preparing financial statements - checkpoint learning cpe

PFST09

SELF�STUDY CONTINUING PROFESSIONAL EDUCATION

Companion to PPC's Guide to

Preparing FinancialStatements

Fort Worth, Texas(800) 323�8724trainingcpe.thomson.com

PFST09

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Interactive Self�study CPE

Companion to PPC's Guide to PREPARING FINANCIAL STATEMENTS

TABLE OF CONTENTS

Page

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

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

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

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

Lesson 3: Accounting Changes 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Glossary 101. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 103. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COURSE 2: ACCOUNTING FOR CERTAIN TAX TRANSACTIONS

Overview 105. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 1: Selected Topics Part 1 107. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 2: Selected Topics Part 2 157. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Glossary 197. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 199. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COURSE 3: THE STATEMENT OF INCOME

Overview 201. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 1: General Considerations Related to the Statement of Income 203. . . . . . . . . . . . . . . . . . . . .

Lesson 2: The Accounting and Presentation of Certain Expenses Related to the Statement of Income 231. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 3: Income Tax Accounting 263. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Glossary 297. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 299. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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COURSE 4: PREPARING FINANCIAL STATEMENTS: ASSETS

Overview 301. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 1: Current Assets 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 2: Long�term Investments 343. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 3: Property and Equipment 363. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 4: Intangible Assets, Other Deferred Costs, and Long�lived Assets 389. . . . . . . . . . . . . . . . . .

Glossary 413. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 415. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

EXAMINATION INSTRUCTIONS, ANSWER SHEETS, AND EVALUATIONS

Course 1: Testing Instructions for Examination for CPE Credit 419. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Course 1: Examination for CPE Credit Answer Sheet 421. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Course 1: Self�study Course Evaluation 422. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 2: Testing Instructions for Examination for CPE Credit 423. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Course 2: Examination for CPE Credit Answer Sheet 425. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Course 2: Self�study Course Evaluation 426. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 3: Testing Instructions for Examination for CPE Credit 427. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Course 3: Examination for CPE Credit Answer Sheet 429. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 3: Self�study Course Evaluation 430. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Course 4: Testing Instructions for Examination for CPE Credit 431. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Course 4: Examination for CPE Credit Answer Sheet 433. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Course 4: Self�study Course Evaluation 434. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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INTRODUCTION

Companion to PPC's Guide to Preparing Financial Statements consists of four interactive self�study CPE courses.These are companion courses to PPC's Guide to Preparing Financial Statements designed by our editors toenhance your understanding of the latest issues in the field. To obtain credit, you must complete the learningprocess by logging on to our Online Grading System at OnlineGrading.Thomson.com or by mailing or faxing yourcompleted Examination for CPE Credit Answer Sheet for print grading by November 30, 2010. Completeinstructions are included below and in the Test Instructions preceding the Examination for CPE Credit AnswerSheet.

Taking the Courses

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

Qualifying Credit HoursQAS or Registry

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

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

Obtaining CPE Credit

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

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

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

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

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

Retaining CPE Records

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

PPC In�House Training

A number of in�house training classes are available that provide up to eight hours of CPE credit. Please call ourSales Department at (800) 323�8724 for more information.

PFST09 Companion to PPC's Guide to Preparing Financial Statements

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COMPANION TO PPC'S GUIDE TO PREPARING FINANCIAL STATEMENTS

COURSE 1

PREPARING FINANCIAL STATEMENTS: LIABILITIES AND STOCKHOLDERS' EQUITY (PFSTG091)

OVERVIEW

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

PUBLICATION/REVISION

DATE:

November 2009

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

PREREQUISITE/ADVANCE

PREPARATION:

Basic knowledge of financial statements.

CPE CREDIT: 8 QAS Hours, 8 Registry Hours

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

FIELD OF STUDY: Accounting

EXPIRATION DATE: Postmark by November 30, 2010

KNOWLEDGE LEVEL: Basic

Learning Objectives:

Lesson 1Liabilities

Completion of this lesson will enable you to:

� Identify and present current and noncurrent liabilities.

� Classify and report income taxes payable.� Identify other liabilities, ownership agreements and provisions that affect balance sheet reporting.

Lesson 2Stockholders' Equity


� Identify and correctly report stockholders' equity on the balance sheet.

Lesson 3Accounting Changes

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

PFST09Companion to PPC's Guide to Preparing Financial Statements

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TO COMPLETE THIS LEARNING PROCESS:

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

Thomson ReutersTax & AccountingR&GPFSTG091 Self�study CPE36786 Treasury CenterChicago, IL 60694�6700

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

ADMINISTRATIVE POLICIES:

For information regarding refunds and complaint resolutions, dial (800) 323�8724 for Customer Service and yourquestions or concerns will be promptly addressed.


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Lesson 1:�Liabilities

INTRODUCTION

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

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

� Current Assets. Cash and other assets that are reasonably expected to be realized in cash or sold orconsumed during one year or within the company's normal operating cycle if it is longer than a year.(Current assets normally include cash, marketable securities, receivables, inventories, and prepaidexpenses.) [FASB ASC 715�20�45�3 (formerly SFAS No. 158) modifies the preceding definition of currentassets as discussed in the Retirement Plan Considerations section.]

� Current Liabilities. Obligations whose liquidation is reasonably expected to require the use of current assetsor the creation of other current liabilities. (Current liabilities include short�term obligations such as payablesfor materials and supplies, wages, taxes, amounts collected in advance of delivery of goods or services,the current portion of long�term obligations, and any other obligations expected to be liquidated within ayear.) [FASB ASC 470�10�45�13 (formerly SFAS Nos. 6), FASB ASC 470�10�45�12 (formerly 78), and FASBASC 715�20�45�3 (formerly 158) modify the preceding definition of current liabilities as discussed in theRefinancing of Short�term Debt and Retirement Plan Considerations sections.]

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

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


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

CLASSIFYING AND REPORTING CURRENT LIABILITIES

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

� Short�term debt (notes and loans)

� Current portion of long�term debt

� Accounts payable

� Accrued liabilities

� Income taxes payable�current and deferred


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

Short�term Debt

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

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

b. Material loans from related parties should be disclosed.

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

d. The order of presentation should be as follows:

(1) Notes payable to third parties

(2) Notes payable to related parties

(3) Loans

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

20X2 20X1

CURRENT LIABILITIES

Short�term notes $ 50,000 $ 75,000

Loans payable to stockholders � 25,000

Accounts Payable

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

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

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


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Accrued Liabilities

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

� Compensation

� Income taxes

� Interest

� Payroll taxes

� Retirement plan contributions

� Royalties

� Damages under lawsuits

� Vacation pay

� Warranty claims

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

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

b. The amount can be reasonably estimated.

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

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

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

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

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

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

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

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

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


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

c. Payment of the compensation is probable.

d. The amount can be reasonably estimated.

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

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

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

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

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

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

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

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

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

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

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

a. Determine total salaries and wages for the year.

b. Compute the cost per week.

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


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

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

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

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

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

� Salary continuation

� Supplemental unemployment benefits

� Severance benefits

� Disability�related benefits

� Job training and counseling

� Continuation of health care benefits and life insurance coverage

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

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

� Employees' rights to those benefits accumulate or vest.

� Payment of the benefits is probable.

� The amount of the benefits can be reasonably estimated.

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

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

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

b. Bonuses

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

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

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


8

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

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

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

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

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

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

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

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

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

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


9

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

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

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

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

20X2 20X1

CURRENT LIABILITIES


Accounts payable 90,000 80,000

Accrued expenses

Compensation 10,000 15,000

Retirement plan contributions 7,000 6,000

Other 3,000 4,000

TOTAL CURRENT LIABILITIES 160,000 165,000

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

20X2 20X1

CURRENT LIABILITIES





Other 3,000 4,000


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

20X2 20X1

CURRENT LIABILITIES



Accrued expenses 20,000 25,000


Other Current Liabilities

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


10

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

� Sales taxes

� Escrow obligations

� Refundable deposits

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

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

� Membership dues and fees received in advance

� Advance rental payments received from lessees

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

� Membership fees received in advance

� Refundable damage deposits

Refinancing of Short�term Debt

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

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

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

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

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

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

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

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

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


11

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

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

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

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

(2) Financing Agreement. Before the balance sheet is issued or available to be issued, the company hasentered into a financing agreement that clearly permits refinancing on terms that are readilydeterminable, and all of the following conditions are met:

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

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

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

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

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

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

January 1, 20X1 $ 10,000

January 1, 20X2 10,000

January 1, 20X3 10,000

In FASB ASC 470�10�45�9 and 45�10 (formerly EITF Issue No. 86�5, �Classifying Demand Notes with RepaymentTerms") an obligation that, by its terms, is due on demand should be considered a current liability in accordancewith FASB ASC 470�10�45�12 (formerly SFAS No. 78, Classification of Obligations That Are Callable by the Creditor).Factors such as an assessment of the likelihood that the creditor actually will call the notes do not affect the


12

classification decision. Demand notes that specify or permit installments, lines of credit, and borrowings fromstockholders are current liabilities unless the creditor has specifically waived the right to demand payment for morethan one year from the balance sheet date. GAAP requires an unconditional waiver, however, before short�termdebt may be classified as noncurrent. A waiver stating that the loan will not be called provided there are no adverseshifts in operations or using similar language is not sufficient.

Accounting for Violations of Debt Covenants

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

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

� the violation is cured after the balance sheet date but before financial statements are issued or availableto be issued, or

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

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

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

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

Default, Acceleration and Setoff

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

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

MATERIAL ADVERSE CHANGE:

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


13

In both of the preceding examples, a change in the financial condition of either the debtor or guarantors triggers theclause. The clause in the first example is also triggered by declines in the value of the collateral, whether the debtor,one of its owners, or some other entity owns the collateral. Neither example requires the bank to call the loan; theclause only gives it the option of calling the loan. But the existence of the option raises measurement and disclosurequestions, such as the following:

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

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

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

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

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

a. Identify the events that would trigger the clause.

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

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

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

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


14

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

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

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

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

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

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


15

Exhibit 1�1

Accounting for Covenant Violations

Yes

Yes

Did a

violation occur at the balance sheet date

or would one have occurred absent

a loan modification?

Yes

No

Was an

unconditionalwaiver

covering

the next 12 monthsobtained?

Classify as

current

Did a violation

occur prior toissuance of the

statement?

Does it indicate

a conditionexisting at the

balance sheet?

No No

No

Yes

NoAre violations

within thenext 12 months

probable?

Classify as

noncurrent

Yes

* * *


16

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

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

CovenantViolation

Subsequent EventClassification

Effect on FinancialStatements

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

Nonrecognized Possible disclosure

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

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

Measurement ordisclosure

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

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

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

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

� The lender retains the future covenant compliance requirements.

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


17

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

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

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

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

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

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

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

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

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

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

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

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

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

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


18

considered as current unless the lender unconditionally waived its right to call the loan prior to January 1,20X3.

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

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


19

SELF�STUDY QUIZ

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

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

a. Notes payable.

b. Accrued expenses.

c. Deferred income tax benefit.

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

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

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

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

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

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

a. A nonpublic company has an informal vacation policy.

b. The employees have nonvesting rights to sick pay.

c. The employee has vested rights in vacation time.

d. Payment of the compensation is reasonably possible.

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

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

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

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

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

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

a. Sales taxes.

b. Withholding taxes.

c. Health insurance premiums.


20

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

included with noncurrent liabilities?

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

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

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

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

a. True.

b. False.

8. According to general observations about the guidance in FASB ASC 470�10�45�1 (formerly EITF Issue No.

86�30), in which of the following situations would the debt be classified as current?

a. A covenant violation would have occurred at the balance sheet date absent a modification by the lender

and it is probable that the borrower will not be able to cure the default by the quarterly measurement date.

b. A covenant violation occurred at the balance sheet date (The covenant requires annual measurement.),

but the lender waived its right to call the loan for the next year.

c. A covenant violation occurred at the balance sheet date (The covenant requires interim measurementwhich the lender reserved its right to reconsider compliance at any future measurement date within the

year.), but compliance is probable during the period.

d. A covenant violation occurred at the balance sheet date (The covenant requires interim measurement.),

but the lender waives its right to call the loan for the next year.


21

SELF�STUDY ANSWERS

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

7. A subjective acceleration clause in a note would require disclosure in the financial statements even if there isonly a remote chance the loan will be called. (Page 14)

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

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

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

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

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

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

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


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CLASSIFYING AND REPORTING INCOME TAXESPAYABLE ANDDEFERRED

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

Accounting for Uncertainty in Income Taxes

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

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

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

When first issued, FASB ASC 740�10 (formerly FIN 48) was to be effective for all entities for years beginning afterDecember 15, 2006. Although early adoption was permitted, small and midsize nonpublic entities are unlikely tohave chosen that option. However, FASB ASC 740�10�65�1 (formerly Paragraphs 9 and 11 of FSP FIN 48�3,Effective Date of FASB Interpretation No. 48 for Certain Nonpublic Enterprises) permits nonpublic entities to deferapplication of the guidance until annual periods beginning after December 15, 2008.

In May 2009, the FASB issued an exposure draft of a proposed FSP, Application Guidance for Pass�through Entities

and Tax�Exempt Not�for�Profit Entities and Disclosure Modifications for Nonpublic Entities. The final guidance wasissued in September 2009 through Accounting Standards Update (ASU) No. 2009�06, Implementation Guidanceon Accounting for Uncertainty in Income Taxes and Disclosure Amendments for Nonpublic Entities.

The guidance in ASU No. 2009�06 appears in the Codification in various parts of FASB ASC 740�10. The effectivedate of ASU No. 2009�06 varies depending on whether the application of the guidance in FIN 48 has been deferred:

a. For entities that have adopted the requirements of FIN 48, the guidance in ASU No. 2009�06 is effective forperiods ending after September 15, 2009.

b. For entities that have deferred adopting the requirements of FIN 48, the guidance in ASU No. 2009�06 iseffective when FIN 48 is adopted.

The guidance in ASU No. 2009�06 is viewed as clarifying, rather than changing, the guidance in FIN 48.

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Current tax provision $ 80Income tax due currently $ 80

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

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

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

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

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

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

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

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

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

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

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

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

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

c. The taxing authority examines and accepts the position.

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


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

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

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

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

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

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

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

A taxable or deductible temporary difference is a difference between the tax basis of an asset or liability and itscarrying amount in the financial statements. However, once this guidance is implemented, the tax basis of an assetor liability will no longer be determined solely based on positions taken, or expected to be taken, in tax returns.Instead, only tax positions that meet the �more likely than not" criterion will be considered in determining the taxbasis of an asset or liability.

Prior to the implementation of this guidance, the entity would conclude that, in this set of facts and circumstances:

a. The tax basis of the liability is zero.

b. The difference between the carrying amount of the liability for financial statement reporting and its zero taxbasis is a deductible difference because payment of the liability will result in a deduction.

The Interpretation requires a different approach. Once the guidance is implemented, the decision of whetherrecognizing the liability for financial statement reporting creates a deductible difference depends on whether the taxposition for deducting payment of the liability meets the �more likely than not" criterion. The tax basis of the liabilityis its carrying amount for financial statement reporting less the future deduction from its settlement that meets the�more likely than not" criterion.

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

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

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


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

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

Current tax provision $ 120Income tax due currently $ 120

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

Deferred tax asset $ 40Deferred tax provision $ 40

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

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

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

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

The tax provision would therefore consist solely of the $120 current tax provision, which is $40 greater than the $80amount that would be obtained by applying the 40% tax rate to the $200 pretax income reported in the financialstatements. This difference is due to no tax benefit being recognized for the $100 expense recognized in thefinancial statements.

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

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

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


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

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

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

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

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

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

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

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

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

As a practical matter, it is believed many small and midsize nonpublic entities have no tax positions that do not meetthe more�likely�than�not criterion of FASB ASC 740�10 (formerly FIN 48), particularly now that disclosures arerequired in tax returns that contain tax positions that do not meet that criterion. If small and midsize nonpublicentities have positions that do not meet the criterion, there are likely to be only a few of them, and a tabularreconciliation may not have been needed. Instead, information required by FIN 48 could have easily have beenprovided through narrative.

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

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

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


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

The Initial Application of FASB ASC 740�10 (formerly FIN 48). Although the FASB requires applying theguidance in the Interpretation retrospectively, it only permits determining the cumulative effect of retrospectiveapplication as of the beginning of the year the Interpretation is first applied. Therefore, in the year this guidance isfirst applied

a. The reporting entity should determine whether changes would have been needed to the statement offinancial position as of the end of the prior year if this guidance had always been applied.

b. Those adjustments should be made as of the beginning of the year this guidance is first applied.

c. The entity should not revise any prior�year financial statements that are presented in comparison with thoseof the year in which this guidance is first applied.

GAAP does not prescribe how the adjustment of beginning retained earnings should be reported. FASB ASC250�10�45�5 (formerly Paragraph 7 of SFAS No. 154) only says, �an offsetting adjustment, if any, shall be made tothe opening balance of retained earnings (or other appropriate components of equity or net assets in the statementof financial position)." Therefore, a variety of approaches for reporting the cumulative effect adjustment areacceptable. For example, beginning retained earnings as originally reported could be shown, followed by thecumulative effect adjustment, with a revised beginning retained earnings amount shown. An equally acceptableapproach would be to show the amount of beginning retained earnings, followed by the cumulative effect adjust�ment, but without showing a revised beginning retained earnings amount.

To illustrate presentation considerations, assume that the reporting entity uses a calendar year for financial state�ment reporting and first applies this guidance in its financial statements for 2009. The entity had no temporarydifferences as of the end of 2008, and if it had always followed the requirements, at the end of 2008, the entity wouldhave reported a $60,000 liability to defer tax benefits that had been realized through deductions in tax returns. Theentity records the $60,000 liability through a charge to retained earnings at the beginning of 2009 through thefollowing entry:

Beginning retained earnings $ 60,000Liability for unrecognized tax benefits $ 60,000

The entity presents its financial statements for 2009 in comparison with those for 2008 and reports the adjustmentof retained earnings as a line item in its statement of results of operations as follows.

2009 2008

Net Income $ 250,000 $ 225,000Beginning retained earnings 530,000 400,000Cumulative effect of an accounting change (60,000 ) �Dividends (90,000 ) (95,000 )

Ending retained earnings $ 630,000 $ 530,000

The entity describes the accounting change in the following note to the financial statements.

NOTE XACCOUNTING CHANGE

Generally accepted accounting principles have been changed to impose a threshold for deter�mining when an income tax benefit can be recognized. The threshold now imposed for financialstatement reporting generally is higher than the threshold imposed for claiming deductions inincome tax returns. The change in generally accepted accounting principles was first effective forthe Company in 2009 and was applied retrospectively as of the beginning of 2009. To comply withthe new requirements, tax benefits totaling $60,000 that were realized through deductions in


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prior�year returns through 2008 have been deferred as of the beginning of 2009. The effect of thischange is to reduce retained earnings by $60,000 and to recognize an offsetting liability fordeferral of the benefits.

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

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

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

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

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

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

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

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

ASU No. 2009�06 also clarifies that

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

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

To illustrate the accounting considerations, assume that a corporation that has elected Subchapter S status takesthe position that it does not have nexus with a state that does not recognize that election. The corporation shouldevaluate whether the position would more likely than not be sustained by the state in an examination. Thatevaluation should consider the positions taken by the state in applying nexus requirements, such as how manyyears are considered open if tax would be assessed retrospectively, and whether the state has adopted thresholdsof taxable income attributable to the state below which it will not assert nexus.

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

The entity recognizes that there is the possibility a state that does not recognize the S election may assert that theentity has nexus with it and assess income taxes. However, the entity also has found that the possible statestypically only assess taxes for three to five prior years. In addition, the entity has had no notification from thosestates, there is no indication that they are aggressive in asserting nexus, and the entity believes it is more likely than


32

not that the entity would prevail in the event the states assert that there is nexus. Accordingly, the entity concludesthat its tax position of not filing returns in those states meets the �more likely than not" criterion. (The entity may alsonote that allocation of taxable income to those states would not result in material tax assessments.) Even if the entityconcludes its tax position does not meet the �more likely than not" criterion, consideration of the states' administra�tive practices is permitted in determining that it is not necessary to go back more than three to five years to applythe Interpretation.

Some Observations. The following observations may be helpful.

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

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

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

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

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

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

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

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

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

Classifying Deferred Income Tax Assets and Liabilities

FASB ASC 740�10�45�4 through 45�10 (formerly SFAS No. 109, Accounting for Income Taxes) requires companiesto classify deferred tax assets and liabilities into a current and noncurrent portion. The basic steps are as follows:

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

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

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

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

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

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


33

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

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

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

� Depreciation Methods. The use of an accelerated method for tax reporting and the straight�line method forthe financial statements initially causes GAAP earnings to be higher than taxable earnings. The tax effectof the excess earnings is deferred to future periods. During the early years, a deferred tax liabilityaccumulates. The temporary difference reverses as the asset is reduced through depreciation. It also wouldreverse if the asset were sold. Accordingly, the temporary difference is related to property and equipment,and the related deferred tax liability is classified as noncurrent.

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

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

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

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

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


34

in the next year, it would classify 10% of both the deferred tax asset and the valuation allowance as current andclassify the remainder as noncurrent. Thus, its financial statements would report a net current deferred tax asset of$20,400 (10% of the deferred tax asset of $255,000 less 10% of the $51,000 valuation allowance) and a netnoncurrent deferred tax asset of $183,600.

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

Total Current NoncurrentBasis for

Classification

Deductible temporary difference:

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

Inventory 100,000 100,000 � Same as inventory

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

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

100 % 21 % 79 %

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

Balance Sheet Presentation

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

20X2 20X1


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

DEFERRED INCOME TAXES 23,000 18,000

TOTAL LIABILITIES 260,000 261,000

or

20X2 20X1



DEFERRED INCOME TAXES 23,000 18,000

STOCKHOLDERS' EQUITY

Common stock 10,000 10,000

Retained earnings 353,800 328,200

363,800 338,200

$ 623,800 $ 599,200

or


35

20X2 20X1

NONCURRENT LIABILITIES

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

Deferred income taxes 23,000 18,000

TOTAL NONCURRENT LIABILITIES 100,000 111,000

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

20X2 20X1

PROPERTY AND EQUIPMENT 320,000 298,000

OTHER ASSETS

Notes receivableofficer 65,000 80,000

Deferred income tax benefit 12,000 18,000

Goodwill 100,000 100,000

177,000 198,000

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

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

20X2 20X1

CURRENT LIABILITIES

Accounts payable $ 90,000 $ 80,000


Income taxes

Current 5,000 10,000

Deferred 70,000 65,000



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

20X2 20X1

CURRENT LIABILITIES

Accounts payable $ 90,000 $ 80,000


Current income taxes 5,000 10,000


Deferred income taxes 70,000 65,000


Current Income Tax Assets. If income taxes are refundable at the balance sheet date, the claims for refundsshould be reported as receivables and generally should be classified as current assets. Current deferred tax assets


36

also should be included in the current assets section of the balance sheet. The following are illustrative presenta�tions:

20X2 20X1

CURRENT ASSETS

Cash $ 16,000 $ 20,000

Accounts receivable 155,000 100,000

Deferred income tax benefit 10,000 �

Inventory 24,000 15,000

TOTAL CURRENT ASSETS 205,000 135,000

or

20X2 20X1

CURRENT ASSETS

Cash $ 16,000 $ 20,000

Accounts receivable

Trade 130,000 90,000

Related parties 20,000 10,000

Tax refund claim 5,000 �

Deferred income tax benefit 10,000 �

Inventory 24,000 15,000

TOTAL CURRENT ASSETS 205,000 135,000

Offsetting Tax Assets and Liabilities

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

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


37

SELF�STUDY QUIZ


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

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

b. FASB ASC 740�10 (formerly FIN 48).

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

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

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

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

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

a. $20,000.

b. $40,000.

c. $60,000.

d. $80,000.

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

a. $20,000.

b. $40,000.

c. $60,000.

d. $80,000.

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

a. $20,000.

b. $40,000.

c. $60,000.

d. $80,000.


38

14. What is a liability for unrecognized tax benefit?

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

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

c. A deferred tax liability.

d. An offset against deferred tax assets.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


39

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

a. $2,040.

b. $10,000.

c. $13,600.

d. $34,000.

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

a. $10,000.

b. $13,600.

c. $18,360.

d. $20,400.


40



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

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

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

10. Dino Company develops a tax position under which it will claim a deduction for an expense. Under which ofthe following scenarios should Dino recognize a tax benefit? (Page 25)

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

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

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

11. Pea Picker Company's financial statements report income before income taxes of $50,000, consisting ofrevenue of $200,000 and expense of $150,000. Pea Picker believes the expense is deductible in thecurrent�year return and, therefore, the tax return reports taxable income of $50,000, which is the same as pretaxincome reported in the financial statements. A single taxing authority imposes a simple 40% tax rate. Pea Pickerdid not make any estimated tax payments during the year. If the entity believes there is greater than a 50%chance that, upon examination, the tax position for deducting the $150,000 expense in the current�year returnwould be sustained and that there is greater than a 50% chance the full amount of the deduction would beallowed, how much will Pea Picker recognize as its current tax provision? (Pages 25 & 26)

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

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

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

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

12. Assume the same facts as the previous question except that Pea Picker believes there is less than a 50% chancethe tax position would be sustained. How much will Pea Picker recognize as its current tax provision? (Page 26)

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


41

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


42

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

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

16. Which of the following provides primary guidance on disclosures of uncertainty in income taxes? (Page 29)

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

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

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

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

17. When classifying deferred income tax assets and liabilities, which of the following is one of the basic steps?(Page 32)

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

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

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

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


43

18. Which of the following would normally cause GAAP earnings to be lower than taxable income? (Page 33)

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

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

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

19. An entity is subject to federal income taxes at the 34% rate. It has a $100,000 operating loss that it may carryforward for 20 years. The deferred tax asset for the loss carryforward is not related to a particular asset or liabilityfor financial reporting. The entity expects to offset $10,000 of the loss carryforward against taxable income inthe next year. The entity expects $40,000 of the loss carryforward will expire unused. How much will it reportas a net current deferred tax asset? (Page 33)

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

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

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

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

20. Assume the same facts as the previous question. How much will the entity report as a net noncurrent deferredtax asset? (Page 33)

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

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

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

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


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CLASSIFYING AND REPORTING LONG�TERM DEBT

Long�term debt consists of the following:

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

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

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

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

Current Maturities of Long�term Debt

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

a. There is no amortization schedule.

b. Payments are in arrears.

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

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

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

a. The lender may provide it.

b. It may be derived through present value computations.

Problems of GAAP Measurement for Debt

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

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


45

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

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

Restructurings) requires its use for certain modifications of terms.

