recognized in the period when the resources are required to be used or when use is first permitted. (Resources received or recognized as receivable before that period should be reported as deferred revenues.) The $1,980,000 is derived by from the total $2,000,000 levied less $20,000 (the 1% of $2,000,000) expected to be uncollectible. The $15,000 written off as uncollectible does not factor anywhere in the equation. (Chapter 18-3-1, CBT Skill: Analysis, CSO: 4.2.1) 36. (c) An option contract is a derivative. Derivatives are recognized as assets or liabilities on the financial statements and measures using fair value. Changes in fair value of non-hedge securities are reported as gains or losses in earnings. On December 1, Bann would initially record the option contract at $80,600 (2,000 shares × $40 market price on December 1 + $600 time value). At the end of December, the fair value of the option contract was $86,400 (2,000 shares × $43 market price on December 31 + $400 time value). Bann would report this change in fair value which would result in net income increasing by $5,800. (Chapter 2-5-2, CBT Skill: Analysis, CSO: 3.8.0) 37. (c) Conditional promises to give, which depend on the occurrence of a specified future and uncertain event to bind the promisor, shall be recognized when the conditions on which they depend are substantially met. A conditional promise to give is considered unconditional if the possibility that the condition will not be met is remote. A transfer of assets with a conditional promise to contribute them shall be accounted for as a refundable advance until the conditions have been substantially met. (Chapter 20-1-4, CBT Skill: Analysis, CSO: 5.1.1) 38. (c) The term current liabilities is used primarily to designate obligations whose liquidation is reasonably expected to require the use of existing resources classified as current assets, or the creation of other current liabilities. Accounts payable is a type of current liability. Short-term obligations are those scheduled to mature within one Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 155 of 160 Financial Accounting & Reporting year or operating cycle, whichever is longer, and generally are classified as current liabilities. However, if they are to be refinanced on a long-term basis they will be appropriately classified as longterm liabilities. Exclusion from current liabilities requires two conditions be met; 1) the enterprise must intend to refinance the obligation on a longterm basis, and 2) the enterprise must have the ability to consummate the financing. A refinancing that occurs after the balance sheet date but before the issuance of the balance sheet is evidence of intent and ability. (Chapter 7-2-4, CBT Skill: Analysis, CSO: 1.2.2) 39. (d) Pledges are reported in the period in which they are made, net of an allowance for uncollectible amounts. If part of a pledge is to be applied during some future period, that part is reported as restricted revenue. Although the $300,000 of pledges received during the current year was unrestricted as to its use, there was a time restriction (designated for next year) on $100,000. The $100,000 less $5,000, for the 5% expected to be uncollectible, equals $95,000 to be reported as restricted support. (Chapter 20-1-4, CBT Skill: Analysis, CSO: 5.2.1) 40. (b) The term current liabilities is used primarily to designate obligations whose liquidation is reasonably expected to require the use of existing resources classified as current assets, or the creation of other current liabilities. Long-term liabilities are all obligations not expected to be liquidated by the use of existing current assets or by the creation of current liabilities. Short-term obligations are those scheduled to mature within one year or operating cycle, whichever is longer, and generally are classified as current liabilities. However, if they are to be refinanced on a long-term basis they will be appropriately classified as longterm liabilities. Income taxes payable within the next period, or operating cycle, are classified as current liabilities. A deferred tax liability is over a longer period of time and not considered a current liability. The only amount that would be reported is the $16,000 due within 12 months from the mortgage note payable. (Chapter 7-1-3, CBT Skill: Analysis, CSO: 1.2.2) 41. (b) The exchange rate to be used for translation of foreign currency transactions is as follows. At the date the transaction is recognized, each asset, liability, revenue, expense, gain, or loss arising from the transaction should be measured and recorded in the functional currency of the recording entity by use of the exchange rate in effect at that date. At each balance sheet date, recorded Updating Supplement Version 38.3 balances that are denominated in a currency other than the functional currency of the recording entity should be adjusted to reflect the current exchange rate. These adjustments should be currently recognized as transaction gains or losses and reported as a component of income from continuing operations. Upon settlement, a transaction gain or loss, measured from the transaction date or the most recent intervening balance sheet date (whichever is later), should be included as a component of income from continuing operations for the period in which the transaction is settled. The U.S. company would recognize a gain of $100 when the receivable is collected (settlement date) based on 2,000 pounds × $0.05, the increase in the exchange rate of $1.45 on the balance sheet date to $1.50 on the settlement date. (Chapter 16-2-2, CBT Skill: Analysis, CSO: 3.9.0) 42. (a) The amount of the bonus is determined by solving the proper equation that describes the terms of the bonus agreement. Using B to represent the bonus, B equals 25% of the total of income before taxes less $100,000 less B. The answer is computed as follows: B = 0.25 × ($160,000 – $100,000 – B); setup B = 0.25 × ($60,000 – B); reduced $ figure B = $15,000 – .25B; simplified right-side 1.25B = $15,000; added .25B to both sides B = $12,000; divided both sides by 1.25 (Chapter 7-1-4, CBT Skill: Analysis, CSO: 2.12.0) 43. (d) A warranty or guarantee is a promise made by the seller to the buyer to make good certain deficiencies in the product during a specified period of time after the sale. Obligations related to product warranties and product defects are an