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

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

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

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

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

(1) Fair value of the items received

(2) Market value of the note

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


46

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

Information required for calculation:

� Payment amount $25,000 per quarter

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

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

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

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

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

An �appropriate interest rate" should be determined at the inception of the note, and subsequent changes inmarket conditions should not be considered. FASB ASC 835�30�25�12 (formerly APB Opinion No. 21, Paragraph13) offers the following guidance on determining an appropriate interest rate:

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

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

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

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

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

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

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

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


47

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

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

a. Forgiveness of principal

b. Transfer of assets in full settlement

c. Transfer of an equity interest in full settlement

d. Modification of terms

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

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

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

When assets or equity interests are transferred in settlement of debt, the borrower should recognize a gain equal tothe excess of the debt's carrying amount over the fair value of assets or equity interests transferred to the creditor.Any difference between the fair value and the carrying amount of assets or equity interests transferred is an ordinarygain or loss on transfer of assets. If the debt is forgiven and no consideration is required, the entire principalreduction is included in earnings as a gain. (However, forgiveness of related party debt ordinarily should berecorded as an increase in paid�in capital.) FASB ASC 470�50�45�1 (formerly SFAS No. 145, Rescission of FASBStatements No. 4, 44, and 64, Amendment of FASB Statement No.�13, and Technical Corrections) permits therecognition of an extraordinary gain or loss from debt extinguishment only when it meets the criteria of FASB ASC225�20 (formerly APB Opinion No. 30, Reporting the Results of OperationsReporting the Effects of Disposal of aSegment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions).

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

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


48

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

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

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

troubled debt restructuring. The guidance concluded that

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

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

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

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

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

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

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

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

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

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

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


49

7.75% 7.25%

New monthly payment $ 51,925 $ 49,991

Cash flows to use for the 10% test:

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

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

Cash paid for the refinancing 25,000 25,000

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

Change from the old terms:

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

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

% change 9.3 % 14.1 %

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

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

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

The implementation guidelines note the following:

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

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

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

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

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


50

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

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

FASB ASC 470�50�40�12; 470�50�40�15 and 40�16 [formerly EITF Issue No. 06�6, �Debtor's Accounting for aModification (or Exchange) of Convertible Debt Instruments"], which was ratified by the FASB in November 2006,amends FASB ASC 470�50 (formerly EITF Issue No. 96�19) and applies to modifications of debt instruments orexchanges of debt instruments that (a) affect an existing embedded conversion option's fair value or (b) add oreliminate an embedded conversion option. It does not apply in situations where the embedded conversion optionis separately accounted for as a derivative prior to, subsequent to, or both prior to and subsequent to themodification. As a practical matter, conversion options of small and midsize nonpublic entities generally are notaccounted for separately.

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

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

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

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

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

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

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

Credit Line or Revolving Debt Arrangements. A credit line or revolving debt arrangement allows the borrower tomake multiple borrowings up to a specified maximum amount, repay portions of prior borrowings, and thenreborrow under the same contract. The arrangements may include both amounts drawn by the debtor and loancommitments. The debtor generally defers and amortizes the costs incurred to establish the arrangement over theterm of the arrangement. Although FASB ASC 470�50 (formerly EITF Issue No. 96�19) provides guidance for debt


51

modifications and exchanges, it does not specifically address credit line or revolving debt arrangements or how toapply the 10% cash flows tests to such arrangements.

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

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

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

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

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

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

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

Classification of revolving debt agreements can also be an issue. FASB ASC 470�10�45�3 through 45�6 (formerlyEITF Issue No. 95�22, �Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agree�ments that Include both a Subjective Acceleration Clause and a Lock�Box Arrangement") applies to any revolvingline of credit that (a) contains a subjective acceleration clause and (b) requires customer payments to be madedirectly to a lock�box account which is then applied directly to the outstanding balance of the line of credit.According to the consensus, if a line of credit includes these features, it must be classified as a current liability eventhough the agreement may not expire until more than one year after the balance sheet date. In its 2003�2004preliminary inspections of the �Big Four" firms, the Public Company Accounting Oversight Board (PCAOB) notedover 20 clients that had failed to properly classify their revolving credit agreements. Thus, these agreements appearto be fairly common and the classification issues may be easily overlooked by basing the classification on theexpiration date of the agreement.

Installment Loans. Installment loans are sometimes recorded on a gross basis by charging an �asset" account forthe interest portion of installments outstanding and crediting a �liability" account for the total of installments


52

(principal and interest) outstanding. That method arose when the �Rule of 78s" method was more prevalent, and itwas necessary to keep track of unamortized interest charges. The unamortized amount is not an asset, and insteadshould be offset against total installments outstanding. The net amount would be reported as a liability.

Costs of Obtaining Financing or Refinancing. Companies incur costs in obtaining financing or refinancing. Forsmall to medium�sized companies, those costs include bank fees, accounting fees to prepare prospective presen�tations, and legal fees to draft the necessary documents. FASB ASC 310�20 (formerly SFAS No. 91, Accounting for

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

FASB Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, views discount anddebt issue costs the same. Neither has substance apart from the debt, and neither is an asset. Both should be offsetagainst the debt and amortized to interest expense using the interest method. The interest method produces aperiodic interest cost that reflects a level effective rate on the net loan proceeds. By offsetting discounts and debtissue costs against the debt, interest expense relates directly to the amount reported as a liability.

This course's recommendation differs from GAAP in one respect: the costs that are not in substance discountshould be reported as a deferred charge. FASB ASC 835�30�45 (formerly APB Opinion No. 21, Interest on Receiv�ables and Payables), requires offsetting discount against the face amount of the debt, but it requires reporting debtissue costs as a deferred charge. FASB Statements of Financial Accounting Concepts, are not authoritative so theconclusion in FASB ASC 835�30�45 (formerly APB Opinion No. 21) takes precedence over the conclusion in SFACNo. 6. [However, the position in FASB ASC 835�30�45 (formerly APB Opinion No. 21) is inconsistent with thedefinition of carrying amount of debt in FASB ASC 470�50�20 (formerly APB Opinion No. 26, Early Extinguishment

of Debt), and FASB ASC 470�60�20 (formerly SFAS No. 15, Accounting by Debtors and Creditors for Troubled DebtRestructurings). Each defines the carrying amount of the debt as the face amount adjusted for unamortizedpremium, discount, and cost of issuance.] However, the effect of the GAAP departure is limited to the balance sheet(that is, it understates noncurrent assets and long�term debt) and is rarely material.

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

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

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

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

� If the loan is payable on demand, the fees should be amortized using the straight�line method over a periodconsistent with the understanding between the borrower and lender. If no such understanding exists, the


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fees should be amortized over the borrower's estimate of the period that the loan will be outstanding. Anyunamortized amount should be charged to interest expense when the loan is paid in full.

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

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

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

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

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

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

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

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

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

Extinguishments of Liabilities. FASB ASC 405�20�40�1 (formerly SFAS No. 140, Accounting for Transfers and

Servicing of Financial Assets and Extinguishments of Liabilities) specifies that a liability is considered extinguishedif either of the following conditions is met:

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

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

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

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


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FASB ASC 405�20�55 [formerly the FASB Implementation Guide (Q & A) titled A Guide to Implementation of

Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities]provides the following guidance on debt extinguishment issues:

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

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

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

In�substance Defeasance of Debt. In certain �in�substance" defeasances of debt, the debtor irrevocably placescash or other risk�free monetary assets in a trust solely for satisfying the debt; however, the creditor does not relievethe debtor of primary obligation under the debt (although the possibility that the debtor will be required to makefurther payments may be remote). The debtor's liability in such an �in�substance" defeasance is not consideredextinguished because it would not meet either criteria in the �Extinguishments of Liabilities" section. Therefore, thedebtor could not remove the liability from its balance sheet. However, disclosure is required of the nature ofrestrictions placed on assets set aside after December 31, 1996, solely for satisfying scheduled payments of aspecific obligation. (If the assets are set aside in an irrevocable trust, the portion used to satisfy the current debtshould be classified as current, and the remainder should be classified as noncurrent. If the assets are set aside ina revocable trust, the entire amount may be classified as current, but noncurrent classification would be acceptablesince it is more conservative.)

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

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

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

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

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

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

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

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

FASB ASC 405�20�55; 860 (formerly the FASB Q & A on SFAS No. 140) includes several questions and answersrelated to secured borrowings and collateral. As a practical matter, small and medium�sized entities rarely encoun�ter most of the transactions (such as repurchase and resale agreements) addressed by those questions. However,Question 117 addresses how a debtor should measure transferred collateral that must be reported as a restricted


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asset in accordance with requirement a. discussed in the paragraph above. In that case, the transfer should notchange how the debtor measures the collateral. For example, securities previously classified as available for saleshould continue to be measured at fair value with changes in fair value reported in other comprehensive income,even if the securities are transferred to a broker as collateral and reported as restricted assets.


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

20X2 20X1

CURRENT LIABILITIES


Loans payable to stockholders � 25,000

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





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

REPORTING OTHER LIABILITIES

Environmental Cleanup Costs and Liabilities

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

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

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

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

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

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

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

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


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

� FASB ASC 450�20 (formerly SFAS No. 5, Accounting for Contingencies) provides general guidance onaccruing liabilities for loss contingencies. (In June 2008, the FASB issued an exposure draft of a proposedstandard, Disclosure of Certain Loss Contingencies, which would expand disclosures about certain losscontingencies and would provide the principal guidance relevant to disclosures of environmentalremediation loss contingencies. It would not change the recognition and measurement guidance for thoseloss contingencies. Practitioners should monitor the FASB website at www.fasb.org for futuredevelopments related to the proposed standard.)

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

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

� FASB ASC 410�30 (formerly EITF Issue No. 90�8, �Capitalization of Costs to Treat EnvironmentalContamination") provides guidance for determining whether environmental cleanup costs should becapitalized.

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

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

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

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

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

� be estimated based on enacted laws and regulations.

� be estimated based on expected improvements in remediation technology.


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

� consider discounting when appropriate.

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

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

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

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

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

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

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

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

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

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

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

� Remedial Design and Implementation of Corrective Measures. During the design phase of the remediation,engineers develop a better estimate of the work to be performed and can provide more precise estimates


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of the total remediation costs. The company should continue to refine and recognize its best estimate ofits share of the liability as additional information becomes available throughout the operation andmaintenance of the remedial action plan.

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

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

Estimating Environmental Remediation Costs. GAAP indicates that environmental remediation liabilities shouldprovide for the following costs:

a. Incremental direct costs, including:

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

� Costs related to the remedial investigation or feasibility study

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

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

� Government oversight costs (such as, fines)

� Costs of machinery and equipment dedicated to remedial actions

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

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

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

� Technical employees involved with remediation activities

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

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

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


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

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

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

� What Is the Likelihood the Other PRPs Will Pay Their Full Share of the Liability? The company should assessthe likelihood that the other PRPs will pay their allocable portion of the total remediation liability. Thatassessment generally is based on the financial condition of the other PRPs and must be monitored as theremediation progresses. Any amounts that will not be paid by other PRPs must be allocated among theremaining PRPs and included in the remaining PRPs' liabilities.

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

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

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

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

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

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

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

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

Claims for Recovery. Companies may be able to pursue recoveries of amounts expended for environmentalremediation from a variety of sources, including insurers, nonparticipating PRPs, the government, or other thirdparties. GAAP requires the amount of an environmental remediation liability to be determined independently fromany potential claim for recovery. Furthermore, an asset related to a potential claim for recovery should be recog�


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nized only when realization of the claim is considered probable. (If a claim for recovery is being litigated, realizationof the claim generally is not considered probable.) A�potential claim for recovery should be measured at its fairvalue, considering both the costs related to the recovery and the time value of money. However, GAAP states thatthe time value of money should not be considered if the related liability is not discounted and timing of the recoverydepends on the timing of paying the liability. In addition, the guidance from FASB ASC 210�20�45 (formerly FIN 39,Offsetting of Amounts Related to Certain Contracts), is cited, which states that liabilities should not be presented netof related receivables unless there is a legal right of offset. The SOP concludes that environmental remediationliabilities and related claims for recovery rarely, if ever, meet the requirements for offsetting. Thus, presentation ofthe gross liability and related claim for recovery in the balance sheet generally is appropriate.

Effect on Property Impairment. In addition to recognizing a liability for the costs of curing violations of environ�mental regulations, companies should consider whether environmental regulations impose restrictions on thefuture use of the property. Significant restrictions on the property's future use could reduce the property's fair valueor its ability to generate future cash flows. In that case, the property's carrying amount may not be recoverable andthe company may need to recognize an impairment loss. GAAP does not address whether the recognition ofenvironmental remediation liabilities should be considered in assessing asset impairment. FASB ASC410�20�35�18 (formerly SFAS No. 143, Accounting for Asset Retirement Obligations), provides the following guid�ance on the treatment of certain environmental exit costs recognized when testing a long�lived asset for impair�ment:

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

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

Costs to Retire Long�lived Assets

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

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

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


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The following disclosures are required:

� General description of the obligation

� The long�lived asset associated with the obligation

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

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

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

Accounting for a Guarantee by the Entity

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

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

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

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

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

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

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

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

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

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

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

a. The overriding objective of those provisions is to record a liability for the fair value of the guarantee. Eventhough the FASB views the guarantee as imposing two obligations, the entity only needs to estimate the


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fair value of the guarantee in total. FASB ASC 460�10�25�2 (formerly Paragraph�A45 of FIN 45) states thatbifurcation of the contingent and noncontingent aspects of the guarantee is not required. Those twoaspects of the guarantor's obligation are mentioned only to emphasize that the guidance in FASB ASC450�20 (formerly SFAS No. 5) regarding loss contingencies does not control or prohibit the recognition ofa liability arising from the issuance of a guarantee.

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

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

Guarantees of Related Party Debt. While GAAP does not exempt all related party debt guarantees from itsmeasurement provisions, the authors believe the related party debt guarantees most commonly entered into bysmall and midsize nonpublic entities will be exempted. For example, following the guidance in FASB ASC460�10�30�1 (formerly Paragraph 7 of FIN 45), the measurement provisions would not apply to the entity's guaran�tee of debt of a sister corporation, a subsidiary, or the entity's parent. In addition, an entity's guarantee of debt of amajor stockholder is analogous to guarantee of debt of its parent and therefore would also be exempt from themeasurement provisions. However, disclosure of those guarantees is required, which would ordinarily

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

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

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

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

a. The carrying amount of the liability.

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

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

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

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

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


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

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

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

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

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

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

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

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

Initial and Subsequent Measurement Considerations. It is believed that

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

b. Changes in the liability in subsequent years should be recorded through a debit or credit to earnings. Forexample, the fair value of a guarantee ordinarily would decline as principal outstanding under theguaranteed debt declines, and reduction of the liability under the guarantee should be recorded througha credit to earnings. Three alternatives for recognizing the decline are providedupon expiration orsettlement of the guarantee, by a systematic and rational amortization method, or as the fair value of theguarantee changes. However, as clarified by FASB ASC 460�10�35�2 (formerly (FSP) FIN 45�2, �WhetherFASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others, Provides Support for Subsequently Accountingfor a Guarantor's Liability at Fair Value"), FASB ASC 460�10�35 (formerly FIN 45) intentionally does notprovide guidance regarding when each of those methods would be appropriate. For example, thisguidance should not be cited as support in justifying the use of fair value in accounting for the guarantor'sliability for its obligations subsequent to the issuance of a guarantee.


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REPORTING BUY�SELL AGREEMENTS AND OTHER OWNERSHIPINTEREST REDEMPTION PROVISIONS

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

In November 2003, FASB ASC 480�10�65�1 through 65�7 [formerly (FSP) FAS 150�3, �Effective Date, Disclosures,and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Manda�torily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial

Instruments with Characteristics of both Liabilities and Equity"], announced that the FASB is deferring indefinitelythe provisions of FASB ASC 480�10 (formerly SFAS No. 150) for mandatorily redeemable financial instruments ofnonpublic entities unless they are redeemable on fixed dates for amounts that either are fixed or determined byreference to an index. Therefore, the equity redemption agreements of most small and midsize nonpublic entitiesare exempt from the requirements of FASB ASC 480�10 (formerly SFAS No. 150) indefinitely.

FASB ASC 480�10�65�1 (formerly FSP FAS 150�3) says, �During that indefinite deferral, the Board plans to recon�sider implementation issues and, perhaps, classification or measurement guidance for those instruments in con�junction with the Board's ongoing project on liabilities and equity." The FASB has announced that thereconsideration will be part of its joint project with the IASB to develop a comprehensive standard of accountingand reporting for financial instruments with characteristics of equity. The FASB and the IASB are conducting thisproject under a modified joint approach. Under that approach, the initial due process document issued by theFASB will be in the form of a preliminary views document. The IASB will concurrently expose the document forcomment. In November 2007, the FASB issued the Preliminary Views document, Financial Instruments with Charac�

teristics of Equity. The FASB plans to consider the comments received from respondents to the Preliminary Viewsdocument and to issue an exposure draft in the first half of 2010. A final document is expected in 2011. Accountantscan monitor this project by visiting the FASB website at www.fasb.org.


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SELF�STUDY QUIZ


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

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

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

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

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

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

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

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

d. Use the current prime rate.

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

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

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

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

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

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

a. A note is exchanged solely for cash.

b. A note is exchanged for property.

c. When industrial revenue bonds are involved.

d. In parent�subsidiary transactions.

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

a. $0.

b. $100,000.

c. $300,000.

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

a. $0.

b. $20,000.

c. $30,000.

d. $50,000.

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

a. $20,000.

b. $25,000.

c. $38,000.

d. $45,000.


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

a. A legal defeasance.

b. An in�substance defeasance.

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

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

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

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

d. FASB ASC 410�30 (formerly EITF Issue No. 90�8).

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

a. Disclosure of the nature is not required.

b. Liability recognition is required.

c. Disclosure of the amount is not required.

d. Disclosure of the nature and amount is advised.


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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


70

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

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

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

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

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

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

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

b. $100,000. [This answer is incorrect. The borrowing capacity of this arrangement is not equal to the existingline�of�credit in this example.]

c. $300,000. [This answer is correct. Borrowing capacity is calculated by multiplying the remainingterm by the maximum available credit (3 years � $100,000 commitment).]

29. Star Company has a $500,000 loan commitment with two years remaining and unamortized loan costs of$20,000. The debt arrangement is refinanced as a $600,000 commitment for three years at a cost of $30,000.How much of the loan costs will be amortized over the three�year term of the new commitment? (Page 51)

a. $0. [This answer is incorrect. Star Company should amortize loan costs over the term of the newcommitment.]

b. $20,000. [This answer is incorrect. The unamortized loan cost of the old arrangement is not the correctamount to amortize over the term of the new commitment.]

c. $30,000. [This answer is incorrect. The $30,000 loan cost of the new arrangement is not the correct amountto amortize over the term of the new commitment.]

d. $50,000. [This answer is correct. Since the borrowing capacity of the new arrangement ($1,800,000)is more than the borrowing capacity of the old arrangement ($1,000,000), the $50,000 total of the$20,000 loan costs remaining under the old commitment and the $30,000 cost of obtaining the newcommitment should be amortized over the three�year term of the new commitment.]

30. Edgar Company has a $400,000 loan commitment with three years remaining and unamortized loan costs of$20,000. The debt arrangement is refinanced as a $390,000 commitment for two years at a cost of $25,000.How much of the loan costs will be amortized over the two�year term of the new commitment? (Page 51)

a. $20,000. [This answer is incorrect. Edgar Company should amortize more than $20,000 in loan costs overthe term of the new commitment.]

b. $25,000. [This answer is incorrect. The unamortized loan cost of the new arrangement is not the correctamount to amortize over the term of the new commitment.]


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c. $38,000. [This answer is correct. Since the borrowing capacity of the new arrangement ($780,000)is less than the borrowing capacity of the old arrangement ($1,200,000), $7,000 of the $20,000 loancosts remaining under the old commitment is written off (Borrowing capacity is reduced by 35%.Therefore, 35% of the $20,000 costs is $7,000.). The $13,000 remaining under the old commitmentand the $25,000 cost of obtaining the new commitment should be amortized over the three�year termof the new commitment.]

d. $45,000. [This answer is incorrect. The $45,000 total of the $20,000 loan costs remaining under the oldcommitment and the $25,000 cost of obtaining the new commitment is not the correct amount to amortizeover the term of the new commitment.]

31. Which of the following is an extinguishment of debt? (Page 54)

a. A legal defeasance. [This answer is correct. In a legal defeasance, the creditor legally releases thedebtor from being the primary obligor. Therefore, a legal defeasance generally is accounted for asan extinguishment.]

b. An in�substance defeasance. [This answer is incorrect. In an in�substance defeasance, the debtor placesassets in a trust to satisfy the debt. However, the creditor does not relieve the debtor of primary obligationunder the debt; therefore, it is not an extinguishment.]

32. Which of the following authoritative literature was issued to provide specific guidance for accruing legallyrequired environmental remediation? (Page 56)

a. FASB ASC 450�20 (formerly SFAS No. 5). [This answer is incorrect. FASB ASC 450�20 (formerly SFAS No.5, Accounting for Contingencies), does provide guidance on accruing liabilities for loss contingencies;however, it only provides general guidance.]

b. FASB ASC 410�30 (formerly SOP 96�1). [This answer is correct. FASB ASC 410�30 (formerly SOP96�1, Environmental Remediation Liabilities) was issued to provide more specific guidance forrecognizing, measuring, and disclosing liabilities for legally required environmental remediationsince it is difficult to determine when a liability has been incurred and the amount of the liability oftenis difficult to reasonably estimate.]

c. FASB ASC 410�20 (formerly SFAS No. 143). [This answer is incorrect. FASB ASC 410�20 (formerly SFASNo. 143, Accounting for Asset Retirement Obligations) provides accounting and reporting guidance forenvironmental remediation obligations arising from the normal operation of a long�lived asset and that isassociated with the retirement of that long�lived asset.]

d. FASB ASC 410�30 (formerly EITF Issue No. 90�8). [This answer is incorrect. FASB ASC 410�30 (formerlyEITF Issue No. 90�8, �Capitalization of Costs to Treat Environmental Contamination") provides guidancefor determining whether environmental cleanup costs should be capitalized.]

33. How is the typical guarantee reported according to FASB ASC 460�10�50�2 and 50�3 (formerly SFAS No. 5)?(Page 61)

a. Disclosure of the nature is not required. [This answer is incorrect. Even though the possibility of a loss isremote, the financial statements should disclose the nature of the guarantee.]

b. Liability recognition is required. [This answer is incorrect. Since the possibility of a loss is remote (less thanprobable), liability recognition is not required according to the guidance in FASB ASC 460�10�50�2 and50�3 (formerly SFAS No. 5, Accounting for Contingencies).]

c. Disclosure of the amount is not required. [This answer is incorrect. Even though the possibility of a lossis remote, the financial statements should disclose the amount of the guarantee.]

d. Disclosure of the nature and amount is advised. [This answer is correct. Even though the possibilityof a loss is remote, the financial statements should disclose the nature and amount of theguarantee.]


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EXAMINATION FOR CPE CREDIT

Lesson 1 (PFSTG091)

Determine the best answer for each question below. Then mark your answer choice on the Examination for CPECredit Answer Sheet located in the back of this workbook or by logging onto the Online Grading System.

1. Roger, Inc. incurred an expense but has not received the bill. The liability has been incurred, and the amountcan be reasonably estimated. The estimate for this expense is a range, and the amounts within the range areall equally possible. How much should be reported as an accrued liability at the balance sheet date accordingto GAAP?

a. No accrued liability should be reported because the expense is a range.

b. The accrued liability should be reported at the lowest amount in the range.

c. The accrued liability should be reported at the median amount in the range.

d. The accrued liability should be reported at the highest amount in the range.

2. FASB ASC 712�10 (formerly SFAS No. 112) requires employers to accrue postemployment benefits if all of theconditions listed in the Statement are met. Which of the following is one of the conditions?

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

b. Payment of the benefit is reasonably possible.

c. The cost of the benefits cannot be reasonably determined.

d. The rights to those benefits are nonvested.

3. This course recommends recording payroll taxes on accrued compensation using which of the followingcaptions?

a. Accrued FICA.

b. Accrued unemployment taxes.

c. Accrued payroll taxes.

d. Compensation.

4. Which of the following measurement or presentation considerations accurately describes the accrual reportingfor claims�made insurance policies?

a. If it is reasonably possible that a loss has been incurred during the policy period but the loss has not beenreported to the insurance company, a liability should be reported.

b. If a loss is probable and reasonably estimated, a liability should be reported if the loss has not beenreported to the insurance company.

c. A subsequent purchase or renewal of claims�made insurance will not affect the liability previously recordedfor unreported losses.

d. A claims�made insurance policy operates the same as an occurrence insurance policy.


73

5. Which of the following is not classified as deferred revenues?

a. Nonrefundable deposits.

b. Refundable damage deposits.

c. Membership fees received in advance.

d. Do not select this answer choice.

6. Archer, Inc. violated a long�term debt agreement with ABC Bank which makes the debt callable within one yearfrom the balance sheet date. In which of the following situations would the debt be classified as a currentliability?

a. Archer speculates that it is possible it will be able to cure the violation within the grace period.

b. The violation is cured after the balance sheet date but before Archer's financial statements are issued.

c. ABC Bank has specifically waived the right to demand payment for more than one year from the balancesheet date.

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

7. Covenant violations that occur subsequent to the balance sheet date:

a. Are never recorded in the financial statements.

b. Are recorded in the financial statements if a technical covenant was violated.

c. Are disclosed in the financial statements if a nonrecognized subsequent event occurred.


8. A loan agreement requires the following working capital levels:

12/31/X1 $300,000

6/30/X2 350,000

12/31/X2 400,000

If working capital at December 31, 20X1 was less than $300,000 but the lender unconditionally waives itsright to call the loan prior to January 1, 20X4, when might classification problems appear?

a. December 31, 20X1.

b. June 30, 20X2.

c. December 31, 20X2.

d. March 31, 20X3.

9. How many steps are in the approach to recognizing tax benefits according to GAAP?

a. 1.

b. 2.

c. 3.

d. 4.


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10. Recognition and measurement of tax benefits as required by GAAP can be determined qualitatively orquantitatively.

a. True.

b. False.

c. Do not select this answer choice.


11. Bubble Company's financial statements report income before income taxes of $600,000, consisting of revenueof $900,000 and expense of $300,000. Bubble believes the expense is deductible in the current�year return and,therefore, the tax return reports taxable income of $600,000, which is the same as pretax income reported inthe financial statements. A single taxing authority imposes a simple 40% tax rate. Bubble did not make anyestimated tax payments during the year. If the entity believes there is greater than a 50% chance that, uponexamination, the tax position for deducting the $300,000 expense in the current�year return would be sustainedand that there is greater than a 50% chance the full amount of the deduction would be allowed, how much willBubble recognize as its current tax provision?

a. $60,000.

b. $120,000.

c. $240,000.

d. $360,000.

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

a. $60,000.

b. $120,000.

c. $240,000.

d. $360,000.

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

a. $60,000.

b. $120,000.

c. $240,000.

d. $360,000.


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14. Bubble reported a liability for unrecognized tax benefit in its financial statements in the previous example.Assuming that the taxing authority does not examine the position before the statute of limitations expires. Whenthe statute of limitations expires, Bubble would eliminate the liability and recognize an offsetting tax benefit byrecording a credit in what account?

a. Income tax due currently.

b. Current tax provision.

c. Deferred tax asset.

d. Deferred tax provision.

15. According to GAAP, entities are required to provide for the effect of interest and penalties on the liability for taxbenefits that have been realized but have not been recognized.

a. True.

b. False.



16. When first applying FASB ASC 740�10 (formerly FIN 48), what guidance in the choices below is correct?

a. The entity should revise any prior�year financial statements that are presented in comparison with the yearFASB ASC 740�10 (formerly FIN 48) is first applied.

b. Any adjustments should be made as of the end of the year immediately preceding the first application ofFASB ASC 740�10 (formerly FIN 48).

c. The entity should determine whether changes would have been needed to the statement of financialposition as of the end of the prior year if this guidance had always been applied.


17. If a reduction of an asset or liability causes a temporary difference to reverse, then the temporary difference isrelated to a specific asset or liability. What would be an example of a reduction of a liability?

a. Sale.

b. Amortization.

c. Depreciation.

d. Collection of installment receivable.

18. Which of the following would create a temporary difference?

a. Tax�exempt interest.

b. Nondeductible portion of meals.

c. Penalties and fines.

d. Tax credit carryforward.


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19. An entity is subject to federal income taxes at the 34% rate. It has a $300,000 operating loss that it may carryforward for 20 years. The deferred tax asset for the loss carryforward is not related to a particular asset or liabilityfor financial reporting. The entity expects to offset $15,000 of the loss carryforward against taxable income inthe next year. The entity expects $120,000 of the loss carryforward will expire unused. How much will it reportas a net current deferred tax asset?

a. $3,060.

b. $15,000.

c. $40,800.

d. $102,000.

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

a. $15,000.

b. $40,800.

c. $58,140.

d. $61,200.

21. The value of current maturities of long�term debt is easily attainable if:

a. The interest rate floats.

b. Payments are in arrears.

c. An amortization schedule is provided.


22. Which of the following best describes the costs included in the �interest method?"

a. The interest rate on the principal.

b. The interest rate on the principal and the amortization of premium or discount.

c. The interest rate on the principal, the amortization of premium or discount, and costs incurred in obtainingthe debt.

d. The interest rate on the principal, the amortization of premium or discount, costs incurred in obtaining thedebt, and the principal repayment.

23. When determining an appropriate interest rate at the inception of the note, which of the following should notbe considered?

a. The discount rate of similar financing from other sources on the same date.

b. The discount rate of similar financing of other borrowers with similar credit ratings.

c. The prevailing rate of similar transactions between independent parties.

d. Changes in market conditions occurring after the signing of the debt agreement.


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24. Imputing interest on a loan for cash is essential in which of the following situations?

a. When it is an interest�free loan between related parties.

b. When other rights or privileges are received.

c. When it is a related party loan at below�market rates.

d. For premium payments made on split dollar life insurance arrangements.

25. Which of the following is correct concerning changes in debt terms?

a. A modification of terms is accounted for retrospectively.

b. Forgiveness of principal is not a change in debt terms.

c. A borrower reduces the carrying amount of the debt to the total future cash payments of the new terms.

d. When a modification occurs, interest expense is always recognized when making a payment.

26. What percentage is used when considering whether an exchange of debt or modification of terms issubstantial?

a. 10%.

b. 15%.

c. 20%.

d. 25%.

27. The cash flows computation determines the gain or loss on debt extinguishment.

a. True.

b. False.



28. When does FASB ASC 470�50 [formerly EITF Issue No. 06�6, �Debtor's Accounting for a Modification (orExchange) of Convertible Debt Instruments"] apply?

a. When an embedded conversion option is separately accounted for as a derivative subsequent to themodification.

b. When an embedded conversion option is separately accounted for as a derivative prior to the modification.

c. When an embedded conversion option is separately accounted for as a derivative both prior to andsubsequent to the modification.

d. When a modification of a debt instrument adds or eliminates an embedded conversion option.


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29. Moon Company has a $200,000 loan commitment with four years remaining and unamortized loan costs of$10,000. The debt arrangement is refinanced as a $240,000 commitment for four years at a cost of $12,000.How much of the loan costs will be amortized over the four�year term of the new commitment?

a. $10,000.

b. $12,000.

c. $21,000.

d. $22,000.

30. Which of the following guidance should be used by borrowers to amortize fees charged by lending institutions?

a. Fees for a revolving line of credit, fees should be charged to interest expense using the interest method.

b. If a loan is payable on demand, fees should be charged to interest expense when the loan is paid in full.

c. When an unexercised loan commitment expires, the fees should be charged to interest expense in thatperiod.

d. If a loan is payable on demand, fees should be charged to interest expense using the interest method.

31. When would a lender record collateral on its balance sheet?

a. When the lender has the right to sell or repledge the collateral.

b. When the lender sells the collateral.

c. When the debtor defaults on the loan.

d. When a debtor grants a security interest in an asset.

32. Which of the following is included in environmental remediation costs?

a. Legal costs for allocation of costs among PRPs.

b. Costs related to routine environmental compliance matters.

c. Legal costs associated with potential recoveries.


33. The accrual of environmental liabilities should not be based on which of the following?

a. Anticipated changes in laws.

b. Productivity improvements.

c. Technology improvements.



79

Lesson 2:�Stockholders' Equity

INTRODUCTION

The components of stockholders' equity and the recommended order of presentation are as follows:

a. Preferred stock

b. Common stock

c. Additional paid�in capital

d. Stock subscriptions receivable

e. Retained earnings

f. Accumulated other comprehensive income

g. Treasury stock

When treasury stock is present, stockholders' equity is generally subtotaled after retained earnings (or accumu�lated other comprehensive income, if presented). However, a caption for the subtotal is unnecessary.

If liabilities exceed assets, a negative equity balance will be reported. The term �equity" should not be used in thosesituations and instead recommend using the following captions:

� Negative equity shown in all periods�Deficiency in assets" or �Stockholders' deficit"

� Negative equity shown in one period and a positive equity shown in another period�Stockholders' equity(deficiency in assets)" or �Stockholders' equity (deficit)"


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

Preferred and Common Stock

Usually, each class of stock is disclosed on the face of the balance sheet (in the order of priority in liquidation). Thepresentation of the equity section of the balance sheet is affected by a mixture of legal and accounting require�ments. The terms used to describe classes of stock should be the legal title of the stock issue, for example, capitalstock, common stock, or some other title. Traditionally, the following information is disclosed for each class ofstock.

a. Title of issue, for example, common stock or Class A common stock

b. Par value (or stated value) per share

c. Shares authorized

d. Shares issued

e. Shares outstanding

Common Stock. Normally, the disclosures may be provided on the face of the balance sheet by expansion of thecaption. For example:


80

20X2 20X1

Common stock, $10 par value; 1,000 shares authorizedand 500 shares issued and outstanding 5,000 5,000

The following illustrates appropriate disclosure for a company with more than one class of common stock:

20X2 20X1

Class A common stock, $10 par value; 1,000 sharesauthorized and 500 shares issued and outstanding 5,000 5,000

Class B common stock, $10 par value; 5,000 sharesauthorized and 2,500 shares issued and outstanding 25,000 25,000

Preferred Stock. The rights attaching to preferred stock may include preferences over common stock in distribu�tions of earnings and assets. Specific disclosure requirements apply to preferred stock. FASB ASC 505�10�50�3through 50�5 (formerly SFAS No. 129, Disclosure of Information about Capital Structure) requires the followingdisclosures:

a. Liquidation preferences substantially in excess of par or stated value (in the equity section of the balancesheet)

b. Aggregate or per�share amounts at which preferred shares may be called or are subject to redemptionthrough sinking�fund operations or otherwise

c. Aggregate and per�share amounts of cumulative preferred dividends in arrears

As previously noted, liquidation preferences must be disclosed in the equity section of the balance sheet. Forexample:

5% cumulative preferred stock, $20 par value ($150,000 aggregateliquidation preference), 5,000 shares authorized, issued, andoutstanding 100,000

The other disclosures may be in the notes.

Certain other disclosures, including a description of the rights and privileges of securities, required the number ofshares issued during the most recent annual period and any subsequent interim period presented, and redemptionrequirements for all issues of stock usually are made in the notes to the financial statements.

Accounting for Share�based Payments

FASB ASC 505; 718 [formerly SFAS No. 123(R), Share�Based Payment] establishes accounting standards forshare�based payment transactions. The following discussion focuses only on these requirements relevant tononpublic entities. See PPC's Guide to GAAP for a more complete discussion of accounting for share�basedpayments.

Scope. GAAP establishes accounting standards for companies that receive goods or services, including theservices of employees, in exchange for its equity instrumentssuch as equity shares, equity share options, orother equity instruments. It also applies to liabilities that are based, at least in part, on the price of a company'sequity instruments, or that may be settled by issuing equity instruments, that are incurred in exchange for goods orservices. These situations are referred to as share�based payment transactions. While this guidance establishes theaccounting for all share�based payment transactions involving the receipt of goods or services, it focuses primarilyon those involving the receipt of employee services. It does not change the accounting for share�based paymenttransactions with parties that are not employees as provided in the original SFAS No. 123 and FASB ASC 505�50(formerly EITF Issue No. 96�18). This guidance also does not address accounting for employee stock ownershipplans.


81

Accounting for Share�based Payment Transactions with Employees. A company should measure the cost ofemployee services received in exchange for awards of equity instruments based on the grant�date fair value of theequity instruments, with limited exceptions, net of any amount paid or to be paid by the employee. The fair value ofequity share options and similar instruments should be measured using observable market prices if available. Inthe absence of such market prices, fair value should be estimated using a valuation technique such as anoption�pricing model.

One of the variables in an option�pricing model is the volatility of the underlying stock. If a nonpublic company isunable to reasonably estimate fair value because it is impracticable to estimate the expected volatility of thecompany's share price, the value may be calculated using the historical volatility of an appropriate industry sectorindex in place of the expected volatility of the company's share price. Furthermore, while GAAP indicates it shouldbe possible to reasonably estimate the fair value of most equity instruments at the grant date, it does provide analternative for equity instruments with terms that make it impossible to reasonably estimate fair value at the grantdate. Those equity instruments should be accounted for based on the intrinsic value of the instruments and shouldbe remeasured at each reporting date through the date of exercise or other settlement.

Compensation cost should be recognized over the period that the employee is required to provide services inexchange for the award with a corresponding credit to equity, generally to paid�in capital. That period is referred toas the requisite service period and is generally the vesting period. Compensation cost should not be recognized ifthe requisite service has not been provided, however.

To illustrate accounting for share�based compensation, assume that a company issued 5,000 stock options onDecember 31, 20X6. The fair value of each option on that date was $15, and each option entitles its holder toreceive one share of $10 par common stock at an exercise price of $50 per share. Furthermore, the options vest infive years (no other award conditions are assumed). Total compensation cost at the grant date is $75,000 (5,000 �$15) and would be recognized by making the following entry during each year of the vesting period: (For simplicity,the illustration ignores the effects of estimated forfeitures and deferred taxes.)

Compensation expense ($75,000 ��5) 15,000

Additional paid�in capitalstock options 15,000

Assuming the options are exercised at the end of the five�year vesting period, the following entry would be neededto record the issuance of common stock:

Cash (5,000 � $50) 250,000

Additional paid�in capitalstock options 75,000

Common stock (5,000 � $10) 50,000

Additional paid�in capitalcommon stock 275,000

Certain financial instruments awarded in share�based payment transactions should be classified as liabilities (usingan account such as share�based compensation liability) and not as equity. While the measurement objective of aliability award is similar to an equity award, it differs in that liability awards are remeasured at the end of eachreporting period until they are settled. GAAP allows nonpublic entities to elect, as a policy decision, either the fairvalue method or the intrinsic value method for measuring all liability awards under share�based payment arrange�ments. In either case, liabilities are required to be remeasured at each reporting date until the settlement date.

FASB ASC 718�10�35�15 [formerly FSP FAS 123(R)�4, �Classification of Options and Similar Instruments Issued asEmployee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event"] amends theguidance for options or similar instruments that are issued as part of employee compensation arrangements andrequire cash settlement upon the occurrence of a contingent event, such as the death or disability of the holder ora change in control. As a result of the amendment, liability recognition is not required for a cash settlement featurethat can be exercised only upon the occurrence of a contingent event that is outside the employee�s control untilthe event is probable of occurring. If the event becomes probable of occurring, the accounting is similar to theaccounting for a modification from an equity award to a liability award. The entity should recognize a share�basedliability equal to the portion of the award attributed to past service multiplied by the award's fair value on that date.


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Changes in the fair value or intrinsic value of liability awards are recognized as compensation cost over the requisiteservice period. At the end of any reporting period, the percentage of the fair value or intrinsic value recognizedshould equal the percentage of requisite service that has been rendered at that date. That is, if the requisite serviceperiod is four years and as of December 31, 20X7 three years of service have been provided, 75% (3 years � 4years) of the fair value or intrinsic value should be recognized as a liability. Changes in the fair value or intrinsicvalue after the requisite service period are recognized as compensation cost in the period of change. Similarly, anydifference between the settlement amount of the liability award and its fair value is an adjustment of compensationcost in the period of settlement.

Transactions with Nonemployees. A company that issues stock options or other equity instruments (or incursliabilities based on the price of its stock or other equity instruments) in return for goods or services from nonemploy�ees (e.g., suppliers) must account for the transaction using either the fair value of (a) the goods or services receivedor (b) the stock options or other equity instruments issued, whichever can be more reliably measured. The fair valueof goods or services received from suppliers usually can be reliably measured, and therefore should be used toaccount for the fair value of the equity instrument issued. However, if the fair value of the equity instrument is usedto account for the transaction, FASB ASC 505�50�30�11 (formerly EITF Issue No. 96�18, �Accounting for EquityInstruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices") indicates that the fair value of the equity instrument issued to a nonemployee should be measured usingthe stock price on the earlier of (a) the date at which a performance commitment by the nonemployee is reached(A performance commitment is a commitment under which the nonemployee's performance to earn the equityinstruments is probable because of sufficiently large disincentives for nonperformance. Forfeiture of the equityinstruments in the event of nonperformance is not considered sufficient disincentive. In addition, the ability to suefor nonperformance is not, in and of itself, a sufficiently large disincentive to ensure that performance is probable.)or (b) the date at which the nonemployee's performance is complete. Performance is complete when the nonem�ployee has delivered or purchased the goods or services, even if the quantity or terms of the equity instruments stilldepends on other events (such as a target stock price requirement) at that date. [FASB ASC 505�50�30�6;505�50�30�8 and 30�9 (formerly EITF Issue No. 96�18) address transactions in which the fair value of the equityinstruments issued to nonemployees can be more reliably measured than the fair value of the goods or servicesreceived. (It does not address accounting for equity instruments issued to a lender or investor who providesfinancing or in a business combination.)] FASB ASC 505�50�30 also concludes that

a. equity instruments should be measured at their fair value if the quantity and terms of the equity instruments(1) do not depend on market conditions or the nonemployee's performance or (2) depend only on theachievement of market conditions.

b. equity instruments should be measured at the lowest amount within a range of aggregate fair values if thequantity and terms of the equity instruments (1)�depend on the achievement of nonemployee performanceconditions that, based on the various possible outcomes, result in a range of aggregate fair values, or (2)depend on the achievement of both market conditions and nonemployee performance conditions that,based on the various possible outcomes, result in a range of aggregate fair values. (If the quantity or termsof the equity instruments are revised after the measurement date, the lowest aggregate fair value amountshould be adjusted to reflect any additional cost of the transaction. The adjustment is the differencebetween the fair value of the instruments after revision and the fair value of the instruments before revision.)

In addition, an asset or expense (or sales discount) should be recognized as if the company paid cash rather thanequity instruments for the goods or services (or used cash rebates as sales discounts). A recognized asset orexpense (or sales discount) should not be reversed if a nonemployee's stock option expires unexercised. Thisguidance provides numerous examples that illustrate its application in various situations. Regardless of the methodused to determine fair value, a company that issues equity instruments to acquire goods or services from nonem�ployees should make disclosures similar to those made for share�based employee compensation if they wouldhelp financial statement readers better understand the effects of the transactions on the financial statements.

Although FASB ASC 505�50 (formerly EITF Issue No. 96�18) provides accounting guidance for companies thatissue stock to nonemployees in return for goods or services, it does not address how the grantee should accountfor the transaction. FASB ASC 505�50 (formerly EITF Issue No. 00�8, �Accounting by a Grantee for an EquityInstrument to Be Received in Conjunction with Providing Goods or Services"), provides similar guidance for the


83

grantee in determining (a) which date the grantee should use to measure the fair value of the equity instrument and(b) how the grantee should account for an increase in fair value after the measurement date due to an adjustmentbased on market or performance conditions.

Practice Alert 2000�1, Accounting for Certain Equity Transactions, issued by the AICPA's Professional Issues TaskForce, provides several examples of accounting for transactions in which companies issue stock to nonemployeesin exchange for goods or services. Such transactions should be accounted for using either the fair value of thegoods or services received or the stock issued, whichever can be more reliably measured. If neither the fair valueof the goods or services received nor the stock issued can be reliably measured, the Practice Alert states that thetransaction should be recorded at a nominal value. It further specifies that the book, par, or stated value of the stockor the contractual value assigned to the goods or services generally is not a reliable measure of the transaction'svalue. The Practice Alert also addresses stock issued to an owner in return for expertise or intellectual capitalcontributed to a business. Generally, such transactions should be recorded at the transferor's historical cost underGAAP. Although the Practice Alert is nonauthoritative and intended for auditors, it may help financial statementpreparers better understand various types of equity transactions. The Practice Alert can be accessed via theAICPA's website at www.aicpa.org.

Accounting for Income Tax Benefits under the Fair Value Method. The income tax effect of share�basedcompensation is accounted for essentially as provided by FASB ASC 740 (formerly SFAS No. 109, Accounting forIncome Taxes). That is, if amounts deducted for income tax purposes differ from the amounts expensed for financialreporting, deferred taxes should be provided. If the tax deduction is higher than the cumulative amount expensedfor financial reporting for an equity award, the tax effect of the difference (that is, the excess tax benefit) should beadded to paid�in capital unless the excess is due to a reason other than changes in the fair value of shares betweenthe measurement dates used for accounting and tax. If the excess is due to another reason, the difference shouldbe included in income. Conversely, if the tax deduction is lower than the cumulative amount expensed for financialreporting, the tax effect of the difference (that is, the write�off of the deferred tax asset) should be subtracted fromadditional paid�in capital, but only to the extent it is attributable to excess tax benefits from previous awardsaccounted for under the fair value method.

Transition. For nonpublic entities, FASB ASC 505; 718 [formerly SFAS No. 123(R)] is effective as of the beginningof the first annual reporting period beginning after December 15, 2005. It applies to all awards that are granted afterits effective date and should not be applied to awards granted before the effective date unless they are modified,repurchased, or cancelled after the effective date. Thus, the transition period may be for an extended number ofyears. The cumulative effect of initially applying this guidance, if any, should be recognized at the effective date.

As of the effective date, the method of transition depends on the method of accounting for share�based compensa�tion used prior to the effective date:

� Modified Prospective Method. Nonpublic companies that used the fair�value based method for eitherrecognition or disclosure under the original FASB ASC 505; 718 are required to use this method. Thismethod requires this guidance to be applied to all new awards and awards modified, repurchased, orcancelled after the effective date. Compensation cost for existing awards with unrecognized compensationcost as of the effective date is recognized as service is rendered for those awards. However, compensationcost for such awards must be based on the grant�date fair value as calculated under FASB ASC 505; 718[formerly SFAS No. 123(R)]no change to the previously determined grant�date fair value is allowed. Inaddition, the previous method of attributing compensation cost to future periods must be continued afterthe effective date, with the exception that recognizing forfeitures only as they occur should not becontinued. Remaining deferred compensation or other contra�equity accounts should be eliminatedagainst equity.

� Prospective Method. Nonpublic companies that used the minimum value method under FASB ASC 505;718 [formerly SFAS No. 123(R)] for either measurement or disclosure must continue to use their existingaccounting method for remaining portions of outstanding awards. These provisions should be appliedprospectively to new awards, as well as to those modified, repurchased, or cancelled after the effectivedate.


84

For the modified prospective method, the following is required as of the effective date:

a. If an instrument is classified as a liability but was previously classified as equity, the appropriate portion ofthe fair value liability should be recognized (based on requisite service). The liability is recorded byreducing equity to the extent of previously recognized compensation cost, and any difference is reflectedin income, net of tax. For previous liability instruments that were measured at intrinsic value, the effect ofmeasuring the liability at fair value should also be reflected in income, net of tax. The income effect in bothsituations is recognized as the cumulative effect of a change in accounting principle.

b. Companies that previously recognized the effect of forfeitures as they occurred should estimate thenumber of instruments expected to be forfeited and adjust the related balance sheet accounts (net of taxeffects) through income as the cumulative effect of a change in accounting principle. (No other transitionadjustment as of the required effective date should be made for any deferred tax assets associated withoutstanding equity instruments that continue to be accounted for as equity instruments. However, the entityshould calculate the net excess tax benefits available to absorb tax deficiencies if deferred tax assets needto be written off in subsequent periods.

Additional Paid�in Capital

A descriptive balance sheet caption, such as �additional paid�in capital" or �capital in excess of par or stated value"is used for this account, and it is presented immediately following preferred and common stock. The account maybe affected by the following capital�related transactions:

a. Sale of stock at an amount in excess of par or stated value

b. Issuance of awards of equity instruments in share�based payment transactions

c. Purchase or sale of treasury stock

d. Capitalization of retained earnings, for example, for stock dividends

e. Fair value of contributed assets at the date of contribution

f. Reorganization costs

However created, additional paid�in capital may not be used to relieve income of current or future charges thatwould otherwise be made against income. The only exception is in reorganization or quasi reorganization of acompany [FASB ASC 505�10�25�1 (formerly ARB No. 43, Ch. 1A)]. In some states there is no legal prohibitionagainst issuing stock at less than par value. When that occurs, a caption such as �Discount on issuance of commonstock" may be used.

FASB ASC 505�10�50�2 (formerly APB Opinion No. 12) requires changes in additional paid�in capital to be dis�closed. Changes usually are disclosed in a separate statement or in combination with changes in other elementsof stockholders' equity or in the notes to the financial statements.

Stock Subscriptions Receivable

A subscription for the purchase of stock normally is debited to subscriptions receivable and credited either to stocksubscribed or common stock issued and additional paid�in capital. Stock subscription agreements may be formalor informal, and stock may be either issued in advance of collection or as the receivable is collected. Theaccounting issue is when to recognize capital from the transaction. Stock subscriptions receivable generally shouldbe recognized as a deduction from stockholders' equity as follows:


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20X2 20X1

Stockholders' Equity

Common stock, $25 par value, 10,000 shares authorized1,400 issued20X2, 1,000 issued20X1 35,000 25,000

Additional paid�in capital 25,000 15,000

Stock subscriptions receivable (20,000 ) �


105,000 90,000

Stock subscriptions receivable should be shown as an asset only in rare circumstances (a) when there is substan�tial evidence of ability and intent to pay, such as when notes for stock are secured by irrevocable letters of credit orhave been discounted at a bank and (b) when the obligations mature in a reasonably short period of time. In thosecases, the agreement would be reported as an asset using a caption such as �Stock subscriptions receivable" or�Notes receivable" and classified as current or noncurrent based on the payment schedule.

Forgiveness of Related Party Receivables and Payables

For a variety of reasons, an entity may forgive the amount receivable from a related party or a related party mayforgive the amount due from an entity. According to Practice Alert 00�1, Accounting for Certain Equity Transactions,both of those events ordinarily should be accounted for as equity transactions, with no effect on earnings. Inaddition, FASB ASC 470�50�40�2 (formerly footnote 1 to Paragraph 20 of APB Opinion No. 26, Early Extinguishment

of Debt), says �extinguishment transactions between related entities may be in essence capital transactions."

The financial statements should disclose forgiveness of related party receivables and payables in connection withother changes in equity. The following note illustrates disclosure of forgiveness of a related party payable.

NOTE XINCREASE IN PAID�IN CAPITAL IN 20X9

Paid�in capital is for 200 shares of common stock; 1,000 shares are authorized. In 20X9, theCompany paid the negotiated balance of $119,673 that was due for back charges related totobacco�processing equipment that it finished manufacturing for a foreign customer in 20X5.Wilson Machinery then forgave the Company's $377,565 liability for components that WilsonMachinery fabricated for the equipment. Under generally accepted accounting principles, for�giveness of related party debt generally is viewed as in essence a capital transaction. Accord�ingly, forgiveness of the Wilson Machinery debt is reported in the 20X9 financial statements as a$377,565 increase in paid�in capital, from $2,724,671 at the end of 20X8 to $3,102,236 at the endof 20X9.

Retained Earnings

Retained earnings represent undistributed earnings. A statement of changes in retained earnings (presentedseparately or combined with the income statement) is generally considered necessary to present results ofoperations in conformity with GAAP.

Balance Sheet Caption. Normally the caption �Retained earnings" is sufficient. However, an exception is neces�sary when negative retained earnings are reported. The following captions are recommended in comparativebalance sheets:

� When balance sheets report negative retained earnings in all periods, a caption such as �Accumulateddeficit" is suggested.

� When the balance sheet in one period presents a negative balance and another period presents a positivebalance, a caption such as �Retained earnings (accumulated deficit)" is appropriate.

Restrictions on Retained Earnings. According to FASB ASC 505�10�45�3 (formerly Paragraph 15 of SFAS No. 5,Accounting for Contingencies), appropriations of retained earnings are permitted, provided they are shown withinthe stockholders' equity section of the balance sheet. An appropriate presentation would be:


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20X2 20X1


Common stock, $15 par value, 10,000 shares authorizedand issued 150,000 150,000

Additional paid�in capital 50,000 50,000

Retained earnings

Appropriated for self�insured losses 60,000 50,000

Unappropriated 100,000 60,000

360,000 310,000

An appropriation of retained earnings is, in essence, a bookkeeping entry and a way of disclosing restrictions onretained earnings. It does not indicate that funds have been segregated, nor does it affect income. [FASB ASC505�10�45�4 (formerly SFAS No. 5) also states that costs or losses should not be charged to an appropriation ofretained earnings and that none of it should be transferred to income.] Most companies disclose restrictions onretained earnings in the notes to the financial statements rather than on the face of the balance sheet. For example,a loan agreement may contain a restriction on payment of dividends, which represents a retained earningsrestriction that is typically disclosed in the notes to the financial statements.

Changes in Retained Earnings. Changes in retained earnings are generally limited to:

a. net income or loss for the year,

b. distribution of earnings (dividends), and

c. adjustments to the opening balance. The opening balance in retained earnings may be adjusted as a resultof:

(1) certain changes in accounting principles, or

(2) prior�period adjustments.

Dividends. Dividends are distributions of accumulated assets to stockholders generally in the form of cash,property, or stock. Cash dividends are liabilities of the company as of the date the dividends are declared. Theamount of the dividend is presented as a reduction of retained earnings in the statement of retained earnings orstockholders' equity. If unpaid at the balance sheet date, the amount also is recorded as a current liability. Althoughnot required by generally accepted accounting principles, some companies choose to disclose the per shareamount of dividends paid to stockholders as well as the total amount in the statement of retained earnings. Suchdisclosure is usually made in the dividend caption as the following illustrates.

20X2 20X1

Dividends declared, $.10 per share in 20X2 and $.09 pershare in 20X1 10,000 9,000

Property dividends reduce retained earnings in an amount equal to the fair value of the assets distributed [FASBASC 845�10�30�1 (formerly APB Opinion No. 29)]. At the date property dividends are declared, the companyrecognizes a gain or loss for the difference between the carrying value and the fair value of the assets distributed.For example, if property dividends consist of inventory with a carrying value of $75,000 and a fair value at thedeclaration date of $100,000, entries such as the following would be made:

Inventory ($100,000 fair value less $75,000 carrying value) 25,000

Gain on distribution of inventory 25,000

Retained earnings (fair value of assets distributed) 100,000

Property dividends distributable 100,000

Stock Dividends. A corporation may elect to distribute stock dividends in lieu of, or in addition to, cash or propertydividends. Accounting for stock dividends is discussed in FASB ASC 505�20 (formerly Chapter 7B of ARB No. 43).