example of loss contingencies. An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met; 1) information available prior to the issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements, and 2) the amount of the loss can be reasonably estimated. It is probable that repairs are required and the 2% of net sales is a reasonable estimate so there is a charge to income through warranty expense. Proper accrual of the warranty expense for year 2 would be 2% of the net sales from year 2 (0.02 × $300,000 = $6,000). (Chapter 7-1-5, CBT Skill: Analysis, CSO: 2.10.0) 44. (b) A bond that is issued with a stated rate of interest that is less than the effective rate on the Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 156 of 160 Financial Accounting & Reporting issuance date is a bond issued with a discount. A bond issued at a discount will have an increasing carrying value and an increasing amount of interest expense. On the first interest payment date the company should report an interest expense that is greater than the cash payment made to bondholders. (Chapter 6-2-3, CBT Skill: Judgment, CSO: 2.9.0) 45. (a) Net cash flow from operating activities may be reported under the indirect method by adjusting net income to reconcile it to net cash flow from operating activities. The reconciliation of net income to net cash flow from operating activities should separately report all major classes of reconciling items. In addition, when the direct method is used, amounts of interest paid (net of amounts capitalized) and income taxes paid during the period should be provided in related disclosures. The $325,000 income taxes paid plus the $220,000 net interest payments total $545,000. (Chapter 14-13, CBT Skill: Analysis, CSO: 1.2.4) 46. (a) In general, accounting for nonmonetary transactions (those involving nonmonetary assets or liabilities) should be based on the fair values of the assets involved. The acquisition is recorded at the fair value of the asset surrendered or the fair value of the asset received, whichever is more clearly determinable, and gains or losses should be recognized. The rationale associated with immediate gain/loss, recording the transactions at fair value, is that the exchange represents the culmination of the earnings process associated with the assets surrendered. The best statement describing the proper accounting for losses when nonmonetary assets are exchanged is that a loss is recognized immediately, because assets received should not be valued at more than their cash equivalent price. (Chapter 4-2-1, CBT Skill: Judgment, CSO: 3.14.0) Updating Supplement Version 38.3 amounts of assets and liabilities as of the beginning of the first period presented or earliest period to which the new accounting principle can be applied, 2) an offsetting adjustment, if needed, shall be made to the opening balance of retained earnings for that period, 3) financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new principle, and 4) only the direct effects of a change in accounting principle are included in retrospective application, including any related income tax effects. (Chapter 11-4-1, CBT Skill: Judgment, CSO: 3.1.0) 48. (a) Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income. Both the $28,000 from dividends that were declared and paid and the $200,000 from issuance of common stock are cash flows from financing activities, not operating. With the limited information provided it is best to use the indirect method to compute the cash provided by operating activities. Computation under this method is done by converting net income to net cash flow from operating activities. Start with net income and then make adjustments to reconcile net income to net cash provided by operating activities. Take the $78,000 net income less the $82,000 increase in accounts receivable plus the $24,000 increase in accounts payable and the result is $20,000 net cash provided by operating activities. (Chapter 14-3-3, CBT Skill: Analysis, CSO: 1.2.4) 49. (b) A lease is classified as a capital lease if at the date of the lease agreement the lease satisfies at least one of the following four criteria: 1) the lease transfers ownership of the property to the lessee by the end of the lease, or 2) the lease contains a bargain purchase option, or 3) the lease term is equal to 75% or more of the estimated economic life of the leased property, or 4) the present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property at lease inception. (Chapter 8-2-1, CBT Skill: Understanding, CSO: 3.13.0) 47. (d) The change from cash-basis accounting to accrual-basis accounting is a change in accounting principle. A change in accounting principle results from the adoption of a generally accepted accounting principle (GAAP) different from 50. (a) A bond issued at 98 indicates the bond the GAAP previously used for reporting purposes. A was issued at a 2% discount. The entry the change in accounting principle is reported through company would use to record the original issue retrospective application of the new accounting would be a debit to cash for $49,000, a debit to bond principle to all prior periods, unless it is impracticable discount for $1,000 and a credit to bonds payable for to do so. Retrospective application requires the $50,000. (Chapter 6-2-3, CBT Skill: Analysis, CSO: following: 1) the cumulative effect of the change to 2.9.0) the new accounting principle on periods prior to those presented shall be reflected in the carrying __________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 157 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Solution 3 SIMULATION ANSWERS Deferred Tax Worksheet Stanhope, Inc. Worksheet for Deferred Income Taxes Year ended December 31, year 2 A C D Description of temporary differences 1 B Temporary differences Deferred tax assets Deferred tax liabilities 2 Allowance for doubtful accounts 3 Accumulated depreciation, excess of tax over GAAP 4 Unrealized gain (loss) on trading securities 21,000 6,930 767,000 253,110 8,000 2,640 5 6 7 8 9 Totals 6,930 255,750 Explanations: Row 2: The Allowance for doubtful accounts (bad debts) is a temporary difference in that for financial reporting an allowance method is used to record bad debts expense for the year whereas for income tax purposes a direct write off method is used. The amount of the temporary difference is $21,000; the $11,000 starting balance less $5,000 actually written off plus the additional $15,000 charged. This results in a deferred tax asset of $6,930, $21,000 × 33% (the enacted tax rate), because this amount is expected to be written off for income tax purposes in future years, Row 3: The Accumulated depreciation, excess of tax over GAAP is a temporary difference in that for financial reporting the straight-line depreciation rate is used and for income tax purposes accelerated methods are used. The amount of the temporary difference is $767,000 (the amount provided as the difference at December 31, year 2). This results in a deferred tax liability of $253,110, the $767,000 × 33% (the enacted tax rate), because more income will be taxable in future years. Row 4: The Unrealized gain (loss) on trading securities is a temporary difference in that for financial reporting the unrealized gain (loss) is reported in current income and for income tax purposes it is not. The amount of the temporary difference is $8,000 (the amount provided at December 31, year 2). This results in a deferred tax liability of $2,640, $8,000 × 33% (the enacted tax rate), because more income will be taxable in future years. Row 9, columns C and D: The total sum of deferred tax assets and deferred tax liabilities, respectively. Balance Sheet – Deferred Taxes Assets: Deferred taxes, current asset Deferred taxes, noncurrent asset 4,290 [1] - [2] - [3] 253,110 [4] Liabilities: Deferred taxes, current liability Deferred taxes, noncurrent liability Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 158 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 [1] The allowance for doubtful accounts and unrealized gain on trading securities are allowance-type accounts that will be reviewed annually and as such are considered current. They equal a net $4,290 asset. [2] There are no noncurrent deferred tax assets. [3] There are no current deferred taxes liabilities [4] No information was given stating the depreciable asset’s carrying amount will be recovered through use or sale within the next year so it is implied that it is noncurrent. Communication To: Vice president, Stanhope, Inc. Re: Deferred Income Taxes The objective of accounting for income taxes is to recognize the amount of taxes payable or refundable for the current year. A second objective is to recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an enterprise's financial statements or tax returns. A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized. Deferred tax liabilities and assets must be adjusted in the period of enactment for the effect of an enacted change in tax laws or rates. The effect is included in income from continuing operations. The objective of general purpose external financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions. To help achieve its objective, financial reporting should provide information to help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity’s future cash inflows and outflows (the entity’s future cash flows). To help present and potential investors and creditors and others in assessing an entity’s ability to generate net cash inflows, financial reporting should provide information about the economic resources of the entity (its assets) and the claims to those resources (its liabilities and equity). Information about the effects of transactions and other events and circumstances that change resources and claims to them is also essential. Tax laws often differ from the recognition and measurement requirements of financial accounting standards, and differences can arise between (a) the amount of taxable income and pretax financial income for a year and (b) the tax bases of assets or liabilities and their reported amounts in financial statements. Differences between the years in which transactions affect taxable income and the years in which they enter into the determination of pretax financial income are called timing differences. Timing differences create differences (sometimes accumulating over more than one year) between the tax basis of an asset or liability and its reported amount in financial statements. Other events such as business combinations may also create differences between the tax basis of an asset or liability and its reported amount in financial statements. All such differences collectively are referred to as temporary differences. Temporary differences ordinarily become taxable or deductible when the related asset is recovered or the related liability is settled. A deferred tax liability or asset represents the increase or decrease in taxes payable or refundable in future years as a result of temporary differences and carryforwards at the end of the current year. A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years. A deferred tax liability is recognized in the current year for the related taxes payable in future years. A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards. A deferred tax asset is recognized in the current year for the reduction in taxes payable in future years. A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 159 of 160 Financial Accounting & Reporting Updating Supplement Version 38.3 Research FAS 109, Par. 27 or FAS 109, par.112 27. Deferred tax liabilities and assets shall be adjusted for the effect of a change in tax laws or rates. The effect shall be included in income from continuing operations for the period that includes the enactment date. 112. A change in tax law or rate or a change in the tax status of an enterprise is an event that has economic consequences for an enterprise in the year that the change occurs, that is, in the year that a change in tax law or rate is enacted or a change in tax status is approved. As a result of the change, deferred tax consequences become larger or smaller. Conceptually, it could be argued that an enterprise should anticipate the tax effect of an expected future change in tax law or rate or a change in tax status on its deferred tax liability or asset at the end of the current year. The Board believes, however, that recognition of those tax consequences in the year that a change occurs permits a more reliable measurement of the economic effects of an enacted change in tax law or rate or a change in the tax status of an enterprise. _________________ Copyright © 2009 by Bisk Education, Inc. All rights reserved. Page 160 of 160 ...
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