87

Stock dividends are generally no more than a realignment of stockholders' equity. However, GAAP recognized thatthe public looks at stock dividends as distributions of corporate earnings and usually in an amount equal to the fairvalue of the shares received. Thus, GAAP provides that as long as the number of shares issued in a stock dividendis so small in comparison to the number of shares outstanding that they have no apparent effect on the market priceof the shares, the stock dividend should be accounted for by transferring an amount equal to the fair value of theshares issued from retained earnings to capital stock and additional paid�in capital. Thus, stock dividends reduceretained earnings, but they do not reduce total stockholders' equity. They are disclosed in a statement of retainedearnings or stockholders' equity in a manner similar to cash or property dividends.

However, GAAP added that in closely held companies, there would be no need to capitalize retained earnings(other than to meet legal requirements) for stock dividends. That conclusion was based on the presumption thatshareholders of a closely held company are intimately knowledgeable of the company's affairs and therefore theygenerally would not consider stock dividends as a distribution of company earnings. Thus, stock dividends ofclosely held companies may be treated in a manner consistent with stock splits.

Stock Splits. Stock splits are similar to stock dividends in that they both involve the issuance by a company of itsown shares to its shareholders. However, the term stock split is used to refer to such distributions of sharesgenerally in excess of 20% to 25% of currently outstanding shares. Accounting for stock splits, however, is verydifferent from the accounting for stock dividends. When a distribution is classified as a stock split, no part ofretained earnings should be capitalized, other than that required by the laws of the state of incorporation of thecompany (generally not exceeding the par value of the shares issued). Instead, there is an increase in the numberof shares of stock outstanding and a corresponding decrease in the par value per share. Stock splits made after thebalance sheet date but before the financial statements are issued or are available to be issued are recognizedsubsequent events, and accordingly, they should be reflected in the financial statements as if they had occurred asof the balance sheet date.

Adjustments to Opening Retained Earnings for Accounting Changes. FASB ASC 250�10�05 (formerly SFAS No.154, Accounting Changes and Error Corrections), establishes retrospective application as the required method forreporting a change in accounting principle unless it is impracticable to do so or the newly adopted accountingprinciple contains explicit transition requirements. Retrospective application may require an adjustment to theopening balance of retained earnings.

Prior�period Adjustments. The balance of retained earnings at the beginning of the period should be restated forthe effects of prior�period adjustments. (Since the beginning retained earnings balance must be restated forprior�period adjustments, FASB ASC 220�10 (formerly SFAS No. 130, Reporting Comprehensive Income), statesthat prior�period adjustments are, in effect, included in comprehensive income of earlier periods and should not bedisplayed in comprehensive income of the current period.) According to FASB ASC 250�10�45�23 (formerly SFASNo. 154), adjustment of prior period financial statements should only be made for the correction of an error in thefinancial statements of a prior period. [Certain other types of adjustments are permitted for interim financialstatements. According to FASB ASC 740 (formerly SFAS No. 109), however, the realization of income tax benefitsof preacquisition operating loss carryforwards of purchased subsidiaries is not treated as a prior�period adjust�ment.]

FASB ASC 250�10�20 (formerly SFAS No. 154), defines an error in previously issued financial statements as �anerror in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematicalmistakes, mistakes in the application of GAAP, or oversight or misuse of facts that existed at the time the financialstatements were prepared. A change from an accounting principle that is not generally accepted to one that isgenerally accepted is a correction of an error."

Although the authoritative literature is not explicit, a change to GAAP from a comprehensive basis of accountingother than GAAP also should be accounted for as a correction of an error. Financial statements of prior periodsshould be restated or, if that is not practicable, opening balances of the current�period financial statements shouldbe adjusted to conform with generally accepted accounting principles. Prior�period financial statements should notbe presented in comparative form with those of the current period unless they have been restated.

RAR Adjustments (Income Tax Audit Adjustments). Adjustments to income taxes paid in prior years as a resultof IRS agent examinations usually fall into two categories: (a) those resulting from obvious errors such as using an


88

incorrect income tax rate or (b) those resulting from negotiated settlements of gray areas of tax law. While there aresound theoretical arguments to treat error corrections as prior�period adjustments, to do so necessitates a time�consuming and subjective evaluation of the nature of each adjustment on an RAR. Such adjustments ordinarily arenot material, and accordingly, the additional assessment ordinarily may be recorded as an adjustment of incometax expense in the year the assessment is made. Practice generally has adopted that approach. (If corrections oferrors of previously reported income tax expense are recorded as prior�period adjustments, the charge to retainedearnings should be the amount of the additional tax due. Penalty and interest should be reported as expenses ofthe year in which the additional assessment is made.)

Accumulated Other Comprehensive Income

FASB ASC 220�10�45�14 (formerly SFAS No. 130) requires the accumulated balance of other comprehensiveincome to be displayed separately from retained earnings and additional paid�in capital in the equity section of thebalance sheet and labeled with a descriptive title such as �accumulated other comprehensive income." Thefollowing is an example presentation:

STOCKHOLDERS' EQUITYCommon stock $ 500,000Additional paid�in capital 100,000Retained earnings 300,000Accumulated other comprehensive income 50,000

950,000

In addition, the accumulated balances for each component of other comprehensive income should be presentedon the face of the balance sheet, in the statement of changes in stockholders' equity, or in the notes to the financialstatements. The following example illustrates presenting the accumulated balance for each component of othercomprehensive income on the face of the balance sheet:

STOCKHOLDERS' EQUITYCommon stock $ 500,000Additional paid�in capital 100,000Retained earnings 300,000Accumulated other comprehensive income:

Foreign currency translation adjustments $ 5,000Unrealized holding gains on securities 45,000 50,000

950,000

If accumulated other comprehensive income consists of only one component, such as unrealized gains or losseson available�for�sale marketable securities, that component could be listed individually on the face of the balancesheet, as follows:

STOCKHOLDERS' EQUITYCommon stock $ 500,000Additional paid�in capital 100,000Retained earnings 300,000Unrealized holding gains on securities 50,000

950,000

Treasury Stock

Stock issued should correspond with the dollar amount reported for the stock caption. Accordingly, if shares havebeen acquired and retired they would be eliminated from shares issued. However, if shares have been acquiredand are being held as treasury stock they would be included in shares issued. Traditionally, the following informa�tion is disclosed:

a. Title of the issue

b. Number of shares held in treasury


89

c. Carrying basis

d. Restrictions of state laws, if any

Most of the disclosures generally may be provided through expansion of the balance sheet caption. Although thecaption �Treasury stock" is acceptable, more descriptive captions such as �Common stock held by the Companyin treasury" or simply �Common stock held by the Company" may be clearer to readers. For example:

20X2 20X1


Common stock, $250 par value, 5,000 shares authorizedand 2,500 shares issued 625,000 625,000


750,000 720,000

Cost of 1,500 shares of common stock held by theCompany (435,000 ) (435,000 )

315,000 285,000

When stock is retired or purchased for constructive retirement, the par value of the shares should be charged to thespecific stock issue. In addition, FASB ASC 505�30�30�8 and 30�9 (formerly ARB No. 43, Chapter 1B, paragraph 7)provides the following guidance on accounting for treasury stock when stock is retired or purchased for construc�tive retirement:

a. an excess of the purchase price over par value may be charged to additional paid�in capital with any excessremaining charged to retained earnings (alternatively, the excess may be charged entirely to retainedearnings); and

b. an excess of par value over the purchase price should be credited to additional paid�in capital.

Treasury stock refers to a corporation's own stock that it holds. As a general rule, treasury stock should bepresented in the financial statements as a deduction from stockholders' equity or as a deduction from capital stockoutstanding. (However, when a corporation purchases treasury stock as part of a systematic method of fulfilling itsrequirements to issue shares in connection with an employee stock option plan, it may be shown as an asset.)

a. When stock is acquired for purposes other than retirement, or when ultimate disposition has not beendecided, the cost of the stock may be handled in either of the following ways:

(1) A deduction from the sum of capital stock, additional paid�in capital, and retained earnings

(2) Treated the same as retired stock

(3) In rare instances, shown as an asset

b. If treasury stock has been shown as a deduction from other equity components and is subsequently sold:

(1) Gains should be credited to additional paid�in capital.

(2) Losses are normally charged first to additional paid�in capital, then to retained earnings.

The predominant practice for nonpublic companies appears to be to report treasury stock as a deduction fromother equity components.

Costs of Issuing Stock and Reorganizing

FASB ASC 505�30�30�2 through 30�4 (formerly FASB Technical Bulletin No. 85�6, Accounting for a Purchase ofTreasury Shares and Costs Incurred in Defending Against a Takeover Attempt), requires considering whether the


90

total amount paid in a treasury stock transaction includes the receipt of stated or unstated rights, privileges, oragreements in addition to the capital stock, such as a seller's agreement to settle litigation or to abandon certainacquisition plans. If those other elements are present, the excess of the amount paid over the cost of the treasuryshares should be allocated to the other elements and accounted for according to their substance. For example,agreements to settle litigation or to abandon acquisition plans probably would be charged to expense. GAAPpermits allocations based either on an assessment of the fair value of the stock acquired or on the fair value of thoseother elements. The allocation of amounts paid and their accounting treatment should be disclosed.

GAAP also requires recording costs incurred under the following arrangements (commonly referred to as �green�mail") as ordinary expenses:

� Payments under an agreement in which a present or former stockholder agrees not to purchase additionalshares

� Costs incurred by a company in defending itself against a takeover attempt

Although such arrangements may be more common to public companies, analogous situations also might occurin nonpublic companies, for example, due to dissident minority shareholders.

Costs of issuing stock should be deducted from the proceeds of the issue and should not be reported as an asset.(Similarly, syndication costs (for example, costs paid to attorneys or accountants and fees paid to selling agents ofa limited partnership) for an offering of a limited partnership should be accounted for in a manner similar to costsassociated with the issuance of stock. They should be recorded as a reduction of capital contributed by the limitedpartners as provided in an AICPA Technical Practice Aid at TIS 7200.07.) In effect, the costs are charged againstadditional paid�in capital. Reorganization costs normally should also be charged against additional paid�in capital.However, if that causes a negative balance in additional paid�in capital, reorganization costs should be chargedagainst retained earnings.

Disclosure of Changes in Capital Accounts

FASB ASC 250�10�50�9 (formerly APB Opinion No. 9, Reporting the Results of Operations), implies that disclosureof changes in retained earnings should be made for each period an income statement is presented. Often, that isaccomplished through expansion of the income statement. When both a balance sheet and an income statementare presented, GAAP requires disclosing changes in accounts comprising stockholders' equity in addition tochanges in retained earnings and in the number of shares of equity securities to be disclosed.

Changes in equity accounts other than retained earnings and other comprehensive income may be disclosed inany of the following ways depending on space requirements:

a. Line item in the balance sheet

b. Separate statement

c. Notes to the financial statements

For a nonpublic company, changes usually may be incorporated in expanded balance sheet captions. For exam�ple, a change in common stock might be disclosed as follows:

20X2 20X1

Common stock, $20 par value, 1,000 shares authorized,shares issued750 in 20X2 and 500 in 20X1 15,000 10,000

A change in treasury stock might be disclosed as follows:

20X2 20X1

Cost of 1,500 shares of common stock held by theCompany in 20X2 and 500 shares held in 20X1 135,000 46,000

GAAP requires all entities to disclose the number of shares issued during at least the most recent annual period andany subsequent interim period presented.


91

SELF�STUDY QUIZ


34. What balance sheet caption is appropriate when one period has negative equity and the other period haspositive equity?

a. Stockholders' equity.

b. Stockholders' deficit.

c. Deficiency in assets.

d. Stockholders' equity (deficit).

35. Which of the following preferred stock disclosures is disclosed in the equity section of the balance sheet?

a. Redemption requirements for all issues of stock.

b. A description of the rights and privileges of securities.

c. Liquidation preferences that are substantially in excess of par or stated value.

d. The number of shares issued during the most recent annual period.

36. Which of the following applies to the issuance of an equity instrument to a nonemployee in exchange for goods?

a. Sales discounts should be recognized in this situation.

b. The grant date should be used to value the equity instrument.

c. The value of the goods received is always used to value the equity instrument.

d. The equity instruments are measured at the highest amount within a range of fair values.

37. Forgiveness of a receivable from a related party is an equity transaction.

a. True.

b. False.

38. Edge Corporation, a publicly traded corporation, issued a small amount of stock dividends. How would thecorporation account for the stock dividends?

a. In this situation, the stock dividends should be accounted for like a stock split.

b. The corporation should reduce retained earnings and increase capital stock and additional paid�in capital.

c. Edge Corporation should not capitalize a portion of retained earnings.

d. Edge Corporation should increase the number of outstanding shares and decrease the par value pershare.


92



34. What balance sheet caption is appropriate when one period has negative equity and the other period haspositive equity? (Page 79)

a. Stockholders' equity. [This answer is incorrect. If liabilities exceed assets, the term �equity" should not beused. A negative equity balance can be reported using a different caption.]

b. Stockholders' deficit. [This answer is incorrect. �Stockholders' deficit" could be used if negative equity isshown in all periods.]

c. Deficiency in assets. [This answer is incorrect. �Deficiency in assets" is an acceptable caption to report anegative equity balance on the balance sheet when all periods show negative equity.]

d. Stockholders' equity (deficit). [This answer is correct. When negative equity is shown in one periodand a positive equity is shown in another period, �Stockholders' equity (deficiency in assets)" or

�Stockholders' equity (deficit)" may be used.]

35. Which of the following preferred stock disclosures is disclosed in the equity section of the balance sheet?

(Page 80)

a. Redemption requirements for all issues of stock. [This answer is incorrect. Redemption requirements for

all issues of stock are usually made in the notes to the financial statements.]

b. A description of the rights and privileges of securities. [This answer is incorrect. A description of the rights

and privileges of securities is disclosed in the notes to the financial statements.]

c. Liquidation preferences that are substantially in excess of par or stated value. [This answer is

correct. Liquidation preferences must be disclosed in the equity section of the balance sheet, while

most other disclosures are made in the notes.]

d. The number of shares issued during the most recent annual period. [This answer is incorrect. In the notes

to the financial statements, a disclosure is made regarding the number of shares issued during the mostrecent annual period and any subsequent interim period presented.]

36. Which of the following applies to the issuance of an equity instrument to a nonemployee in exchange for goods?(Page 82)

a. Sales discounts should be recognized in this situation. [This answer is correct. An asset or expense(or sales discount) should be recognized as if the company paid cash rather than equity instruments

for the goods. In addition, a recognized sales discount should not be reversed if a nonemployee's

stock option expires unexercised.]

b. The grant date should be used to value the equity instrument. [This answer is incorrect. If the fair value of

the equity instrument is used to account for the transaction, FASB ASC 505 and 718 [formerly SFAS No.123(R)] does not prescribe the measurement date. However, FASB ASC 505�50 (formerly EITF Issue No.

96�18) gives guidance that the fair value of the equity instrument is used to measure the stock price on the

earlier of (a) the date at which a performance commitment by the nonemployee is reached or (b) the dateat which the nonemployee's performance is complete.]

c. The value of the goods received is always used to value the equity instrument. [This answer is incorrect.A company that uses equity instruments in return for goods from nonemployees must account for the

transaction using either the fair value of the goods received or the equity instruments issued, whichevercan be more reliably measured.]


93

d. The equity instruments are measured at the highest amount within a range of fair values. [This answer isincorrect. Equity instruments should be measured at the lowest amount within a range of aggregate fairvalues if the quantity and terms of the equity instruments (1) depend on the achievement of nonemployeeperformance conditions that, based on the various possible outcomes, result in a range of aggregate fairvalues, or (2) depend on the achievement of both market conditions and nonemployee performanceconditions that, based on the various possible outcomes, result in a range of aggregate fair values.]

37. Forgiveness of a receivable from a related party is an equity transaction. (Page 85)

a. True. [This answer is correct. When an entity forgives a receivable from a related party or a relatedparty forgives the amount due from an entity, the events should ordinarily be accounted for as equitytransactions, with no effect on earnings.]

b. False. [This answer is incorrect. Forgiveness of a receivable from a related party should not affect theearnings of the entity. FASB ASC 470�50�40�2 (formerly APB Opinion No. 26, Early Extinguishment of Debt),says �extinguishment transactions between related entities may be in essence capital transactions."]

38. Edge Corporation, a publicly traded corporation, issued a small amount of stock dividends. How would thecorporation account for the stock dividends? (Page 86)

a. In this situation, the stock dividends should be accounted for like a stock split. [This answer is incorrect.If Edge Corporation was a closely held company, the stock dividends may be treated in a mannerconsistent with stock splits, because shareholders of a closely held company are intimately knowledge�able of the company's affairs and therefore they generally would not consider stock dividends as adistribution of company earnings.]

b. The corporation should reduce retained earnings and increase capital stock and additional paid�incapital. [This answer is correct. GAAP provides that as long as the number of shares issued in astock dividend is so small in comparison to the number of shares outstanding that they have noapparent effect on the market price of the shares, the stock dividend should be accounted for bytransferring an amount equal to the fair value of the shares issued from retained earnings to capitalstock and additional paid�in capital. Thus, stock dividends reduce retained earnings, but they do notreduce total stockholders' equity.]

c. Edge Corporation should not capitalize a portion of retained earnings. [This answer is incorrect. Stocksplits do not capitalize a portion of retained earnings. Stock dividends, however, affect the retainedearnings account.]

d. Edge Corporation should increase the number of outstanding shares and decrease the par value pershare. [This answer is incorrect. In stock splits, the number of outstanding shares increases and the parvalue per share decreases. This is not the correct way to account for stock dividends.]


94


Lesson 2 (PFSTG091)


34. If present, what component of stockholders' equity is generally listed after all other stockholders' equity itemsare subtotaled?

a. Accumulated other comprehensive income.

b. Stock subscriptions receivable.

c. Additional paid�in capital.

d. Treasury stock.

35. When an employee receives equity instruments in exchange for employee services, what date is used to valuethe equity instruments?

a. The reporting date.

b. The grant date.

c. The date exercised.

d. The vesting date.

36. Which of the following would not affect additional paid�in capital?

a. Reorganization costs.

b. Purchase or sale of treasury stock.

c. Sale of stock at stated value.

d. Capitalization of retained earnings for stock dividends.

37. Which of the following items best describes restrictions on retained earnings?

a. An appropriation of retained earnings affects income.

b. An appropriation of retained earnings discloses restrictions on retained earnings.

c. An appropriation of retained earnings indicates that funds have been segregated.

d. Most appropriations of retained earnings are disclosed on the face of the balance sheet.

38. Treasury stock is included in the number of shares issued.

a. True.

b. False.




95

Lesson 3:�Accounting Changes

INTRODUCTION

According to FASB ASC 250�10�05�01; 250�10�05�4 (formerly SFAS No. 154, Accounting Changes and Error

Corrections), the term accounting changes includes changes in an accounting estimate,changes in the reportingentity, and changes in an accounting principle. The term does not include correction of errors.


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

Change in Accounting Estimate

A change in accounting estimate results from new information. Examples of accounting estimates that periodicallychange are allowances for bad debts, useful lives or salvage values of depreciable assets, and inventory obsoles�cence. The effects of changes in estimates should be reported in the period of change and subsequent periods.Restatement or retrospective adjustment of amounts reported in prior period financial statements or the presenta�tion of pro forma prior period amounts is not permitted. For example, a change in the estimated useful lives ofassets would be accounted for by adjusting depreciation expense in the current and future periods to depreciatethe carrying value of assets over their remaining (new) useful lives.

Changes that are inseparable from changes in accounting principle, such as a change in depreciation, amortiza�tion, or depletion method for long�lived nonfinancial assets, should be accounted for as a change in accountingestimate effected by a change in accounting principle. Such changes are accounted for as a change in an estimate.However, a change in accounting estimate effected by a change in accounting principle is permitted only if thereporting entity can justify the new principle on the basis that it is preferable. Changing from certain depreciationmethods, for example, the Modified Accelerated Cost Recovery System (MACRS), to the straight�line method at aspecified point in the life of an asset to fully depreciate the asset's cost over its estimated life is not a change inaccounting principle if the change had been planned when the asset was placed in service and the policy is appliedconsistently.

Change in Reporting Entity

A change in reporting entity refers to a change that results in financial statements that are, in effect, the statementsof a different reporting entity. Typically, such changes are limited to changes in the companies or subsidiaries thatare included in combined or consolidated financial statements. Changes in the reporting entity are accounted forby retrospectively applying the change to the financial statements of all previous periods presented to show thefinancial information for the new reporting entity for the previous periods.

Change in Accounting Principle

A change in accounting principle is generally defined as a change from one acceptable principle to another or achange in the method of applying an acceptable accounting principle. A change from an unacceptable principle toan acceptable principle is a correction of an error and not a change in accounting principle as defined by GAAP.

The following events or circumstances are not considered to be accounting changes for the purpose of applyingthis guidance:

a. Initial adoption of a new accounting principle for new events or transactions or for material events ortransactions that were previously immaterial

b. Adoption or modification of an accounting principle due to substantially different events or transactionsthan those previously occurring


96

Justifying Changes in Accounting Principles

GAAP permits a change in accounting principle only if a company justifies the use of an alternative acceptableaccounting principle on the basis that it is preferable or a newly issued accounting pronouncement requires thechange.

Accounting for and Reporting of a Change in Accounting Principle

This guidance applies to all voluntary changes in accounting principle as well as to changes required by anaccounting pronouncement when that pronouncement does not include explicit transition provisions. If a pro�nouncement includes explicit transition provisions, those provisions should be applied.

A change in accounting principle should be reported by retrospective application of the new principle to thefinancial statements of all prior periods, unless it is impracticable to determine either the period�specific effects orthe cumulative effect of the change. Retrospective application is the application of a different accounting principleto previous accounting periods as if it had always been used. The following steps are required to retrospectivelyapply a new accounting principle:

a. Determine the cumulative effect of the change to the new accounting principle on periods before theperiods presented. Apply the cumulative effect of the change to the carrying amounts of assets andliabilities as of the beginning of the first period presented.

b. If necessary, record an offsetting adjustment to the opening retained earnings balance (or otherappropriate components of equity or net assets) for that period.

c. Adjust the financial statements for each individual prior period presented to reflect the period�specificeffects of applying the new accounting principle.

If the cumulative effect of applying the change to all prior periods can be determined, but it is impracticable todetermine the period�specific effects of the change on all prior periods presented, the cumulative effect of thechange should be applied to the balances of assets and liabilities as of the beginning of the earliest period to whichthe new principle can be applied. In those situations, an offsetting adjustment to the opening retained earningsbalance (or other appropriate components of equity or net assets) for that period may be necessary. If it isimpracticable to determine the cumulative effect of applying a change in accounting principle to any prior period,the new principle should be applied as if it were adopted prospectively from the earliest date practicable.

When applying a new accounting principle retrospectively, an entity should include only the direct effects of thechange and the related income tax effects, if any. The retrospective application should not include any indirecteffects that would have been recognized if the new principle had been used in previous periods. Indirect effects ofthe change that are actually incurred and recognized should be reported in the period the change is made. Anexample of an indirect effect is a change in a nondiscretionary profit�sharing contribution that is based on netincome.


97

SELF�STUDY QUIZ


39. All Pro needs to report a change in the salvage value of its production equipment. In what periods should thechange be reported?

a. All Pro will restate prior period financial statements.

b. All Pro would present pro forma prior period amounts.

c. All Pro will make a retrospective adjustment.

d. All Pro will report the change in the current and subsequent periods.

40. Which of the following is considered a change in accounting principle?

a. A change in the method of applying an acceptable accounting principle.

b. A change to an acceptable principle from an unacceptable principle.

c. Initial adoption of a new accounting principle for new transactions.

d. A modification of an accounting principle due to substantially different events.


98



39. All Pro needs to report a change in the salvage value of its production equipment. In what periods should thechange be reported? (Page 95)

a. All Pro will restate prior period financial statements. [This answer is incorrect. Restatement of amountsreported in prior period financial statements is not permitted for a change in accounting estimate.]

b. All Pro would present pro forma prior period amounts. [This answer is incorrect. The presentation of proforma prior period amounts is not permitted for a change in an accounting estimate.]

c. All Pro will make a retrospective adjustment. [This answer is incorrect. A change in an accounting methodis not reported my making a retrospective adjustment of amounts in prior period financial statements. Infact, retrospective adjustments are not permitted.]

d. All Pro will report the change in the current and subsequent periods. [This answer is correct. Theeffects of changes in estimates should be reported in the period of change and subsequent periods.Examples of accounting estimates that periodically change are allowances for bad debts, usefullives or salvage values of depreciable assets, and inventory obsolescence.]

40. Which of the following is considered a change in accounting principle? (Page 95)

a. A change in the method of applying an acceptable accounting principle. [This answer is correct. Achange in accounting principle is generally defined as a change from one acceptable principle toanother or a change in the method of applying an acceptable accounting principle.]

b. A change to an acceptable principle from an unacceptable principle. [This answer is incorrect. A changefrom an unacceptable principle to an acceptable principle is a correction of an error and not a change inaccounting principle as defined by GAAP.]

c. Initial adoption of a new accounting principle for new transactions. [This answer is incorrect. The initialadoption of a new accounting principle for new events or transactions or for material events or transactionsthat were previously immaterial is not considered to be accounting changes for the purpose of applyingthe guidance.]

d. A modification of an accounting principle due to substantially different events. [This answer is incorrect.An adoption or modification of an accounting principle due to substantially different events or transactionsthan those previously occurring is not considered to be an accounting change for the purpose of applyingthe guidance.]


99


Lesson 3 (PFSTG091)


39. Which of the following is not an accounting change?

a. An error correction.

b. An accounting estimate change.

c. A change in the reporting entity.

d. Accounting principle changes.

40. Which of the following is not one of the required steps to retrospectively apply a new accounting principle?

a. Reflect the period�specific effects of applying the new accounting principle by adjusting the financialstatements for each individual prior period presented.

b. Determine and apply the cumulative effect of the change to the beginning of the first period presented.

c. Adjust the opening balance of retained earnings, if necessary, for the first period presented.

d. Determine and apply any indirect effects of the change to the beginning of the first period presented.


100


101

GLOSSARY

Current Assets: Cash and other assets that are reasonably expected to be realized in cash or sold or consumedduring one year or within the company's normal operating cycle if it is longer than a year.

Current Liabilities: Obligations whose liquidation is reasonably expected to require the use of current assets or thecreation of other current liabilities.

Operating Cycle: The time needed to convert cash first into materials and services, then into products, then by saleinto receivables, and finally by collection back into cash.

Short�term Debt: Debt payable within 12 months, it includes the current portion of the long�term debt.

Accrued Liabilities: Estimates of the obligation for expenses that have been incurred but for which no billing hasbeen received. .

Claims�made Insurance Policy: Cover only those asserted claims and incidents that are reported to the insurancecarrier while the policy is in effect. Thus, a claims�made policy does not represent a transfer of risk for claims andincidents that have been incurred but not reported to the insurance carrier.

Debt Covenant: Part of the conditions of a loan agreement, these covenants are the promises by the managementof the borrowing firm to adhere to certain limits in the firm's operations. For example, not to allow certain balancesheet items or ratios to fall below or go over an agreed upon limit.

Demand Loan: a loan payable upon the demand of the lender.

Deferred Income Tax Asset: A deferred tax asset is recognized for temporary differences that will result in deductibleamounts in future years and for carryforwards.

Deferred Income Tax Liability: Excess of income tax amount shown on an income statement over the actual taxamount, which occurs when book�income exceeds taxable income. This excess is recognized as a liability in thetaxpayer's balance sheet, and is written off in the following accounting period.

Long�term Debt: Amount owed for a period exceeding 12 months from the date of the balance sheet. It could bein the form of a bank loan, mortgage bonds, debenture, or other obligations not due for one year. A firm must discloseits long�term debt in its balance sheet with its interest rate and date of maturity. Amount of long�term debt is a measureof a firm's leverage, and is distinguished from long term liabilities which may include supply of services already paidfor.

Secured Borrowings: Loan agreement under which a borrower pledges a specific asset or property which thelender can seize in case of default.

Share�based Payment: A transaction in which an entity issues equity instruments, share options or incurs a liabilityto pay cash based on the price of the entity's equity instruments to another party as compensation for goods receivedor services rendered.

Stock Dividends: Generally, an actual or constructive distribution of stock to a corporation's shareholders.

Stock Splits: Division of already issued (outstanding) shares of a firm into a larger number of shares, to make themmore affordable and thus improve their marketability while maintaining the current stockholders' proportionalownership of the firm. The aggregate value of the shares remains the same as before the split, but the price (anddividend) per share declines with the split ratio. For example, if the shares are split by a multiple of two (2:1 split),a share with a par value of $10 becomes two shares, each with a par value of $5.


102


103

INDEX

A

ACCOUNTING CHANGE� Change in accounting principle 95. . . . . . . . . . . . . . . . . . . . . . . . . � Change in basis of accounting 87. . . . . . . . . . . . . . . . . . . . . . . . . . � Change in classification 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in estimate 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in estimate effected by a change in accounting

principle 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in principle

�� From unacceptable method to GAAP 87, 95. . . . . . . . . . . . . . �� Justifying changes 96. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Required by new pronouncements 96. . . . . . . . . . . . . . . . . . .

� Change in reporting entity 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Correction of an error 87, 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Retrospective application 96. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ACCOUNTS PAYABLE� Captions 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Composition 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cutoff 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Debit balance 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Discounts 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unrecorded amounts 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

AGENCY TRANSACTIONS� Balance sheet presentations 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

AMORTIZATION� Interest method 44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Rule of 78s method 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B

BALANCE SHEET� Authoritative basis 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Basic financial statement 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Offsetting assets and liabilities 36. . . . . . . . . . . . . . . . . . . . . . . . . . � Operating cycle 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

BUSINESS COMBINATIONS� Purchased loss carryforwards 87. . . . . . . . . . . . . . . . . . . . . . . . . . .

C

CAPTIONS� Accounts payable 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Accrued liability 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Accumulated other comprehensive income 88. . . . . . . . . . . . . . . � Common stock 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Debt issue costs 52. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deferred revenues 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes 34. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Retained earnings 85. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term debt 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stockholders' equity, negative 79. . . . . . . . . . . . . . . . . . . . . . . . . .

CASH VALUE OF LIFE INSURANCE� Imputed interest 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COMPREHENSIVE INCOME� Accumulated other comprehensive income 79, 88. . . . . . . . . . . .

CONTINGENCIES AND COMMITMENTS� Accounting treatment 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Claims�made insurance policies 8. . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax audit adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . � Restrictions on retained earnings 85. . . . . . . . . . . . . . . . . . . . . . . .

COSTS TO RETIRE LONG�LIVED ASSETS 60. . . . . . . . . . . . . . . .

CUTOFF� Accounts payable 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

D

DEFERRED CHARGES� Debt issue costs

�� Amortization 52. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock issue costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Syndication costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DEPRECIATION� Change in estimated useful life 95. . . . . . . . . . . . . . . . . . . . . . . . . . � Change in method planned 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DISCLOSURES� Additional paid�in capital 84. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Changes in retained earnings 90. . . . . . . . . . . . . . . . . . . . . . . . . . . � Changes in stockholders' equity 90. . . . . . . . . . . . . . . . . . . . . . . . . � Common stock 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes

�� Tax adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Preferred stock 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

E

ENVIRONMENTAL REMEDIATION COSTS� Accrual under SOP 96�1

�� Allocating shared costs 59. . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Claims for recovery 59. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Determining when to accrue a liability 57. . . . . . . . . . . . . . . . . �� Effect of changes in laws and regulations 59. . . . . . . . . . . . . . �� Estimating environmental remediation costs 58. . . . . . . . . . . �� Productivity improvements 59. . . . . . . . . . . . . . . . . . . . . . . . . . �� Technology improvements 59. . . . . . . . . . . . . . . . . . . . . . . . . . �� Use of discounting 59. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Authoritative literature 56. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Effect on property impairment 60. . . . . . . . . . . . . . . . . . . . . . . . . . . � Federal environmental laws 55. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ERRORS, CORRECTION OF 87, 95. . . . . . . . . . . . . . . . . . . . . . . . . .

G

GUARANTEES� Accounting treatment 61. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimating fair value of obligation 62. . . . . . . . . . . . . . . . . . . . . . . . � Measurement considerations 63. . . . . . . . . . . . . . . . . . . . . . . . . . . � Product warranties 62. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Related party debt 62. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

I

INCOME TAXES� Audit adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 34. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deferred, liability method

�� Classification as current or noncurrent liability 32. . . . . . . . . . � Disclosures

�� Tax adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Purchased loss carryforward 87. . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Debt extinguishment 50. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Imputed interest 50. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTEREST� Effective rate 45. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Imputing 45. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Incremental borrowing rate 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interest method 44, 45. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Rule of 78s 45, 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unamortized 49, 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


104

L

LEASES� Incremental borrowing rate 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIABILITIES� Accounts payable 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Accrued liabilities

�� Accounting treatment 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Agency obligations 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Balance sheet presentation 9. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Compensation and payroll taxes 7. . . . . . . . . . . . . . . . . . . . . . �� Composition 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Retirement plan contributions 8. . . . . . . . . . . . . . . . . . . . . . . . . �� Vacation and sick pay 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Buy�out agreements 47. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Classification as current or long�term 3, 9. . . . . . . . . . . . . . . . . . . . � Components of current liabilities 3. . . . . . . . . . . . . . . . . . . . . . . . . � Costs to retire long�lived assets 60. . . . . . . . . . . . . . . . . . . . . . . . . � Dividends 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Environmental contingencies 55. . . . . . . . . . . . . . . . . . . . . . . . . . . � Extinguishments 53. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes payable

�� Balance sheet presentation 34. . . . . . . . . . . . . . . . . . . . . . . . . . �� Deferred 32. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Offsetting assets against liabilities 36. . . . . . . . . . . . . . . . . . . .

� Long�term debt�� Acceleration clauses 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Balance sheet presentation 55. . . . . . . . . . . . . . . . . . . . . . . . . . �� Changes in debt terms 47. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Credit line or revolving debt arrangements 50. . . . . . . . . . . . . �� Current maturities 44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Effective interest rate 44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Income tax considerations 50. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Installment loans 51. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� In�substance defeasance 54. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Issue costs 52. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Postemployment benefits 7. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Secured borrowings 54. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term debt

�� Balance sheet presentation 4. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Bridge loans 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Callable by the creditor 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Captions 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Demand notes 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Expected to be refinanced 10. . . . . . . . . . . . . . . . . . . . . . . . . .

� Unrecorded 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Violation of covenants 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Subjective acceleration clauses 12. . . . . . . . . . . . . . . . . . . . . .

M

MATERIALITY� Vacation pay 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

N

NONMONETARY TRANSACTIONS� Property dividends 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

O

OPERATING CYCLE 3, 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

OTHER COMPREHENSIVE BASIS OF ACCOUNTING� Change in basis of accounting 87, 95. . . . . . . . . . . . . . . . . . . . . . .

P

PARTNERSHIPS� Syndication costs 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PENSION PLANS� Accrued liabilities 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PREPAID EXPENSES� Retirement plan expense 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PRIOR�PERIOD ADJUSTMENTS� Defined 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Errors 87, 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax audit adjustments 87. . . . . . . . . . . . . . . . . . . . . . . . . . . � Purchased loss carryforwards 87. . . . . . . . . . . . . . . . . . . . . . . . . . .

PROPERTY AND EQUIPMENT� Contributed assets 84. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

R

RECEIVABLES� Allowance for doubtful accounts 95. . . . . . . . . . . . . . . . . . . . . . . . . � Debit balances in accounts payable 4. . . . . . . . . . . . . . . . . . . . . . . � Discounting 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interest, imputed 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Related party 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock subscriptions 84. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Uncollectible accounts 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RELATED PARTY TRANSACTIONS� Receivables 46. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RETAINED EARNINGS� Adjustment for accounting changed 87. . . . . . . . . . . . . . . . . . . . . � Captions 85. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Changes in 86, 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Dividends

�� Cash 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Property 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stock 86. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stock splits 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Reorganization costs 89. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Restrictions 85. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

REVENUE� Deferred 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

S

STATEMENT OF RETAINED EARNINGS� Combined with income statement 85. . . . . . . . . . . . . . . . . . . . . . . � Separate statement 85. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

STOCKHOLDERS' EQUITY� Accumulated other comprehensive income 88. . . . . . . . . . . . . . . � Additional paid�in capital 84, 89, 90. . . . . . . . . . . . . . . . . . . . . . . . � Captions 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Common stock 79, 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosure of changes 80, 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Forgiveness of related party debt 85. . . . . . . . . . . . . . . . . . . . . . . . � Negative balances 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Order of presentation 79. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Preferred stock 79, 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Reorganization costs 89. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock issue costs 89. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock option plans

�� Nonemployees 82. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock redemptions 47, 88. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Subscriptions receivable 84. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Treasury stock 47, 88. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

SUBSEQUENT EVENTS� Covenant violations 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock splits 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


105


COURSE 2

ACCOUNTING FOR CERTAIN TAX TRANSACTIONS (PFSTG092)

OVERVIEW

COURSE DESCRIPTION: This interactive self�study course provides guidance regarding the accounting forvarious tax transactions. Lesson one briefly covers FIN 48, �Accounting forUncertainty in Income Taxes�an Interpretation of FASB Statement No. 109" andaccounts for the change of accounting method or period, asset capitalization andvaluation, investments in partnerships, and property and equipment transactions.Lesson two discusses the accounting of stock redemptions and relatedtransactions, partnerships, limited liability companies, changes in tax status,transactions with owners, leasing transactions, and miscellaneous other taxtransactions.

PUBLICATION/REVISIONDATE:

November 2009


PREREQUISITE/ADVANCEPREPARATION:

Basic knowledge of financial statements and tax transactions.







Lesson 1Selected Topics Part 1

Completion of this lesson will enable you to:� Determine the effect of tax positions and changes in the treatment of a material item or period on the financial

statements.� Identify various income tax and legal transactions and how they might affect the financial statements.� Determine how to record income tax transactions involving the entity's assets on the financial statements.

Lesson 2Selected Topics Part 2

Completion of this lesson will enable you to:� Determine the income tax and accounting treatment for transactions involving ownership of the entity or various

other transactions.� Calculate adjustments and equity balances for ownership transactions and revenue recognition for lease

transactions for tax and financial reporting.


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Lesson 1:�Selected Topics Part 1

INTRODUCTION

Certain transactions of closely held businesses are first identified because of their income tax significance. Thiscourse provides a bridge to help accountants present specific �tax transactions" in financial statements in confor�mity with GAAP.


Completion of this lesson will enable you to:� Determine the effect of tax positions and changes in the treatment of a material item or period on the financial

statements.� Identify various income tax and legal transactions and how they might affect the financial statements.� Determine how to record income tax transactions involving the entity's assets on the financial statements.

A TAXING AUTHORITY'S EXAMINATION

FASB ASC 740 (formerly FIN 48, �Accounting for Uncertainty in Income Taxesan Interpretation of FASB StatementNo. 109") generally permits recognizing current income tax benefits only if it is more likely than not that theunderlying tax position would be sustained if the taxing authority examined it. A current tax benefit that has beenrealized through a deduction in a tax return but does not meet the �more likely than not" criterion should bedeferred. The liability represents the additional income tax that would be assessed if the position is not sustainedupon examination by the taxing authority.

If the realized tax benefit of taking a position was previously deferred, FASB ASC 740�10�25�9 (formerly FSP FIN48�1, �Definition of Settlement in FASB Interpretation No. 48") notes that the liability for the deferral should beeliminated, or derecognized, when the �tax position is effectively settled through examination, negotiation, orlitigation" and that when deciding whether the position is effectively settled, the entity should consider the following:

a. Has the taxing authority completed its examination procedures?

b. Does the entity intend to appeal or litigate any aspect of the tax position included in the completedexamination?

c. Is there only a remote chance the taxing authority would examine or reexamine any aspect of the taxposition?

Following the guidance in the FSP

a. If the tax position was taken in a year for which the return, but not the position, was examined, the positionfor that year may be considered effectively settled.

b. If the tax position was taken in two or more years, examination and acceptance of the position taken in oneyear does not result in effective settlement for the years that are still subject to examination.

c. An examination may provide additional information that causes the entity to change its assessment of themerits of the position or similar tax positions taken in years that are still subject to examination.

Conceptually, if the reporting entity has deferred the realized tax benefit of taking a tax position, the additionalincome tax assessed for the subsequent disallowance of the position will have no effect on earnings. Instead,payment of the assessment will be recorded through a debit to the liability for the previously deferred tax benefitand a credit to cash.

If the realized tax benefit of taking a position has been recognized, the assessment of additional income tax for thesubsequent disallowance of the position should be charged to the current provision for the year. Disallowance of a


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position does not mean that the assessment of whether the position met the �more likely than not" criterion waswrong. Meeting that criterion requires an assessment of risk and means there is still up to a 49% chance theposition will be disallowed.

The subsequent disallowance of a position for a year may also provide new information that indicates the pre�viously recognized tax benefit from taking the position or similar positions in years still subject to examinationshould be derecognized. The tax benefit derecognized should be recorded through a charge to the current taxprovision for the year and a credit to a liability for the deferral of the tax benefit previously recognized.

Effective Date and September 2009 Amendments

FIN 48, which has been included in the Codification in FASB ASC 740�10, was issued in June 2006 and waseffective originally for fiscal years beginning after December 15, 2006. However, FASB ASC 740�10�65�1 (formerlyParagraphs 9 and 11 of FSP FIN 48�3, Effective Date of FASB Interpretation No. 48 for Certain Nonpublic Enter�prises) permits nonpublic entities to defer application of the guidance until annual periods beginning after Decem�ber 15, 2008.

In September 2009 Accounting Standards Update (ASU) No. 2009�06, Implementation Guidance on Accounting forUncertainty in Income Taxes and Disclosure Amendments for Nonpublic Entities, was issued and appears in theCodification in various parts of FASB ASC 740�10. The effective date of ASU No. 2009�06 varies depending onwhether the application of the original guidance has been deferred:

a. For entities that have adopted the requirements of FASB ASC 740�10 (formerly FIN 48), the guidance in ASUNo. 2009�06 is effective for periods ending after September 15, 2009.

b. For entities that have deferred adopting the requirements of FASB ASC 740�10 (formerly FIN 48), theguidance in ASU No. 2009�06 is effective when FIN 48 is adopted.

Guidance in ASU No. 2009�06 is clarifying, rather than changing, the original guidance.

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

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

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

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

ASU No. 2009�06 also clarifies that

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

b. management's determination of the taxable status of the entity, including its status as a pass�through entityor tax�exempt not�for�profit entity, is a tax position that is subject to the requirements of FASB ASC 740�10(formerly FIN 48).

To illustrate the accounting considerations, assume that a corporation that has elected Subchapter S status takesthe position that it does not have nexus with a state that does not recognize that election. The corporation shouldevaluate whether the position would more likely than not be sustained by the state in an examination. Thatevaluation should consider the positions taken by the state in applying nexus requirements, such as how manyyears are considered open if tax would be assessed retrospectively and whether the state has adopted thresholdsof taxable income attributable to the state below which it will not assert nexus.


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As a practical matter, the entity should also consider the materiality of the effects of the position being denied. Forexample, reallocation of taxable income to the state may enable the entity to reduce taxable income originallyallocated to other states, resulting in recovery of state income taxes paid.

Finally, ASU No. 2009�06 clarifies that the reporting entity must consider the tax positions of all entities within thegroup of entities whose financial results are presented in consolidated or combined financial statements. Toillustrate the accounting considerations, assume that a limited liability company has a controlling financial interestin a corporation that has not elected Subchapter S status. Since the limited liability company has a controllingfinancial interest in the corporation, it must include the consolidated financial results of the corporation in itsfinancial statements. The tax positions taken by the corporation are subject to the requirements of FASB ASC740�10 in determining whether income taxes for the corporation should be recognized in the consolidated financialstatements.

ASU No. 2009�06 exempts nonpublic entities from two of the original uncertainty in income taxes disclosurerequirements:

a. the requirement to provide a tabular reconciliation of the total amount of unrecognized tax benefits at thebeginning and end of the years presented, and

b. the requirement to disclose the total amount of unrecognized tax benefits that, if recognized, would affectthe effective tax rate.

CHANGES IN ACCOUNTING METHOD OR PERIOD

General

Changes in accounting methods for tax purposes may be made subject to certain IRS regulations (generallyrequiring approval by the Commissioner). A change in accounting methods may involve a change in the treatmentof any material item, e.g., FIFO to LIFO basis of valuing inventories, or a change in the overall basis of accounting,e.g., cash to accrual basis for a small corporation. This section discusses certain changes in a company'saccounting method and accounting period.

Change in the Treatment of a Material Item

A change in the accounting treatment of a material item for tax purposes generally would have the following effectson the company's financial statements:

� If the change is from the method used for financial reporting purposes to a different method, temporarydifferences would be created and deferred taxes would usually be recognized.

� If the change is to the method used for financial reporting purposes, previous temporary differences anddeferred taxes related to the item will reverse (sometimes in the year of change, sometimes over aprescribed period).

� If the change is from the method currently used for financial reporting purposes to another methodacceptable under GAAP and the company also decides to adopt the new method for financial reportingpurposes, financial reporting should follow generally accepted accounting principles for a change inaccounting principle. Under FASB ASC 250�10�45�5 and 45�12 (formerly SFAS No. 154), a change inaccounting principle generally is reported retrospectively through an adjustment of retained earnings, andthe change must be justifiable on the basis that it is preferable.

� If the company uses the tax basis for financial reporting purposes, record the adjustment as a deferred itemand amortizing it to earnings as it is charged to taxable income.


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Cash to Accrual and Other Changes in the Basis of Accounting

Changes in the basis of accounting generally are made for both the tax return and the financial statements. Theeffects of those changes on the financial statements are discussed in PPC's Guide to Preparing Financial State�

ments.

a. Change from OCBOA to GAAP

b. Change from GAAP to OCBOA

c. Change in accounting principle in tax basis financial statements

However, changes in the basis of accounting sometimes are made for the tax return only to conform the accountingmethod used for tax purposes with the method used for financial reporting purposes. Those changes only affect theamount of deferred taxes reported in the financial statements.

Changes in Fiscal Year

A taxpayer may, with the permission of the Commissioner of the Internal Revenue Service, change the accountingperiod, e.g., from a December 31 year end to a July 31 year end. The IRS also requires taxpayers to change theirfiscal year in certain circumstances, e.g., a corporation electing S corporation status is required to change to aDecember 31 year end unless it can show that the fiscal year is its natural business year (or the same tax year asthat of shareholders who own more than 50% of its shares) or it pays a deposit. A change in fiscal year requires ashort year (less than 12 months) tax return.

Almost universally, companies also change their fiscal year for financial reporting purposes when a change in taxyear is adopted. Thus, the financial statements of the year of change would cover less than twelve months. NeitherFASB ASC 250 (formerly SFAS No. 154, Accounting Changes and Error Corrections) nor other authoritativepronouncements discuss a change in a company's fiscal year.

A nonauthoritative technical practice aid at TIS 1800.03 indicates that, generally, the change should be disclosedin the current period to make the statements more meaningful. The TPA is interpreted to suggest that in disclosingthe change in the fiscal year, the notes to the financial statements should state whether the effect was to decreasenet income or increase net income, e.g., if, as a result of seasonal differences, the company normally experienceslosses during the months not included in the current period. If the effect is measurable, i.e., the net income for themonths excluded is known, the amount should be disclosed. It is believed that disclosures should be madewhenever the year of change is presented, e.g., in comparative financial statements. The short�year financialstatements may be presented in comparative form with complete years so long as the change in fiscal year isdisclosed, and the financial statements are appropriately captioned such as illustrated below.

� ABC COMPANYBALANCE SHEETSDecember 31, 20X2 and June 30, 20X2

December 31,20X2

June 30,20X2

� ABC COMPANYSTATEMENTS OF INCOMESix Months Ended December 31, 20X2�and Year Ended June 30, 20X2

Six Months EndedDecember 31,

20X2

Year EndedJune 30,

20X2


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The following illustrates disclosing the change in the notes:

NOTE BFISCAL YEAR CHANGE

Effective the calendar year beginning January 1, 20X3, the Company will change from a fiscalyear end of June 30 to December 31. A six�month fiscal transition period from July 1, 20X2through December 31, 20X2, precedes the start of the new calendar�year cycle.

Changes in Depreciable Lives of Assets or the Methods of Depreciation

Changes in the depreciable lives of assets or the methods of depreciation for income tax purposes usually onlyoccur prospectively, with changes in the accelerated depreciation rules for future asset acquisitions. Under FASBASC 250�10�45�17 through 45�19 (formerly SFAS No. 154):

a. The adoption of a depreciation method and the estimate of useful life for a newly acquired asset is not anaccounting change. However, as a practical matter, the adoption of a depreciation method or estimate ofuseful life for newly acquired assets that is different than that of similar existing assets should lead toconsideration of whether the method or estimate of useful life continues to be appropriate for those existingassets.

b. A change in the method of depreciating existing assets is a change in accounting estimate that is effectedby a change in accounting principle. Accordingly, that change should be accounted for prospectively. Asan observation, FASB ASC 250�10�45�20 (formerly SFAS No. 154) does not view a planned change froman accelerated method to the straight�line method at a prescribed point in the estimated useful life of anasset as a change in accounting principle or a change in estimate.


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SELF�STUDY QUIZ


1. According to FASB ASC 740 (formerly FIN 48, �Accounting for Uncertainty in Income Taxes�an Interpretationof FASB Statement No. 109"), when would a current tax benefit that is realized through a deduction in a taxreturn be recognized in the financial statements?

a. Only after the taxing authority examined and approved the deduction.

b. During the same reporting period that the tax benefit is realized in the tax return.

c. When it meets the �more likely than not" criterion.

2. A taxing authority recently examined Ace Corporation's tax return and disallowed a deduction in the returnwhich Ace had determined would be allowed. What action must Ace now take in regard to its financialreporting?

a. Ace will pay the additional tax assessed and debit the liability account for the previously deferred taxbenefit.

b. Ace will pay the additional tax assessed and debit the current tax provision for the current year.

c. Ace will debit the current tax provision and credit a liability for the deferred tax benefit.

d. Ace would not need to take any action since it did not defer the realized tax benefit.

3. Rodeo Right, Inc. decided in 2006 to defer the adopting of FIN 48. As of January 1, 2009, they still have notadopted the guidance. Are they required to adopt ASU No. 2009�06 in 2009?

a. Yes.

b. No.

4. Which of the following changes in the accounting treatment of a material item for tax purposes results in areversal of previous temporary differences and deferred taxes related to that item on the financial statements?

a. When the change for tax purposes is to the method used for financial reporting purposes.

b. When the company uses the tax basis for financial reporting purposes.

c. When the company changes to a different method from the method used for financial reporting purposes.

5. Which of the following choices is considered a change in accounting principle or change in estimate?

a. Arbor Creek Company changes from the double declining depreciation method to the straight�line methodat a certain point in the estimated useful lives of the assets.

b. Arbor Creek Company purchases a new piece of equipment and adopts a depreciation method for the newpiece of equipment that is different than that of similar existing assets.

c. Arbor Creek Company uses a new method of estimating the useful life of an asset when it acquires the newasset.

d. Arbor Creek Company changed the method in which it depreciates its existing assets.


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1. According to FASB ASC 740 (formerly FIN 48, �Accounting for Uncertainty in Income Taxes�an Interpretationof FASB Statement No. 109"), when would a current tax benefit that is realized through a deduction in a taxreturn be recognized in the financial statements? (Page 107)

a. Only after the taxing authority examined and approved the deduction. [This answer is incorrect. If a taxposition is positively settled through examination, it is allowed to be recognized in the financial statements.However, FASB ASC 740 provides a guideline, which if met, allows the expense to be recognized in thefinancial statements before it is examined by the taxing authority, because not all tax positions taken byentities are actually examined by taxing authorities.]

b. During the same reporting period that the tax benefit is realized in the tax return. [This answer is incorrect.Not all current tax benefits realized in a tax return are recognized during the same period in the financialstatements. The recognition in the financial statements may be deferred. Therefore, a tax liability may berecorded in the financial statements for those tax positions that do not meet the criteria in FASB ASC 740.]

c. When it meets the �more likely than not" criterion. [This answer is correct. When evaluating whethera tax position taken on the current tax return meets the FASB ASC 740 criterion, the tax positionshould be examined to determine if would be sustained if the taxing authority examined it. If thecriterion is met, it would be recognized in the financial statements.]

2. A taxing authority recently examined Ace Corporation's tax return and disallowed a deduction in the returnwhich Ace had determined would be allowed. What action must Ace now take in regard to its financialreporting? (Page 107)

a. Ace will pay the additional tax assessed and debit the liability account for the previously deferred taxbenefit. [This answer is incorrect. Since Ace had determined that the deduction would �more likely thannot" be sustained upon examination, the entity did not defer the realized tax benefit. This answer choicewould be correct if Ace had deferred the realized tax benefit.]

b. Ace will pay the additional tax assessed and debit the current tax provision for the current year. [Thisanswer is correct. Ace owes tax on the disallowed deduction. Since the entity realized the deductionon its financial statements, the disallowance will affect earnings. The entity will credit cash and debitthe current tax provision for the current year.]

c. Ace will debit the current tax provision and credit a liability for the deferred tax benefit. [This answer isincorrect. This answer choice would be correct if Ace had deferred a position or similar positions in yearsstill subject to examination and decided the previously recognized tax benefit should be derecognized.]

d. Ace would not need to take any action since it did not defer the realized tax benefit. [This answer isincorrect. Ace did not defer the realized tax benefit, but the entity would still have to take action for thedisallowance of the deduction which would include payment of the tax assessment.]

3. Rodeo Right, Inc. decided in 2006 to defer the adopting of FIN 48. As of January 1, 2009, they still have notadopted the guidance. Are they required to adopt ASU No. 2009�06 in 2009? (Page 108)

a. Yes. [This answer is incorrect. Since Rodeo Rights, Inc. has not adopted FIN 48 (FASB ASC 740�10), thenthey are not required to apply the guidance in ASU No. 2009�06. If they had chosen early adoption of FIN48 (FASB ASC 740�10), then they would have been required to apply ASU No. 2009�06 effective for allperiods ending after September 15, 2009.]


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b. No. [This answer is correct. For entities that have deferred adopting the requirements of FIN 48(FASB ASC 740�10), the guidance in ASU No. 2009�06 is effective when the company adopts FIN 48.Since Rodeo Rights, Inc. has not applied the guidance, they are not required to adopt ASU no.2009�06.]

4. Which of the following changes in the accounting treatment of a material item for tax purposes results in areversal of previous temporary differences and deferred taxes related to that item on the financial statements?(Page 109)

a. When the change for tax purposes is to the method used for financial reporting purposes. [Thisanswer is correct. When a company changes the accounting treatment of a material item for taxpurposes to the method used for financial reporting purposes, the previous temporary differencesand deferred taxes related to the item will reverse. Sometimes the reversal occurs in the year ofchange, and other times it occurs over a prescribed period. General guidance can be found in FASBASC 250�10�45�5 and 45�12.]

b. When the company uses the tax basis for financial reporting purposes. [This answer is incorrect. When thecompany uses the tax basis for financial reporting purposes, the recommendation is to record anadjustment as a deferred item and amortize it to earnings as it is charged to taxable income.]

c. When the company changes to a different method from the method used for financial reporting purposes.[This answer is incorrect. If the company changes the accounting treatment of a material item for taxpurposes from the method used for financial reporting purposes to a different method, temporarydifferences would be created and deferred taxes would usually be recognized.]

5. Which of the following choices is considered a change in accounting principle or change in estimate?(Page 111)

a. Arbor Creek Company changes from the double declining depreciation method to the straight�line methodat a certain point in the estimated useful lives of the assets. [This answer is incorrect. SFAS No. 154 doesnot view a planned change from an accelerated method to the straight�line method at a prescribed pointin the estimated useful life of an asset as a change in accounting principle or a change in estimate.]

b. Arbor Creek Company purchases a new piece of equipment and adopts a depreciation method for the newpiece of equipment that is different than that of similar existing assets. [This answer is incorrect. Accordingto FASB ASC 250�10�45�17 and 45�19, the adoption of a depreciation method for a newly acquired assetis not an accounting change.]

c. Arbor Creek Company uses a new method of estimating the useful life of an asset when it acquires the newasset. [This answer is incorrect. The adoption of the estimate of useful life for a newly acquired asset is notan accounting change according to FASB ASC 250�10�45 and 45�19. However, the adoption of an estimateof useful life for newly acquired assets that is different than that of similar existing assets should lead toconsideration of whether the method or estimate of useful life continues to be appropriate for those existingassets.]

d. Arbor Creek Company changed the method in which it depreciates its existing assets. [This answeris correct. If a company changes the method of depreciating existing assets, it is considered achange in accounting estimate that is effected by a change in accounting principle according toFASB ASC 250�10�45 and 45�19. That change should be accounted for prospectively.]


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THE CAPITALIZATION OF ASSETS AND CONSIDERATIONS REGARDINGVALUATION

Inventory Costs for Manufacturers, Wholesalers, and Retailers

Prior to the Tax Reform Act of 1986 (TRA), manufacturers were required to capitalize direct material and labor andcertain indirect production costs for tax reporting. The capitalization of indirect production costs was determinedaccording to three categories: category one costs were required to be included in inventory, category two costswere not required to be included in inventory, and category three costs were required to follow the treatment infinancial statements prepared in conformity with GAAP. TRA affects category three by requiring most of those coststo be capitalized regardless of their financial statement treatment. The following are examples of category threecosts that were often expensed in the financial statements and tax returns prior to TRA but are now required to becapitalized for tax reporting:

a. Warehousing costs such as rent or depreciation, insurance premiums, and property taxes attributable toa warehouse

b. Cost of recruiting, hiring, relocating, assigning, and maintaining personnel records of employees whoselabor costs are allocable to inventories

c. Accounting and data services operations related to inventory activities, including cost accounting andaccounts payable

But perhaps the most dramatic changes in inventory capitalization rules are the TRA requirements for certainwholesalers and retailers. Prior to TRA, wholesalers and retailers normally only capitalized as inventory costs theinvoice price and transportation and other direct costs incurred in acquiring the goods. Under TRA, wholesalersand retailers with average annual gross receipts over $10 million are required to capitalize indirect costs similar tothe category three indirect costs for manufacturers. Therefore, they are required to capitalize costs such as thefollowing:

a. Costs incidental to the purchasing activity (such as wages of employees responsible for purchasing)

b. Handling, processing, repackaging, assembly, and similar costs, including labor costs attributable tounloading goods and loading goods for shipment to retail facilities (but not including labor costsattributable to loading of goods for final shipment to customers)

c. Cost of storing goods (for example, rent or depreciation, insurance premiums and taxes attributable to thewarehouse, security costs, and wages of warehouse personnel)

d. The portion of general and administrative costs allocable to the preceding functions (which are generallythe same as items b. and c. in the preceding list)

The FASB's Emerging Issues Task Force (EITF) studied whether the types of costs that are required to be allocatedto inventories under TRA would be capitalizable under GAAP and, if so, whether the new costing method would bea preferable method for purposes of justifying a change in accounting principle. In FASB ASC 330�10�55�3 (formerlyIssue No. 86�46), the EITF concluded that a cost capitalizable for tax purposes does not, in itself, indicate that it ispreferable, or even appropriate, to capitalize that cost for financial reporting purposes. Factors such as the natureof the company's operation and industry practice should be considered in determining whether certain of theadditional costs required to be capitalized for tax purposes also may be capitalized for financial reporting purposes.A conclusion about whether the TRA rules meet GAAP capitalization requirements for a company requires anassessment of whether they are met because of a change in circumstances, e.g., a change in the productionprocess, or because generally accepted accounting principles were applied incorrectly in prior periods. A changein circumstances would be accounted for prospectively and would not require adjustment of beginning inventories,but a correction of an error, if material, would require beginning inventories to be adjusted through a restatement ofretained earnings. It is not believed that a change in tax law is a change in circumstances for GAAP reporting andit will be difficult to identify a change in circumstance that justifies a change in accounting for the types of costs


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covered by TRA's requirements. In addition, it is believed that a conclusion that the types of costs covered by TRAshould have been capitalized in prior GAAP financial statements requires consideration of whether they should alsohave been capitalized for tax reporting, particularly for category three costs of manufacturers.

A nonauthoritative AICPA technical practice aid at TIS 2140.01 provides guidance on capitalized warehousingcosts. Part of the TPA is reproduced below.

InquiryA client deals in wholesaling and retailing automotive tires for foreign cars. Most of theinventory is imported, and it is valued on the company's records at the actual inventory cost plusfreight�in. At year�end, the warehousing costs are prorated over costs of goods sold and endinginventory. The company's auditor believes the warehousing costs should not be capitalized toinventory, but the entire amount should be expensed in the year the costs are incurred. Arewarehousing costs considered to be product costs or period costs?

ReplyFASB ASC 330�10�30�1 (formerly Statement 3 of Chapter 4, ARB No. 43) states in part:

As applied to inventories, cost means in principle the sum of the applicable expenditures andcharges directly or indirectly incurred in bringing an article to its existing condition and location.

Costs of delivering the goods from the warehouse would be considered a selling expense andshould not be allocated to the goods that are still in the warehouse.

The TPA also quotes an accounting textbook that states it would seem reasonable to allocate to inventories a shareof storage and warehousing costs. However, the quote states that such costs usually are not included in valuinginventories due to the practical difficulties in allocating such costs. Following the guidance in FASB ASC330�10�30�8 (formerly ARB No. 43), it is believed that general and administrative expenses such as accounting anddata processing services and officers' salaries related to selling, general, and administrative functions ordinarilyshould not be capitalized as inventory costs for financial reporting.

Construction Period Interest and Real Estate Taxes

Current tax requirements for capitalizing construction period interest and real estate taxes, as summarized below,generally conform with the GAAP requirements:

� Tax law requires capitalizing construction period interest and real estate taxes for real property, tangiblepersonal property with an estimated life of more than 20 years, other tangible personal property requiringtwo or more years to produce or construct, and tangible personal property that has a value in excess of$1 million and requires more than one year to produce or construct. Those types of assets would generallyqualify for similar treatment under GAAP.

� Interest to be capitalized includes costs incurred on debt both directly and indirectly attributable toconstruction or production, which generally is consistent with the GAAP requirement to capitalize intereston directly related debt and to use a weighted average rate for all other debt.

� Capitalized interest and taxes should be added to the basis of the property and depreciated accordingly,which is consistent with the GAAP requirement to treat interest and taxes as a cost of acquiring the asset.

Because current tax law and GAAP requirements are similar, construction period interest and taxes incurred oncurrent projects usually will not generate temporary differences.

Long�term Contracts for Construction Contractors and Manufacturers

Generally accepted accounting principles require using the percentage�of�completion method to recognizeincome under most long�term contracts. Historically, the completed�contract method generally could be used fortax purposes to defer income from those contracts until the contract was substantially complete. As a result of the1989 Tax Act, however, companies must report all of their contract earnings using the percentage�of�completionmethod. (The percentage�of�completion method applies to all long�term contracts, including those of manufactur�


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ers and those of construction contractors. However, companies that have average annual gross receipts of $10million or less during the three taxable years preceding the taxable year in which a contract is entered into and thatestimate a real property contract will be completed within two years or that a manufacturing contract will becompleted within one year are exempt from using the percentage�of�completion method. Current tax law alsoexempts certain home construction contracts and allows applying the percentage�of�completioncapitalized costmethod on a 70%�30% basis for other residential contracts.)

GAAP permits two general approaches to determining the percentage of completion; input methods base thepercentage on efforts devoted to a contract, and output methods base the percentage on results achieved. Themethods may be applied in a variety of ways. For example, input methods are commonly based on either contractcosts, engineering estimates, or direct labor hours. It is believed the tax law definition is consistent with an inputmethod based on contract costs. The percentage of completion is to be determined as the percentage of costsincurred to total estimated contract costs, and costs directly and indirectly related to the construction process arerequired to be capitalized. Thus, if a company uses the percentage�of�completion method to account for all of itsearnings under long�term contracts for tax reporting, the same method usually will be acceptable for GAAP. Ifcompanies use the modified method of applying the percentage of completion, however, a temporary differencewill arise for the portion reported under a method other than the percentage�of�completion method.

Liquidations

Tax Attributes. Current tax law requires a taxable gain to be recognized for appreciation of assets distributed aspart of a liquidation. For tax purposes, the gain is recognized when the assets are distributed.

Accounting under GAAP. It is believed that if liquidation of an entity appears imminent, financial information maybe prepared on the assumption that liquidation will occur. An auditing interpretation at AU 9508.33�.37 states thata liquidation basis of accounting may be considered generally accepted accounting principles for entities inliquidation or for which liquidation appears imminent. An example of when the liquidation basis may not beappropriate is when management has the intention and capability of waiting for a certain price. It is believed that theliquidation basis usually involves reporting assets at net realizable values, i.e., the amounts of cash expected to bereceived.

For financial statement purposes, the value of assets generally will be converted to market value when liquidationis imminent. The resulting adjustments to record assets at market value will trigger the recognition of gains andlosses. In other words, gains and losses will be recognized in the financial statements before they are realized.When gains and losses are realized, an entry should be made debiting cash (or a receivable account), crediting theasset account, and recognizing an additional gain or loss if the amount realized from liquidation of the assets differsfrom the market value at the time the assets were converted to liquidation basis.

Since the liquidation basis is GAAP for companies in liquidation, this course views the adjustments to the amountof gain or loss described in the preceding paragraph as changes in estimates and, accordingly, believe they shouldbe reflected in earnings in the year they can be estimated. Note that deferral would not be appropriate since deferralcustomarily implies that recognition will occur in the future. Similarly, it is not believed that restatement would beappropriate since the change is within GAAP instead of from GAAP to an OCBOA.

In October 2008 the FASB issued an exposure draft of a proposed Statement of Financial Accounting Standardstitled Going Concern. There are two primary objectives of this proposed statement: (a) to address the preparationof financial statements as a going concern and an entity's responsibility to evaluate its ability to continue as a goingconcern and (b) to address disclosure requirements when financial statements are not prepared on a goingconcern basis and when there is substantial doubt as to an entity's ability to continue as a going concern.

The FASB's goal is for the guidance to converge with the guidance in the international accounting standards andthe auditing literature. The comment period ends on December 8, 2008 and the proposed effective date is forfinancial statements issued after the FASB Codification is ratified. The FASB decided not to address the liquidationbasis of accounting as part of this project. Future editions of this course will update the status of this project.

Although tax requirements to recognize a gain or loss on liquidation are consistent with GAAP requirements, thetiming of recognition is different. For tax purposes, the gain or loss is recognized on distribution of the assets. As


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explained in the preceding paragraphs, however, the gain or loss is recognized when liquidation is imminent inGAAP presentations. Accordingly, once liquidation appears imminent, GAAP presentations prior to actual liquida�tion should provide for the deferred tax liability related to the gain or the deferred tax asset related to the loss thathas been recognized in the financial statements but deferred to a future period for tax reporting.

The amount of gain or loss for GAAP reporting may differ from the taxable gain or loss because of depreciationdifferences. If so, prior�period financial statements should have provided for the deferred tax effect of the depreci�ation differences.

Illustration. The following example illustrates the gain to be reported for financial statement and tax purposes:

FINANCIAL STATEMENTS INCOME TAX

Fair value of real estate to be distributedin liquidation $ 500,000 $ 500,000

Cost of real estate $ 300,000 $ 300,000

Accumulated depreciation 100,000 200,000

Undepreciated cost 200,000 100,000

Gain $ 300,000 $ 400,000

The $500,000 basis of the real estate for financial reporting exceeds its tax basis ($100,000) by $400,000. It isbelieved the taxable temporary difference normally should be expected to reverse in the year of distribution.Ignoring state taxes and assuming a 30% tax rate, the deferred tax liability should be increased to $120,000 (that is,$400,000 � 30%). Assuming a deferred tax liability of $30,000 had been provided previously for the $100,000taxable difference (that is, the excess of the financial basis of $200,000 over the tax basis of $100,000), the followingentry would be made:

Real estate $ 200,000Accumulated depreciation 100,000Tax provision 90,000

Gain from appreciation $ 300,000Deferred tax liability 90,000

The following entry would record distribution of the property:

Deferred tax liability $ 120,000Equity 500,000

Real estate $ 500,000Taxes payable (30% �

$400,000) 120,000

Reorganization under the Bankruptcy Code

Companies filing petitions for bankruptcy do so either as a reorganization under Chapter 11 of the BankruptcyCode or as a liquidation under Chapter 7. Guidance on accounting for reorganizations is provided by FASB ASC852�10 (formerly AICPA Statement of Position 90�7, Financial Reporting by Entities in Reorganization Under theBankruptcy Code) and PPC's Guide to Troubled Businesses and Bankruptcies.

Under this guidance, special financial statement considerations occur on two dates: the date the petition is filedand the date the plan of reorganization is approved by the bankruptcy court. When the petition is filed, the companyformally begins reorganization proceedings. On that date the presentation of liabilities is changed to distinguish thestatus of creditors in the proceedings, and the results of operations and cash flows related to the proceedings arepresented separately from normal operations. When the plan of reorganization is approved, liabilities are adjustedto the amounts ordered by the bankruptcy court. In addition, if certain conditions are met, assets are revalued totheir current values, retained earnings or accumulated deficit is eliminated, and the company is treated as a newreporting entity.


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Prior to filing the petition for bankruptcy, there are no special financial statement considerations. Therefore, if acompany is preparing its financial statements for the year ended December 31, 20X0, and files a petition in March20X1 before those statements are issued, no measurement or presentation considerations would be reflected in thestatements. The bankruptcy filing would merely be disclosed as a subsequent event.

General Financial Statement Considerations during Chapter 11 Proceedings. The general concept of aChapter 11 reorganization is that the company is a going concern. Therefore, the financial statements duringreorganization should be presented for the customary reporting periods. For example, a company that prepares itsfinancial statements on a calendar�year basis and files its petition in June 20X1 would still present a balance sheetas of December 31, 20X1, and statements of income and retained earnings and cash flows for the year then ended.Although not prohibited, it is recommend that financial statements for earlier years not be presented in comparison,however, since the operations are not comparable, and presentation considerations are different. Some companiesprefer to add a parenthetical caption to financial statement titles such as �Debtor in Possession" to emphasize thatthe company is in bankruptcy proceedings. It is believed, however, that the presentation of the financial statementsand the disclosure in the accompanying notes adequately disclose that fact. Thus, there is no need to modifyfinancial statement titles or headings.

Balance Sheet Considerations during Chapter 11 Proceedings. Unlike liquidation accounting, the carryingamounts of assets should not be adjusted unless there is an impairment of value. Liabilities also should not beadjusted even if the company believes that they will be settled for less than their carrying amounts. Under a Chapter11 reorganization, liabilities are generally classified as follows:

a. Prepetition liabilities are incurred prior to filing the petition for bankruptcy. They are the liabilities from whichthe company is seeking relief and, thus, are the only liabilities that are subject to compromise. Prepetitionliabilities consist of the following general classes:

(1) Secured claims are liabilities that are secured by collateral with a value at least equal to the amountof the claim.

(2) Undersecured claims are liabilities that are secured by collateral with a value that is less than theamount of the claim.

(3) Unsecured claims are liabilities that are not secured. They generally include the excess ofundersecured claims over the value of the collateral, trade creditors, legal and accounting feesincurred before the petition is filed, and claims under executory contracts such as terminatedoperating leases.

b. Postpetition liabilities are incurred after the petition is filed and are not subject to compromise. Generally,they are incurred only with the permission of the bankruptcy court.

The carrying amount of liabilities of companies in Chapter 11 proceedings is determined the same as for othercompanies. Claims are measured and recorded following the requirements of FASB ASC 450�20 (formerly SFASNo.�5). If the court subsequently allows a claim that is different from the recorded amount, the carrying amount ofthe liability should be adjusted and a gain or loss charged to the results of operations.

The presentation of assets and the components of stockholders' equity in the balance sheet of a company inChapter 11 proceedings is generally the same as for other companies. The presentation of the company's liabilitiesis different, however. The presentation must distinguish between liabilities that are subject to compromise (i.e.,unsecured or undersecured claims) and those that are not (i.e., secured prepetition debt and postpetition liabili�ties). Liabilities subject to compromise should be presented together as unclassified liabilities. Their componentsshould be disclosed either as line items in the balance sheet or in the notes to the financial statements. Liabilitiesnot subject to compromise should be classified as current or noncurrent. The following illustrates the appropriatebalance sheet presentation of liabilities:

LIABILITIES NOT SUBJECT TO COMPROMISE

Current


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Short�term bank note $ 50,000

Current portion of fully secured long�term note 20,000

Postpetition trade accounts payable 70,000

Accrued postpetition expenses 10,000

150,000

Fully secured long�term note, less current portion 300,000

450,000

LIABILITIES SUBJECT TO COMPROMISE

Subordinated note 200,000

Prepetition trade accounts payable 100,000

300,000

Income Statement Considerations during Chapter 11 Proceedings. The income statement of a companyduring Chapter 11 proceedings should present the results of reorganization activities separately from other activi�ties. Reorganization activities include revenues, expenses, realized gains and losses, and provisions for losses thatwould not have arisen if the company were not reorganizing. The following are common results of reorganizationactivities:

� Gains and losses may arise from the sale of assets specifically intended to generate cash to liquidatecreditors' claims. For example, a bank may, with the bankruptcy court's permission, foreclose oninvestment land securing its note.

� As a result of the stay on payments during bankruptcy proceedings, a company may accumulate largercash balances than normal. Interest earned on those excess cash balances should be considered to beincome from reorganization activities.

� Legal and accounting fees may be incurred in connection with the proceedings and charged to operationswhen incurred as a reorganization activity. The criteria for capitalizing expenses incurred by a company inreorganization proceedings are the same as for other companies.

If the proceedings reduce interest during the reorganization period, the reduced interest expense recognizedshould be charged to operations rather than reorganization activities. In addition, the difference between the actualinterest and contractual interest should be disclosed.

If generally accepted accounting principles require that a gain or loss be recognized, those requirements should befollowed even if the gain or loss arose in connection with the reorganization. For example, if a component of anentity is disposed of to provide cash for liquidation of prepetition liabilities, the gain or loss would not be includedin reorganization items. Instead, it would be accounted for as the disposal of a component.

Reorganization items should be disclosed as unusual or infrequently occurring items. Accordingly, they should notbe presented net of income taxes. All other presentation considerations are the same as for companies not inChapter 11 proceedings. The following illustrates the presentation of an income statement of a retail companyduring Chapter 11 proceedings:

SALES $ 1,000,000

COST OF MERCHANDISE SOLD 600,000

GROSS PROFIT 400,000

OPERATING EXPENSES

Selling

Advertising 40,000

Compensation 100,000

Other 60,000


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Administrative

Compensation 80,000

Interest, less $10,000 reduction below stated rates 5,000

Other 15,000

300,000

INCOME BEFORE REORGANIZATION ITEMSAND INCOME TAXES 100,000

REORGANIZATION ITEMS

Loss on disposal of stores (100,000 )

Legal and accounting fees (25,000 )

Interest income on cash accumulated during Chapter 11 proceedings 5,000

(120,000 )

LOSS BEFORE INCOME TAXES (20,000 )

INCOME TAX BENEFIT 5,000

NET LOSS (15,000 )

BEGINNING ACCUMULATED DEFICIT (300,000 )

ENDING ACCUMULATED DEFICIT $ (315,000 )

Statement of Cash Flows Considerations during Chapter 11 Proceedings. Reorganization items should bedisclosed separately within the operating, investing, and financing categories of the statement of cash flows. FASBASC 852�10 (formerly SOP 90�7) states that the direct method is preferred. (If the indirect method is used, however,details of operating cash receipts and payments resulting from the reorganization must be disclosed.) The follow�ing illustrates an appropriate presentation:

CASH FLOWS FROM OPERATING ACTIVITIES

Collections from customers $ 1,200,000

Cash paid to suppliers for merchandise (500,000 )

Cash paid to employees and other suppliers (295,000 )

Cash paid for interest (5,000 )

400,000

Reorganization items

Interest received on cash accumulated during Chapter 11 proceedings 5,000

Payment of legal and accounting fees (25,000 )

380,000

CASH FLOWS FROM INVESTING ACTIVITIES

Cash received from disposal of stores 300,000

CASH FLOWS FROM FINANCING ACTIVITIES

Cash received from short�term loans 50,000

Principal payments of prepetition debt (250,000 )

(200,000 )

INCREASE IN CASH 480,000

BEGINNING CASH OVERDRAFT (20,000 )

ENDING CASH $ 460,000


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The reconciliation of net income with net cash provided by operating activities should be disclosed either on thestatement or in the notes to the financial statements. This course recommends disclosure in the notes, however,because adding the reconciliation to the statement is distracting. The reconciliation should be prepared similarly tothose for companies not in Chapter 11 proceedings. There is no need to disclose reconciling adjustments relatedto the reorganization separately from other adjustments.

Disclosure Considerations during Chapter 11 Proceedings. The disclosures required by generally acceptedaccounting principles apply to financial statements of companies in Chapter 11 proceedings. Therefore, compa�nies are still required to disclose significant accounting policies, minimum lease payments due under existingleases, maturities of long�term debt, and other items. Although FASB ASC 852�10 (formerly SOP 90�7) adds nodisclosure requirements, this course suggest the notes to the financial statements should include a disclosure thatthe company is in Chapter 11 proceedings as the first note in the summary of significant accounting policies. Thefollowing is an example of an appropriate note:

NOTE ASUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Reorganization under Bankruptcy Proceedings

In June 20X1 the Company filed petitions under Chapter 11 of the Bankruptcy laws. This gener�ally delays payment of liabilities incurred prior to filing those petitions while the Company devel�ops a plan of reorganization that is satisfactory to its creditors and allows it to continue as a goingconcern. The carrying amounts of assets and liabilities are unaffected by the proceedings, butliabilities are presented according to the status of the creditors.

It is believed other effects of the proceedings can most conveniently be disclosed in separate notes. To illustrate,the disclosure of long�term debt might be modified as follows:

NOTE HLONG�TERM NOTES

Long�term notes consist of the following:

Note to a bank that is payable in monthly installments of $1,000 plus interestat 10%, secured by the Company's operating real estate, and provides thebank with the right to petition the court to permit it to foreclose against theproperty $ 300,000

Note to a former stockholder that is payable in quarterly installments of$5,000, including interest at 12%, and secured by a subordinated interestin the Company's operating real estate that effectively places it in the roleof an unsecured creditor 100,000

Special Considerations for Consolidated Financial Statements during Chapter 11 Proceedings. If some, butnot all, of the companies reflected in consolidated financial statements are in Chapter 11 proceedings, theconsolidated statements should provide separate disclosure of the combined results of those companies.

Financial Statement Considerations When a Company Emerges from Reorganization Proceedings. When theplan of reorganization is approved (i.e., confirmed) by the bankruptcy court, the company's financial statementsshould reflect the following:

a. Financial statements should be presented for customary reporting periods. For example, if the plan for acalendar�year company is approved in September 20X1, the financial statements for 20X1 would includeall transactions for the year.

b. Assets should only be adjusted for impairment of value.

c. Liabilities should be adjusted to the amounts reflected in the plan. Specifically, they should be adjusted tothe present value of amounts to be paid under the plan using appropriate current interest rates.


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In certain circumstances, however, the company is essentially considered to be a new entity, and the basis of itsassets and liabilities should be adjusted to their fair values on the date the plan is approved (referred to as�fresh�start reporting"). Fresh�start reporting must be used if both of the following criteria are met:

a. The fair value of the assets of the emerging entity immediately before the date of plan approval is less thanthe total of all postpetition liabilities and allowed claims.

b. Holders of existing voting shares immediately before plan approval receive less than 50% of the votingshares of the emerging company.

Fresh�start reporting is appropriate provided the loss of control by the former stockholders is substantive and nottemporary. An entity emerging from bankruptcy that applies fresh�start reporting should follow only the accountingstandards in effect at the date fresh�start reporting is adopted, which include those standards eligible for earlyadoption if an election is made to adopt early.

The fair value (or reorganization value) of the emerging entity's assets is the price a willing buyer would pay for thecompany's assets immediately after emergence. It may be calculated using a variety of methods. It is oftencalculated by discounting cash flows, however, and consists of the following components:

a. The discounted cash flows determined for the prospective period

b. The present value of the business attributable to the period beyond the prospective period (referred to as�residual value" or �terminal value")

c. The current value of any excess working capital or other assets that are not needed in reorganization

If fresh�start reporting is appropriate, the reorganization value should be allocated to assets. Any excess reorgani�zation value should be reported as an intangible asset using the caption �Reorganization value in excess ofamounts allocable to identifiable assets." The intangible asset should be amortized or tested for impairment.

Deferred income taxes should be provided the same as for other businesses. Benefits realized from preconfirma�tion loss carryforwards should first reduce reorganization value in excess of amounts allocable to identifiableassets. Any excess preconfirmation loss carryforwards should be recorded as an addition to paid�in capital.

Since fresh�start reporting assumes the formation of a new entity, this course suggests that all transactions throughthe confirmation date (including the adjustments to assets and liabilities to reflect fresh�start reporting) should beincluded in the company's final financial statements. The adjustments should only be presented as extraordinaryitems in the final financial statements if they meet the criteria. Most adjustments normally will not meet the strict testsas both unusual and infrequent prescribed by FASB ASC 225�20�45�1 through 45�7 (formerly APB Opinion No. 30).

The first financial statements of the reorganized company should begin immediately after the confirmation date.They should report the fresh�start values, have no beginning retained earnings, and disclose the following:

a. Adjustments to the historical amounts of individual assets and liabilities

b. The amount of debt forgiveness

c. The amount of prior retained earnings or accumulated deficit eliminated

d. Significant matters relating to the determination of reorganization value such as the following:

(1) The method or methods used to determine reorganization value and factors such as discount rates,tax rates, the number of years for which prospective cash flows were developed, and the method ofdetermining terminal value

(2) Sensitive assumptions; that is, assumptions about which there is a reasonable possibility of theoccurrence of a variation that would have significantly affected measurement of reorganization value


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(3) Assumptions about anticipated conditions that are expected to be different from current conditions,unless otherwise apparent

Financial statements after the confirmation date should not be presented in comparison with those for priorperiods.

Preconfirmation Contingencies. Some uncertainties usually remain at the reorganization date, such as

a. amounts to be ultimately realized from the sale of assets designated for sale in the confirmed plan,

b. nondischargeable claims, such as environmental issues, and

c. other claims that were estimated for purposes of voting on the reorganization plan.

Uncertainties that exist at the bankruptcy reorganization date are referred to as preconfirmation contingencies, andPractice Bulletin, No. 11, Accounting for Preconfirmation Contingencies in Fresh�Start Reporting, previously pro�vided guidance on accounting for them. However, because fresh�start reporting generally requires accounting forthe reorganization as a business combination, FASB ASC 805 [formerly SFAS No. 141(R)], should be applied. Thatguidance, which nullifies Practice Bulletin No. 11 for years beginning on or after December 15, 2008 with earlierapplication prohibited, states that preconfirmation contingencies should be accounted for as assets and liabilitiesarising from contingencies.

After that guidance becomes effective, under FASB ASC 805�20�25�19 through 25�20B [formerly Paragraph 24 ofSFAS No. 141(R), as amended], fresh�start reporting should result in recognizing an asset or liability for a preconfir�mation contingency only if

a. the fair value of the asset or liability can be determined during the measurement period or

b. information available before the end of the measurement period indicates that it is probable that an assetexisted or that a liability had been incurred at the date of reorganization and the amount of the asset orliability can be reasonably estimated.

The entity should also develop a system and a rational basis for subsequently measuring and accounting for assetsand liabilities arising from contingencies, depending on their nature.

Effect of Section 338 Rules on Financial Statements

If one company acquires the stock of another company, and the purchase price exceeds the acquired company'sbook value, Section 338 of the IRC provides an election that enables the acquiring company to treat the transactionas if it were a purchase of assets and to step up the basis of the acquired company's assets for tax purposes.

Current tax law requires using the residual method to allocate the purchase price of a business. Under thatapproach, individual assets and liabilities are valued at their fair value, and the excess of the purchase price overthe assigned values (or the �residual") is charged to goodwill. Goodwill acquired after August 10, 1993 may beamortized and deducted over 15 years for tax purposes. Under GAAP, however, the amount allocated to goodwillis not amortized but is tested for impairment at least annually.

Because the primary tax motivation for a Section 338 election is to increase depreciation and amortization deduc�tions arising from an increase in the basis of assets, when the purchase price is below the tax basis of the acquiredcompany, deductions are maximized by retaining the tax basis of the acquired corporation and, therefore, theSection 338 election would not be desirable.


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127

SELF�STUDY QUIZ


6. How can the effect of the Tax Reform Act of 1986 on GAAP reporting be summarized?

a. The change in tax law is most likely considered a change in circumstances for GAAP reporting.

b. The change in tax law is most likely not a change in accounting for GAAP reporting.

c. The change in tax law is most likely considered an error correction for GAAP reporting purposes.

7. Which of the following methods of recognition of income is required by GAAP?

a. Completed�contract method.

b. Percentage�of�completion capitalized cost method.

c. Percentage�of�completion modified method.

d. Percentage�of�completion method.

8. Which of the following choices discloses the difference between tax and GAAP accounting for assets as a partof a liquidation?

a. The timing of the recognition of the gains or losses on the assets is different.

b. The gain or loss for GAAP reporting is the same as the amount for tax reporting.

c. The timing of the realization of the gains or losses occurs at different times.

d. The taxable temporary difference will reverse when liquidation appears imminent.

9. ABC Company filed for reorganization under Chapter 11 of the Bankruptcy Code. The company has a $100,000liability secured by an asset worth $55,000. How would the $45,000 in excess debt over the value of the assetbe classified?

a. It should be classified as a secured claim.

b. It should be classified as an undersecured claim.

c. It should be classified as an unsecured claim.

10. Which of the following income statement items would be charged to operating expenses during Chapter 11proceedings?

a. Interest earned on excess cash balances due to reorganization activities.

b. Interest expense incurred during reorganization at below contract rate.

c. Gains or losses from the sale of assets to generate cash for claims.

d. Losses from the disposal of stores due to reorganization activities.


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11. How should the statement of cash flows be presented for a company during Chapter 11 proceedings?

a. The cash flows statement should not be presented with the standard categories: operating, investing, andfinancing activities.

b. This course suggests reconciling net income with net cash provided by operating activities directly on thestatement of cash flows.

c. The cash flows statement should be presented with four categories: operating, investing, and financingactivities, plus an additional category titled reorganization items.

d. The direct method of presenting the statement of cash flows is preferred when a company is in Chapter11 proceedings.

12. When the bankruptcy court approves the plan of reorganization, all of the following actions/presentationsshould be reflected in the financial statements except:

a. Assets are adjusted to their fair values on the date the plan is approved.

b. Liabilities are to be adjusted to the amounts approved by the bankruptcy court.

c. Customary reporting periods are used for financial reporting.

d. Assets are adjusted for impairment of value.

13. Which of the following choices follows the guidance for financial statements of an entity using fresh�startreporting?

a. Prepetition financial statements can be presented in comparison financial statements after confirmation.

b. Prior retained earnings (or the accumulated deficit) will be reset to zero for fresh�start reporting.

c. The total reorganization value should be allocated to physical assets. No intangible assets are to bereported.

d. The adjustments to assets and liabilities to reflect fresh�start reporting should be reported as extraordinaryitems.


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6. How can the effect of the Tax Reform Act of 1986 on GAAP reporting be summarized? (Page 116)

a. The change in tax law is most likely considered a change in circumstances for GAAP reporting. [Thisanswer is incorrect. The guidance in the course states that a change in tax law is not a circumstance thatjustifies a change in accounting. Therefore, for example, beginning inventories would not requireadjustment.]

b. The change in tax law is most likely not a change in accounting for GAAP reporting. [This answeris correct. It is not believed that a change in tax law is a change in circumstances for GAAP reportingand it will be difficult to identify a change in circumstance that justifies a change in accounting forthe types of costs covered by TRA's requirements.]

c. The change in tax law is most likely considered an error correction for GAAP reporting purposes. [Thisanswer is incorrect. Beginning inventories would not be adjusted through a restatement of retainedearnings, because a change in tax law in this instance would not be considered as incorrectly appliedaccounting principles in prior periods.]

7. Which of the following methods of recognition of income is required by GAAP? (Page 117)

a. Completed�contract method. [This answer is incorrect. The completed contract method is not anacceptable method for reporting income under GAAP. Historically, the completed�contract methodgenerally could be used for tax purposes to defer income from most long�term contracts until the contractwas substantially complete. As a result of the 1989 Tax Act, companies must report all of their contractearnings using the percentage�of completion method unless exempted.]

b. Percentage�of�completion capitalized cost method. [This answer is incorrect. Current tax law exemptscertain home construction contracts and allows applying the percentage�of�completion�capitalized costmethod on a 70%�30% basis for other residential contracts. However, this method is not acceptable byGAAP.]

c. Percentage�of�completion modified method. [This answer is incorrect. If companies use the modifiedmethod of applying the percentage�of�completion method under tax reporting, a temporary difference willarise for the portion reported under a method other than the percentage�of�completion method since themodified method is not acceptable under GAAP.]

d. Percentage�of�completion method. [This answer is correct. Generally accepted accountingprinciples require using the percentage�of�completion method to recognize income under mostlong�term contracts. GAAP permits two general approaches to determining the percentage ofcompletionthe input method and the output method.]

8. Which of the following choices discloses the difference between tax and GAAP accounting for assets as a partof a liquidation? (Page 118)

a. The timing of the recognition of the gains or losses on the assets is different. [This answer is correct.Current tax law requires a taxable gain to be recognized for appreciation of assets distributed aspart of a liquidation. For tax purposes, the gain is recognized when the assets are actuallydistributed. For financial reporting purposes, the gain or loss is recognized when liquidation isimminent in GAAP presentations. The value of assets generally will be converted to market valueat that time.]

b. The gain or loss for GAAP reporting is the same as the amount for tax reporting. [This answer is incorrect.Depreciation differences between GAAP and tax reporting will cause the gain or loss for GAAP reporting


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to be a different than the taxable gain or loss. Prior�period financial statements should have provided forthe deferred tax effect of the depreciation differences.]

c. The timing of the realization of the gains or losses occurs at different times. [This answer is incorrect. Whenthe liquidation occurs, the gains or losses will be realized for tax and accounting reporting by debiting cash(or a receivable account), crediting the asset account, and recording or adjusting the gain or loss.Realization occurs when the assets are actually distributed. However, recognition may occur at a differenttime than realization in GAAP presentations if the liquidation appears imminent.]

d. The taxable temporary difference will reverse when liquidation appears imminent. [This answer is incorrect.The taxable difference is expected to reverse in the year of distribution. The gain or loss is recognized whenliquidation is imminent in GAAP presentations. The GAAP presentations prior to actual liquidation willprovide for a deferred tax liability related to the gain or a deferred tax asset related to the loss that has beenrecognized in the financial statements but deferred to a future period for tax reporting.]

9. ABC Company filed for reorganization under Chapter 11 of the Bankruptcy Code. The company has a $100,000liability secured by an asset worth $55,000. How would the $45,000 in excess debt over the value of the assetbe classified? (Page 120)

a. It should be classified as a secured claim. [This answer is incorrect. Secured claims are liabilities that aresecured by collateral with a value at least equal to the amount of the claim. Since the value of the collateralis less than the liability amount, no part of this debt will be classified as a secured claim.]

b. It should be classified as an undersecured claim. [This answer is incorrect. Undersecured claims areliabilities that are secured by collateral with a value that is less than the amount of the claim. Since the valueof the collateral is less than the liability amount, the liability is undersecured. However, the $45,000 portionshould not be classified as undersecured.]

c. It should be classified as an unsecured claim. [This answer is correct. Unsecured claims areliabilities that are not secure. They generally include the excess of undersecured claims over thevalue of the collateral. Therefore, the $45,000 ($100,000 liability less $55,000 asset value) isclassified as an unsecured claim.]

10. Which of the following income statement items would be charged to operating expenses during Chapter 11proceedings? (Page 121)

a. Interest earned on excess cash balances due to reorganization activities. [This answer is incorrect. As aresult of the stay on payments during bankruptcy proceedings, a company may accumulate larger cashbalances than normal. Interest earned on those excess cash balances should be considered to be incomefrom reorganization activities.]

b. Interest expense incurred during reorganization at below contract rate. [This answer is correct. Ifthe proceedings reduce interest during the reorganization period, the reduced interest expenserecognized should be charged to operations rather than reorganization activities. Reorganizationactivities include revenues, expenses, realized gains and losses, and provisions for losses thatwould not have arisen if the company were not reorganizing. The interest expense would be incurredeven if the company were not in reorganization.]

c. Gains or losses from the sale of assets to generate cash for claims. [This answer is incorrect. Gains andlosses may arise from the sale of assets specifically intended to generate cash to liquidate creditors'claims. These gains and losses are classified as reorganization items.]

d. Losses from the disposal of stores due to reorganization activities. [This answer is incorrect. Losses dueto disposal of stores as instructed by the bankruptcy court are recorded on the balance sheet as areorganization item because the losses would not have arisen if the company were not reorganizing.]


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11. How should the statement of cash flows be presented for a company during Chapter 11 proceedings?(Page 122)

a. The cash flows statement should not be presented with the standard categories: operating, investing, andfinancing activities. [This answer is incorrect. A company in Chapter 11 bankruptcy will still present thestatement of cash flows with the operating, investing, and financing activities categories. These threecategories are still important to the users of financial statements. However, the readers must be able todistinguish between cash receipts and payments resulting from regular operations and those resultingfrom the reorganization.]

b. This course suggests reconciling net income with net cash provided by operating activities directly on thestatement of cash flows. [This answer is incorrect. The reconciliation can be disclosed either on thestatement or in the notes to the financial statements. However, this course recommends disclosure in thenotes, because adding the reconciliation to the statement is distracting.]

c. The cash flows statement should be presented with four categories: operating, investing, and financingactivities, plus an additional category titled reorganization items. [This answer is incorrect. Reorganizationitems should be disclosed separately within the operating, investing, and financing categories of thestatement of cash flows.]

d. The direct method of presenting the statement of cash flows is preferred when a company is inChapter 11 proceedings. [This answer is correct. FASB ASC 852�10 (formerly SOP 90�7) states thatthe direct method is preferred. If the indirect method is used, details of operating cash receipts andpayments resulting from the reorganization must be disclosed.]

12. When the bankruptcy court approves the plan of reorganization, all of the following actions/presentationsshould be reflected in the financial statements except: (Page 123)

a. Assets are adjusted to their fair values on the date the plan is approved. [This answer is correct.Assets are not adjusted to their fair values unless the company is considered a new entity and�fresh�start reporting" is required.]

b. Liabilities are to be adjusted to the amounts approved by the bankruptcy court. [This answer is incorrect.Adjusting liabilities to the amounts reflected in the plan is an action that must be taken when the plan isapproved. Specifically, liabilities should be adjusted to the present value of amounts to be paid under theplan using appropriate current interest rates.]

c. Customary reporting periods are used for financial reporting. [This answer is incorrect. FASB ASC 852�10(formerly SOP 90�7) does not specify any special reporting periods. Therefore, the financial statements arepresented for customary reporting periods. For example, if the plan for a calendar�year company isapproved in September 20X1, the financial statements for 20X1 would include all transactions for the year.]

d. Assets are adjusted for impairment of value. [This answer is incorrect. Assets are to be adjusted if theirvalue is impaired. Adjustments are not allowed for any other reason unless the entity qualifies for�fresh�start reporting."]

13. Which of the following choices follows the guidance for financial statements of an entity using fresh�startreporting? (Page 124)

a. Prepetition financial statements can be presented in comparison financial statements after confirmation.[This answer is incorrect. Financial statements reporting fresh�start values should not be presented incomparison with those for prior periods.]

b. Prior retained earnings (or the accumulated deficit) will be reset to zero for fresh�start reporting.[This answer is correct. The first financial statements of the reorganized company should beginimmediately after the confirmation date. They should report the fresh�start values and have nobeginning retained earnings per FASB ASC 852�10 (formerly SOP 90�7).]


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c. The total reorganization value should be allocated to physical assets. No intangible assets are to bereported. [This answer is incorrect. The reorganization value should be allocated to assets. Any excessreorganization value should be reported as an intangible asset using the caption �Reorganization valuein excess of amounts allocable to identifiable assets."]

d. The adjustments to assets and liabilities to reflect fresh�start reporting should be reported as extraordinaryitems. [This answer is incorrect. The adjustments should only be presented as extraordinary items in thefinal financial statements if they meet the criteria. Most adjustments normally will not meet the strict testsas both unusual and infrequent.]


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HOW TO ACCOUNT FOR INVESTMENTS IN PARTNERSHIPS

Brief Description and Tax Attributes

Income and losses from partnerships generally pass through to the partners in the proportion specified in thepartnership agreement. However, the deduction of losses by the partners is subject to two significant limitations:

� At�risk Rules. At�risk rules limit the amount of the deduction to the capital contributions adjusted forpass�through items, distributions, loans to the partnership, and the portion of recourse and qualifiednonrecourse partnership debt allocated to the partner. Disallowed losses under the at�risk rules may becarried forward indefinitely. Each year, loss carryforwards generally are added to any loss for the year, andthe total is subject to the at�risk rules to determine the deduction for the year. The at�risk rules generallyapply to partners that are individuals, estates, trusts, and C corporations in which 50% of the stock is ownedby no more than five individuals. (Although the rules do not apply to partnerships and S corporations thatare partners, they do apply to the individual partners or shareholders of such entities.)

� Passive Activity Rules. An investor is considered �passive" if it is not involved in the operations of theinvestee on a regular, continuous, and substantial basis. Under the Uniform Limited Partnership Act, limitedpartners are considered passive investors. Thus, income and losses allocated to them generally areconsidered to be from passive activities. In addition, general partners can be considered passive investors.Passive losses that satisfy the requirements for deduction under the at�risk rules are deductible, under thepassive activity rules, only to the extent they can be offset against passive income. Unused losses areavailable for offset against future passive income indefinitely. The passive activity rules apply to partnersthat are individuals, estates, trusts, C�corporations that are personal service corporations, andC�corporations in which 50% of the stock is owned by no more than five individuals. (Although the rulesdo not apply to partnerships and S�corporations that are partners, they do apply to the individual partnersor shareholders of such entities.)

Accounting under GAAP

Accounting for investments in partnerships is not directly addressed in authoritative literature. FASB ASC 323(formerly APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock) comes closestto being on point, although it applies specifically to investments in common stock. However, FASB ASC323�30�15�3; 323�30�35�2 (formerly AICPA Accounting Interpretation No. 2 of APB Opinion No. 18), while specifi�cally stating that FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) does not address investments in partner�ships, does state that many of those provisions of FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) areappropriate in accounting for such investments.

Based on GAAP corporations, partnerships, and proprietorships ordinarily should use the equity method ofaccounting for investments of 20% or more but less than 50% of a partnership or unincorporated joint venture.[FASB ASC 323�10�15�5 (formerly APB Opinion No. 18 only) applies to investments held by business entities. Itdoes not apply to investments held by nonbusiness entities (such as estates, trusts, and individuals).] However, forpartnerships in certain industries, e.g., oil and gas ventures, it may be appropriate for the investor to record in itsfinancial statements its prorata share of the assets, liabilities, revenues, and expenses of the venture. (Such apresentation may be appropriate if the investor owns an undivided interest in each of the venture's assets and isproportionately liable for its share of each of the venture's liabilities. However, the EITF concluded in FASB ASC323�30�25�1; 910�810�45�1; 930�810�45�1; and 932�810�45�1 (formerly Issue No. 00�1, �Investor Balance Sheet andIncome Statement Display under the Equity Method for Investments in Certain Partnerships and Other Ventures")that such a presentation is not appropriate for investments in unincorporated legal entities accounted for by theequity method unless the investee is in either the construction industry or an extractive industry that traditionally hasused that presentation.) For investments of less than 20%, the cost method generally should be used.

If the equity method is used to account for an investment in a partnership, e.g., when the investor has more than a20% interest and has the ability to exercise significant influence over partnership policies, the investor would recordits prorata share of partnership profits or losses by adjusting the carrying value of its investment in the partnership.

The equity method ordinarily is discontinued when the investment (and net advances) are reduced to zero.However, if the investor has guaranteed obligations of the partnership or is otherwise committed to provide further


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financial support, losses should continue to be recorded by the investor to the extent of the additional fundscommitted. (See TIS 2220.12.) An investment in a partnership accounted for by the equity method that has beenreduced below zero should be presented as a liability in the balance sheet.

GAAP also states that the equity method is not a valid substitute for consolidation. Accountants should considerwhether FASB ASC 810 (formerly ARB No. 51) requires consolidation because the reporting entity controls thepartnership through a means other than ownership of a majority voting interest. FASB ASC 810 [formerly FIN 46(R)]provides guidance on criteria for determining when looking at nominal voting rights is not effective for determiningif the reporting entity has a controlling financial interest in the partnership and provides guidance on looking for acontrolling financial interest in those situations.

In addition, FASB ASC 810�20�25�3 through 25�5 (formerly EITF Issue No. 04�5, �Determining Whether a GeneralPartner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the LimitedPartners Have Certain Rights" establishes a presumption that the general partners in a limited partnership controlthat partnership, regardless of the extent of the general partners' ownership interests. The assessment of whetherthe rights of the limited partners should overcome that presumption is a matter of judgment that depends on thefacts and circumstances. The general partners do not control the limited partnership if the limited partners haveeither:

a. the substantive ability to dissolve (liquidate) the limited partnership or otherwise remove the generalpartners without cause, or

b. substantive participating rights.

Illustration

Assume that ABC Company, which is owned by three individuals, owns 10% of Cost Ltd. Partnership and 45% ofEquity Ltd. Partnership. Also, assume (a) that the cost method is considered appropriate for Cost Ltd. and theequity method for Equity Ltd., (b) that the losses from both limited partnerships are not considered to be frompassive activities for tax reporting, and (c) that the partnerships have no debt. Assume a 30% tax rate and thefollowing additional facts:

10% of Cost Ltd.

45% of Equity Ltd.

Original investment by ABC 1/1/X1 $ �50,000 $ 50,000

Prorata share of losses YE 12/31/X1 (75,000 ) (75,000 )

Loss deducted by ABC Company YE 12/31/X1 (50,000 ) (50,000 )

Additional contribution YE 12/31/X2 �40,000 40,000


Loss deducted by ABC Company YE 12/31/X2 (40,000 ) (40,000 )

Assuming no permanent decline in the value of the investments and that reduction of the equity method investmentbelow zero is appropriate, the combined investment in Cost Ltd. and Equity Ltd. should be presented in thefinancial statements as follows:

Balance Sheet

20X2 20X1

ASSETS

Investments and other assets

Cost Ltd. Partnership $ 90,000 $ 50,000

LIABILITIES

Share of deficiency in assets of Equity Ltd. Partnership 40,000 25,000


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Statement of Income

20X2 20X1

Other income (loss)

Share of loss of Equity Ltd. Partnership (55,000 ) (75,000 )

The difference between the amounts reported in the financial statements and the tax basis of the investments resultin temporary differences for which a deferred tax asset and liability would be provided as follows:

20X2 20X1

Investment in Cost Ltd.

Taxable difference

Financial basis $ 90,000 $ 50,000

Tax basis � �

$ 90,000 $ 50,000

Deferred tax liability $ 27,000 $ 15,000

Investment in Equity Ltd.

Deductible difference

Financial basis $ (40,000 ) $ (25,000 )

Tax basis � �

$ (40,000 ) $ (25,000 )

Deferred tax asset $ (12,000 ) $ (7,500 )

The losses deducted by ABC Company are limited to the amount at risk, but unused losses are available forcarryforward to future years. A deferred tax asset would be provided for them as follows:

20X2 20X1

Loss carryforward

Cost Ltd. $ 40,000 $ 25,000

Equity Ltd. 40,000 25,000

$ 80,000 $ 50,000

Deferred tax asset $ 24,000 $ 15,000

A valuation allowance would be provided if it is more likely than not that some or all of the deferred tax asset will notbe realized. The carryforwards are available indefinitely and are used when the tax basis of the investment isincreased, for example, through undistributed taxable income. (If the losses were considered to be from a passiveactivity, their use after meeting the at�risk rules would require future taxable income from passive activities. Theappropriate income could come from other passive activities, from the same passive activity, or from the sale of theinvestment.)

Assuming that no valuation allowance is needed for the deferred tax asset and that the losses deducted offset othertaxable income of ABC Company, the following tax benefits would be reported in the income statement of ABCCompany:


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20X2 20X1

Current benefitloss deducted � 30%

Cost Ltd. $ (12,000 ) $ (15,000 )

Equity Ltd. (12,000 ) (15,000 )

(24,000 ) (30,000 )

Deferred benefit

Increase in deferred tax liability 12,000 15,000

Increase in deferred tax asset

For deductible difference (4,500 ) (7,500 )

For loss carryforward (9,000 ) (15,000 )

(1,500 ) (7,500 )

$ (25,500 ) $ (37,500 )

The following reconciles the tax benefit that would be obtained by applying the assumed 30% with the benefitreported:

20X2 20X1

Benefit obtained by applying 30% to the loss reported inthe income statement $ (16,500 ) $ (22,500 )

Tax benefit of increase in loss carryforwards (9,000 ) (15,000 )

Benefit reported in the income statement $ (25,500 ) $ (37,500 )

Carryforwards of losses passed through from investees affect temporary differences. A carryforward of a lossdisallowed, either because of the at�risk rules or the passive activity rules, effectively is a deferral of a basisreduction for tax reporting. Thus, the recognition of a deferred tax asset for it is a reconciling item.

Difference between Book and Tax Earnings on Investments in Partnerships

For federal income tax purposes, partnerships may report earnings and losses to their partners on Schedule K�1 ofForm 1065 using a basis that differs from GAAP. Common examples are the partnership's use of the cash basis orits use of an accrual basis that differs from GAAP because, for example, contingent liabilities have not beenaccrued.

If the partnership's basis of accounting does not differ materially from GAAP, the investor partner could recognizeearnings and losses based on amounts reported in the K�1. As an example, assume that a corporation is a generalpartner in a partnership that leases an airplane and that the partnership uses the cash basis for tax reporting. If rentsare paid on completion of trips, unpaid operating expenses are not recorded, and the recovery period for the planeis significantly shorter than its estimated useful life, the understatement of operating expenses may offset theoverstatement of depreciation, and the K�1 earnings and losses might, therefore, approximate GAAP amounts.

If the partnership's K�1 amounts differ from its GAAP amounts, but the difference is not material to the investor'searnings, the K�1 earnings and losses could be recorded in the investor's GAAP financial statements. To illustrate,assume that in the preceding example the understatement of operating expenses was not offset by the overstate�ment of depreciation but that the net difference was not material to the investor's earnings. In that case, theunadjusted K�1 earnings could be recorded as the equity pick�up in the investor's financial statements. (Note thatin both examples, the cumulative difference also would have to be evaluated to determine whether the investmentaccount in the investor's balance sheet was materially misstated.)

However, if there is a material difference, the K�1 earnings and losses should be converted to GAAP. In many cases,the conversion of a few key items will bring the K�1 amounts materially close to GAAP, and a complete conversion


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will be unnecessary. To illustrate, assume that a corporation is a general partner in a partnership that leases officefacilities constructed prior to 1987. If rents are collected in advance and unpaid expenses are insignificant, the onlymaterial difference from GAAP may arise from depreciating a building and amortizing capitalized interest overperiods that are significantly shorter than the building's estimated useful life. In that situation, building depreciationand interest amortization could be converted to GAAP, and the resulting earnings probably would not differmaterially from GAAP.

For tax purposes, investors recognize earnings based on the K�1 regardless of whether the investor and thepartnership use the same basis of accounting. Although the investor uses the equity method for both GAAP and taxreporting, a temporary difference between the amount of the equity pick�up for financial and tax purposes will ariseif the K�1 amounts differ materially from GAAP.

TRANSACTIONS INVOLVING PROPERTY AND EQUIPMENT

ACRS Depreciation

For tax purposes, property and equipment are depreciated on the Accelerated Cost Recovery System (ACRS),which eliminates the need to determine the useful life of an asset and narrows the selection of a depreciationmethod. The term ACRS to refer to tax depreciation for post�1980 acquisitions, including the modifications thatwere established by TRA. The following summarizes the major provisions of the modified ACRS system (dubbedMACRS):

a. Recovery periods of real property are 271/2 years for residential rental property and 39 years for all otherreal property. Recovery periods of personal property are prescribed based on classifying assets accordingto the Asset Depreciation Range (ADR) midpoint life as follows:

ADR Class Lives (in years) MACRS Recovery Period

4 or less 3 years

More than 4 but less than 10 5 years

10 or more but less than 16 7 years



25 or more 20 years

b. Depreciation methods are prescribed for the various recovery periods:

(1) Real propertyStraight�line method

(2) 3, 5, 7, and 10 year recovery classes200% declining balance method (with a switch to straight�lineat the midway point in the life of the asset to maximize deductions)

(3) 15 and 20 year recovery classes150% declining balance method (with a switch to straight�line atthe midway point in the life of the asset to maximize deductions)

(Salvage value is ignored in both the 150% and 200% declining balance methods.)

c. Conventions that determine the allowable depreciation for the year the assets are placed in service areprescribed for the recovery classes:

(1) Real propertyMid�month convention (Property is treated as placed in service halfway through themonth in which the property is actually put to use.)

(2) All otherHalf�year convention (which assumes that the property is depreciable for half of the taxableyear it is placed in service regardless of when the asset actually was acquired), except a mid�quarterconvention is required for all assets acquired during the year if more than 40% of the property is placedin service in the last quarter.

d. The expense allowance under Section 179.


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GAAP require the cost of depreciable assets to be allocated to expense over the expected useful lives of the assetsin a systematic manner. Many tax depreciation methods are used to stimulate investments by accelerating deduc�tions, and their statutory write�off periods for various assets are not intended to approximate the expected usefullives of the assets. Although taxpayers may elect the straight�line method for tax reporting, the tax methods stilldiffer from GAAP because the recovery period is prescribed and salvage value is not considered. As a result,differences between depreciation for financial and tax purposes may arise even when the straight�line method isused, and the differences should be considered when evaluating the materiality of using tax depreciation methodsin GAAP statements.

The MACRS tax method is an acceptable GAAP method unless salvage value would be material, and the belief ofthis course is that using the conventions normally should not result in depreciation that differs materially from GAAP.In general, it is believed that the MACRS recovery periods are closer to GAAP than the ACRS periods. The recoveryperiods for real estate and for three� and five�year property probably would be acceptable for GAAP. However, largeacquisitions in the other classes should be evaluated to determine whether different depreciable lives should beused for financial reporting. Similarly, tax depreciation for significant pre�1987 investments in buildings and heavymachinery or equipment would be expected to differ materially from GAAP.

When tax methods used for financial reporting purposes result in material differences from GAAP, the accountant'sor auditor's report should be appropriately modified for a GAAP departure. (See Chapter 6 of PPC's Guide to

Compilation and Review Engagements or Chapter 3 of PPC's Guide to Auditor's Reports.)

For tax reporting, there are limitations on depreciation of certain automobiles (commonly referred to as luxuryvehicles) used in the business. The effect of the limitations is to require a longer depreciation period for thosevehicles than for other types of five�year property. For tax reporting, some companies will, therefore, be depreciat�ing some five�year property over longer periods than others, which raises the question of whether the use ofdifferent depreciation periods for similar assets is appropriate for GAAP. It is believed that generally, the lives shouldbe the same unless the difference can be attributed to an identifiable condition. Accordingly, that criteria should beconsidered in determining whether accelerated tax methods differ materially from GAAP methods. To illustrate,assume that a company acquires an automobile for $36,000 and can deduct depreciation of $3,060 for the firstyear, $4,900 for the second year, $2,950 for the third year, and $1,775 for each subsequent year. The full cost would,therefore, be deducted over 18�years and, if the estimated life were considered to be five years, depreciationassuming a five�year period should be computed and compared with the tax deduction in considering whether theeffect is material.

Recent Increases in the Section 179 Deduction and Bonus Depreciation

The Economic Stimulus Act of 2008 (the 2008 Act) and the Economic Recovery and Reinvestment Act of 2009 (the2009 Act) significantly increased the portion of the cost of qualifying property that entities may effectively deduct inthe year of acquisition. For qualifying property purchased and placed in service during the tax years that begin in2008 and 2009, the 2008 Act and the 2009 Act increased the maximum Section 179 deduction from $128,000 to$250,000. The 2008 Act also increased from $510,000 to $800,000 the phase�out threshold of the cost of qualifyingadditions beyond which there is a dollar�for�dollar reduction in the Section 179 deduction. Therefore, for example

� An entity with qualifying additions of $250,000 could deduct all of those additions in the year of acquisition.

� An entity with qualifying additions of $1,250,000 could not deduct any of its additions in the year ofacquisition because the total cost exceeds the $800,000 phase�out limitation by more than $250,000, whichis the maximum deduction allowed under IRC Sec. 179. Deductions lost because of the phase�outprovision cannot be carried forward to future years.

The Section 179 deduction continues to be limited by the amount of taxable income before the deduction.Therefore, for example, no Section 179 deduction is allowable in the year there is a taxable loss before thededuction. Similarly, if the entity has qualifying additions of $100,000 and taxable income before the deduction of$50,000, the Section 179 deduction for the year is limited to $50,000. However, the remainder can be carriedforward.

The 2008 Act and the 2009 Act also provided a bonus depreciation deduction of 50% of the depreciable basis ofqualifying property purchased and placed in service before January 1, 2010. Bonus depreciation is computed after


139

the Section 179 deduction and there is no limitation on bonus depreciation. Therefore, for example, an entity thatpurchased qualifying property for $1,250,000 would have no Section 179 deduction, but could elect bonusdepreciation of $625,000, which is 50% of the $1,250,000 cost.

Cost remaining after the Section 179 deduction and bonus depreciation is subject to normal depreciation rules. Toillustrate this, assume that in 2009 an entity purchases and places in service qualifying five�year property that costs$600,000. Depreciation for 2009 would be $460,000, consisting of the following:

Section 179 deduction $ 250,000Bonus depreciation 175,000Regular MACRS deduction 35,000

$ 460,000

The $250,000 Section 179 deduction is the maximum allowable and reduces the depreciable basis from $600,000to $350,000. The 50% bonus depreciation allowance is applied to $350,000, resulting in additional first�yeardepreciation of $175,000. Basis of $175,000 remains ($350,000 � $175,000 bonus depreciation) and is subject tonormal depreciation rules. Applying the double declining balance method with a mid�year convention would yieldadditional depreciation of $35,000 [($175,000 � 5 years) � 2 � 1/2].

While the entity would be able to deduct $460,000 of the $600,000 cost in the year of acquisition for federal incometax reporting, the deduction would likely be smaller for state income tax reporting. Many states presently do notallow bonus depreciation, and some may impose a lower maximum on the Section 179 deduction.

Like�kind Exchanges

Brief Description and Tax Attributes. In a Section 1031 like�kind exchange, one property is exchanged for anotherproperty that is similar in use. In a properly arranged like�kind exchange, no gain is recognized by either partyexcept to the extent of boot received (cash, or other property that does not qualify for nonrecognition of gain, plusthe excess of debts transferred over debts assumed). If a party to a like�kind exchange gives boot consisting ofproperty that has appreciated or depreciated in value, that party will recognize a gain or loss on such property. Thetax basis of the asset received is equal to the tax basis of the asset transferred when no boot is involved. If gain isrecognized because of boot received, the basis of the property received is equal to the basis of the property givenup, increased by the gain recognized and decreased by the boot received. If a loss is realized but not recognized,and boot has been received, the basis of the property received is equal to that of the property given up, decreasedby the boot received.

Uses. Historically, Section 1031 like�kind exchanges were commonly used to turn appreciated real estate proper�ties without incurring large capital gains. Current tax law does not allow special tax rates for corporate capital gainsbut continues the deferral of the tax for like�kind exchanges.

Accounting under GAAP. FASB ASC 845�10�30�1 (formerly APB Opinion No. 29) generally requires recording anexchange of nonmonetary assets at fair value unless the exchange does not have commercial substance. Thenotion of commercial substance was added because the FASB believed the notion of commercial substance ismore consistent with the fair value measurement principle on which GAAP is based, produces financial informationthat more faithfully represents the economics of the exchange, and can be more easily and consistently applied. Anonmonetary exchange has commercial substance if either

a. the configuration of future cash flows is expected to change significantly as a result of the exchange or

b. the entity�specific value of the asset received differs significantly from the entity�specific value of the assetsurrendered.

IRC Sec. 1031 establishes the general presumption of an exchange of like�kind property. However, the interpretiveguidance in the regulations and cases has enabled some exchanges of nonmonetary assets to qualify under IRCSec. 1031 even though they may not appear to be like�kind. Accordingly, some exchanges that qualify under IRCSec. 1031 may have commercial substance, and, as a result, the carrying amount of the asset received in theexchange may be carryover basis for income tax reporting and fair value for financial statement reporting.


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Determining whether an IRC Sec. 1031 exchange has commercial substance requires judgment based on ananalysis of the facts and circumstances. If the exchange has commercial substance, the asset received generallyshould be recorded at the fair value of the asset surrendered unless the fair value of the asset received is moreclearly evident. If the fair value of the asset received is more clearly evident than the fair value of the assetsurrendered, the asset received should be recorded at its fair value.

In the common situation in which the exchange does not have commercial substance:

a. If the exchange does not involve monetary consideration, it should be based on recorded amounts, andno gain recognized. (A loss should be recognized if indicated, however.)

b. If the exchange involves monetary consideration:

(1) the entity receiving the monetary consideration should recognize a portion of the gain in the ratio ofcash received to total consideration received, i.e., cash plus fair value of asset received;

(2) the entity paying monetary consideration should not recognize any gain, i.e., the new asset shouldbe recorded at the carrying amount of the asset surrendered plus any payments; and

(3) any losses should be recognized.

However, in an exchange of real estate in which at least 25% of the total consideration is monetary, the gain shouldbe allocated between the monetary and nonmonetary portion.

Illustration. Assume that on 1/1/X3, XYZ Corporation exchanges Parcel A for $80,000 plus Parcel�B (previouslyowned by John Doe). Also assume that the exchange is considered to not have commercial substance as that termis defined in FASB ASC 845�10�30�4 (formerly SFAS No. 153 and that the mortgages are assumed by the newowners in each case.

Parcel A Parcel B

Current market value $ 1,500,000 $ 1,250,000

Cost to XYZ Corporation 500,000 N/A

Mortgage 370,000 200,000

The tax and book gains to XYZ Corporation are calculated as follows:

Total gain Taxable gain Book gain

Fair value of asset given up ($1,500,000� $370,000) $ 1,130,000

Less book value of asset given up($500,000 � $370,000) 130,000

$ 1,000,000

Taxable gain is limited to boot received:

Cash $ 80,000

Excess of debt transferred over debtassumed 170,000

$ 250,000


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The monetary consideration is 25% or less, and therefore, the book gain is limited to:

$80, 000�� $170, 000

$80, 000�� $170, 000�� $1, 250, 000�� $1, 000, 000��

Monetary�consideration�received�

Total�consideration�received�� Total�gain

$ 166,667

The book gain of $166,667 would likely be presented as an infrequently occurring item in the financial statements,i.e., as a separate line item before income taxes. The difference between the gain recorded for financial and taxpurposes is a temporary difference.

Deferred Condemnation or Casualty Gains

For tax purposes, certain condemnation and casualty gains may be deferred for a prescribed period and offsetagainst the basis of replacement property. For GAAP, however, FASB ASC 605�40�25�3 (formerly FASB Interpreta�tion No. 30) requires recognizing gain or loss when monetary consideration is receivable, even if replacement iscontemplated. As a result, in most instances, there will be a difference between GAAP and taxable income and thebases of the assets and liabilities when material condemnation or casualty gains are deferred for tax purposes. Theinterpretation requires treating those differences as temporary differences.

For example, assume that a company receives proceeds of $250,000 from a fire insurance policy covering a smallwarehouse with a book value (and an adjusted basis for tax purposes) of $100,000. For GAAP reporting, thefollowing entry would be made to record the transaction:

Cash $ 250,000Old warehouse (net) $ 100,000Casualty gain 150,000

For GAAP reporting, the entire $150,000 gain would be reported as a casualty gain in the year the proceeds arereceivable. It would be reported as an extraordinary item only if it meets the criteria in FASB ASC 225�20�45�2(formerly APB Opinion No.�30), i.e., unusual nature and infrequency of occurrence. In practice, it is believed gainsand losses from fires normally do not meet those criteria and, accordingly, should be reported as an element ofincome from operations. In multiple�step income statements, the gains often are included in an �other income"section following operating income.

For tax purposes, the $150,000 gain could be deferred for a prescribed period and offset against the cost of areplacement facility. If the warehouse is not replaced within the prescribed period, the gain would be taxable.Regardless of whether the warehouse is replaced within the prescribed time period, a temporary difference wouldresult because of the difference between the financial and tax basis of the warehouse at the end of each period. Ifthe asset is replaced within the time period, a basis difference would result from the deferred gain that was offsetagainst the replacement property. If the asset is not replaced within the prescribed time period, a basis differencewill exist until the deferred gain is reported for tax purposes.

To illustrate, assume the warehouse was replaced at a cost of $300,000 within the prescribed time period. The basisof the warehouse for GAAP would be $300,000 and the basis for tax would be $150,000 (or the $300,000 cost lessthe $150,000 deferred gain). Deferred taxes would be provided on the $150,000 basis difference. The temporarydifference would reverse through depreciation in each subsequent year.


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143

SELF�STUDY QUIZ


14. The guidance in FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) applies to investments held by whattype of entities?

a. Individuals.

b. Business entities.

c. Trusts.

d. Estates.

15. Which of the following statements is correct regarding accounting for investments in partnerships?

a. The equity method can be used instead of presenting consolidated financial statements.

b. Some entities that should use the equity method may be able to record its prorata share of the partnership'sassets, liabilities, revenues, and expenses.

c. The general partners control the limited partnership if the limited partners have substantive participatingrights.

d. The general partners control the limited partnership if the limited partners have the ability to dissolve thepartnership.

16. Smart Company owns 10% of Learning Ltd. Partnership and 40% of Exam Ltd. Partnership. Smart accountsfor the investment in Learning using the cost method and accounts for the investment in Exam using the equitymethod. The losses from the partnerships are not considered to be from passive activities for tax reporting. Thepartnerships have no debt. Assume a 30% tax rate and the following facts:

10% ofLearning Ltd.

40% ofExam Ltd.

Original investment by Smart 1/1/X1 $ 25,000 $ 25,000


Losses deducted by Smart YE 12/31/X1 (25,000 ) (25,000 )




Assuming no permanent decline in the value of the investments and that reduction of the equity methodinvestment below zero is appropriate, how should the investment in Learning be presented in the financialstatements for 20X1?

a. As an asset with a zero balance.

b. As a $25,000 asset.

c. As a $20,000 asset.

d. As a $45,000 asset.


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17. Using the information in the previous question, how should the investment in Exam be presented in the financialstatements for the year ended 12/31/X2?

a. As a $45,000 asset.

b. As a $25,000 loss.

c. As a $15,000 liability and a $25,000 loss.

d. As a $10,000 liability and a $35,000 loss.

18. At 12/31/X2, how much is the deferred tax asset or liability resulting from the temporary difference for theinvestment in Learning Ltd. Partnership?

a. A $7,500 deferred tax asset.

b. A $13,500 deferred tax asset.

c. A $7,500 deferred tax liability.

d. A $13,500 deferred tax liability.

19. Which of the following choices is correct concerning a difference between book and tax earnings oninvestments in partnerships?

a. Earnings and losses are reported on Schedule K�1 using GAAP.

b. K�1 earnings and losses may be recorded in the investor's GAAP financial statements.

c. Investors can only recognize book earnings for tax purposes if the investor and partnership use the samebasis of accounting.

d. If there is a material difference between K�1 earnings and GAAP, a complete conversion is necessary.

20. If conditions are right, which basis allows for nonrecognition of gain in a like�kind exchange?

a. GAAP basis financial statements.

b. Tax basis financial statements.

c. Both GAAP and tax basis financial statements.

d. Gain must be recognized in both GAAP and tax basis financial statements.

21. On 1/1/X5, Baker Corporation exchanges Parcel A for $50,000 plus Parcel B. The exchange is considered tonot have commercial substance and the mortgages are assumed by the new owners in each case.

Parcel A Parcel B

Current market value $ 800,000 $ 650,000

Cost to Baker Corporation 400,000 N/A

Mortgage 200,000 100,000


145

How much is the taxable gain to Baker Corporation?

a. $50,000.

b. $100,000.

c. $150,000.

d. $400,000.

22. Assume the same facts as the previous example. How much is the book gain to Baker Corporation?

a. $0.

b. $25,000.

c. $75,000.

d. $400,000.

23. May Corporation receives proceeds of $500,000 from a fire insurance policy covering a small building with abook value (and an adjusted basis for tax purposes) of $300,000. The building is replaced at a cost of $525,000within the prescribed time period. How much is the temporary difference before any depreciation is taken onthe new asset?

a. $0.

b. $200,000.

c. $325,000.

d. $525,000.


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14. The guidance in FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) applies to investments held by whattype of entities? (Page 133)

a. Individuals. [This answer is incorrect. Individuals do not have to abide by the guidance in FASB ASC323�10�15�5 (formerly APB Opinion No. 18) concerning accounting for investments in partnerships.However, proprietorships ordinarily would.]

b. Business entities. [This answer is correct. FASB ASC 323�10�15�5 (formerly APB Opinion No. 18)only applies to investments held by business entities such as corporations, partnerships, andproprietorships.]

c. Trusts. [This answer is incorrect. Trusts do not abide by the guidance in FASB ASC 323�10�15�5 (formerlyAPB Opinion No. 18) concerning accounting for investments in partnerships.]

d. Estates. [This answer is incorrect. Estates do not follow the guidance in FASB ASC 323�10�15�5 (formerlyAPB Opinion No. 18) to account for investments in partnerships.]

15. Which of the following statements is correct regarding accounting for investments in partnerships? (Page 133)

a. The equity method can be used instead of presenting consolidated financial statements. [This answer isincorrect. FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) states that the equity method is not a validsubstitute for consolidation. While accounting for investments in partnerships is not directly addressed inauthoritative literature, FASB ASC 323�10�15�5 (formerly APB Opinion No. 18) comes closest to being onpoint.]

b. Some entities that should use the equity method may be able to record its prorata share of thepartnership's assets, liabilities, revenues, and expenses. [This answer is correct. GAAP notes thatfor partnerships in certain industries it may be appropriate for the investor to record in its financialstatements its prorata share of the assets, liabilities, revenues, and expenses of the venture.]

c. The general partners control the limited partnership if the limited partners have substantive participatingrights. [This answer is incorrect. According to FASB ASC 810�20�25 (formerly EITF Issue No. 04�5), thegeneral partners do not control the limited partnership if the limited partners have substantive participatingrights.]

d. The general partners control the limited partnership if the limited partners have the ability to dissolve thepartnership. [This answer is incorrect. The general partners do not control the limited partnership if thelimited partners have the substantive ability to dissolve (liquidate) the limited partnership or otherwiseremove the general partners without cause according to FASB ASC 810�20�25 (formerly EITF IssueNo.�04�5.]

16. Smart Company owns 10% of Learning Ltd. Partnership and 40% of Exam Ltd. Partnership. Smart accountsfor the investment in Learning using the cost method and accounts for the investment in Exam using the equitymethod. The losses from the partnerships are not considered to be from passive activities for tax reporting. Thepartnerships have no debt. Assume a 30% tax rate and the following facts:

10% of Learning Ltd.

40% of Exam Ltd.

Original investment by Smart 1/1/X1 $ 25,000 $ 25,000




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40% of Exam Ltd.

10% of Learning Ltd.




Assuming no permanent decline in the value of the investments and that reduction of the equity methodinvestment below zero is appropriate, how should the investment in Learning be presented in the financialstatements for 20X1? (Page 134)

a. As an asset with a zero balance. [This answer is incorrect. This is Smart's tax basis in Learning Ltd.Partnership.]

b. As a $25,000 asset. [This answer is correct. Since Learning Ltd. Partnership is reported on Smart'sfinancial statements using the cost method, the original investment is reported on the 1/1/X1financial statements as a $25,000 asset.]

c. As a $20,000 asset. [This answer is incorrect. $20,000 is the additional contributions for the year 20X2.]

d. As a $45,000 asset. [This answer is incorrect. This is the amount reported for the investment in Learningat 12/31/X2.]

17. Using the information in the previous question, how should the investment in Exam be presented in the financialstatements for the year ended 12/31/X2? (Page 134)

a. As a $45,000 asset. [This answer is incorrect. This would be the amount reported for the investment inExam at 12/31/X2 if the cost method was appropriate.]

b. As a $25,000 loss. [This answer is incorrect. The loss should be reported on the Statement of Income.However, a liability for the share of deficiency in asset of Exam Ltd. Partnership should also be presented.]

c. As a $15,000 liability and a $25,000 loss. [This answer is correct. Since Exam Ltd. Partnership isreported on Smart's financial statements using the equity method, the liability for Smart's share ofdeficiency in assets of Exam at 12/31/X2 is $15,000 ($10,000 excess losses for 20X1 and $5,000 for20X2) and Smart's share of losses for 20X2 are reported on the Statement of Income.]

d. As a $10,000 liability and a $35,000 loss. [This answer is incorrect. For the equity method, this is thepresentation on the 20X1 financial statements.]

18. At 12/31/X2, how much is the deferred tax asset or liability resulting from the temporary difference for theinvestment in Learning Ltd. Partnership? (Page 135)

a. A $7,500 deferred tax asset. [This answer is incorrect. Based on the cost method, Smart would record adeferred tax liability for its investment in Learning Ltd. Partnership.]

b. A $13,500 deferred tax asset. [This answer is incorrect. Smart would record a deferred tax liability for itsinvestment in Learning Ltd. Partnership.]

c. A $7,500 deferred tax liability. [This answer is incorrect. $7,500 is the deferred tax liability at 12/31/X1.]

d. A $13,500 deferred tax liability. [This answer is correct. The financial basis is $45,000 while the taxbasis is zero. Therefore, $45,000 at the 30% tax rate is $13,500.]

19. Which of the following choices is correct concerning a difference between book and tax earnings oninvestments in partnerships? (Page 136)

a. Earnings and losses are reported on Schedule K�1 using GAAP. [This answer is incorrect. It is possible thatthe partnership's K�1 earnings and losses may not materially differ from GAAP. However, the partnership


148

may report accelerated depreciation amounts on its tax return above what it reports on GAAP financialstatements. In addition, a partnership may not report contingent liabilities in its tax reporting that would beappropriate in GAAP financial statements.]

b. K�1 earnings and losses may be recorded in the investor's GAAP financial statements. [This answeris correct. If the partnership's K�1 amounts differ from its GAAP amounts, the K�1 earnings andlosses could be recorded in the investor's GAAP financial statements provided that the differenceis not material to the investor's earnings.]

c. Investors can only recognize book earnings for tax purposes if the investor and partnership use the samebasis of accounting. [This answer is incorrect. For tax purposes, investors recognize earnings based onthe K�1 regardless of whether the investor and the partnership use the same basis of accounting.]

d. If there is a material difference between K�1 earnings and GAAP, a complete conversion is necessary. [Thisanswer is incorrect. If the partnership's basis of accounting does not differ materially from GAAP, theinvestor partner could recognize earnings and losses based on amounts reported in the K�1. However, ifthere is a material difference, the K�1 earnings and losses should be converted to GAAP. In many cases,the conversion of a few key items will bring the K�1 amounts materially close to GAAP, and a completeconversion will be unnecessary.]

20. If conditions are right, which basis allows for nonrecognition of gain in a like�kind exchange? (Page 139)

a. GAAP basis financial statements. [This answer is incorrect. If certain requirements are met, no gain will berecognized for like�kind exchanges on the financial statements. However, this is not the correct answer tothis question.]

b. Tax basis financial statements. [This answer is incorrect. Recognition of gain can be deferred in Section1031 exchanges. However, this is not the correct answer to this question.]

c. Both GAAP and tax basis financial statements. [This answer is correct. Certain transactions mayqualify for nonrecognition of gain as long as the specific details meet the requirements provided fortax and/or GAAP reporting per IRC Sec. 1031 and FASB ASC 845�10�3�1 (formerly APB Opinion No.29).]

d. Gain must be recognized in both GAAP and tax basis financial statements. [This answer is incorrect.Like�kind exchanges do not require gain recognition in both GAAP and tax basis financial statements.Recognition of gain is dependent upon the specific details of the transaction.]

21. On 1/1/X5, Baker Corporation exchanges Parcel A for $50,000 plus Parcel B. The exchange is considered tonot have commercial substance and the mortgages are assumed by the new owners in each case.

Parcel A Parcel B



Mortgage 200,000 100,000

How much is the taxable gain to Baker Corporation? (Page 140)

a. $50,000. [This answer is incorrect. This is the amount of cash received. This amount is used to computethe taxable gain. The example has other types of boot. Boot can be cash, other property that does notqualify for nonrecognition of gain, and the excess of debts transferred over debts assumed.]

b. $100,000. [This answer is incorrect. This is the excess of debts transferred over debts assumed. Thisexample has other types of boot.]

c. $150,000. [This answer is correct. Taxable gain is limited to boot received. Baker Corporationreceived $50,000 cash and gave up $200,000 in debts but only received a $100,000 debt.]


149

d. $400,000. [This answer is incorrect. This is the total gain. The fair value of asset given up ($800,000 �$200,000) less book value of asset given up ($400,000 � $200,000) equals the $400,000 total gain.]

22. Assume the same facts as the previous example. How much is the book gain to Baker Corporation? (Page 140)

a. $0. [This answer is incorrect. No gain would be recognized if the exchange did not involve monetaryconsideration. However, Baker Corporation did receive monetary consideration in the form of cash anda reduction in debt.]

b. $25,000. [This answer is incorrect. The calculation should include the $100,000 of excess debt transferredover debt assumed.]

c. $75,000. [This answer is correct. The book gain is calculated by dividing the monetary considerationreceived by the total consideration received and multiplying this percentage by the total gain. Themonetary consideration received is $50,000 in cash and $100,000 of excess debt transferred overdebt assumed. The total consideration received includes the $50,000 cash, $100,000 of excess debttransferred over debt assumed, and the $650,000 current value of Parcel B. The total gain is$400,000. Therefore, the book gain is $75,000 (($50,000+$100,000) / ($50,000 + $100,000 +$650,000) � $400,000).]

d. $400,000. [This answer is incorrect. This is the total gain. The fair value of asset given up ($800,000 �$200,000) less book value of asset given up ($400,000 � $200,000) equals the $400,000 total gain.]

23. May Corporation receives proceeds of $500,000 from a fire insurance policy covering a small building with abook value (and an adjusted basis for tax purposes) of $300,000. The building is replaced at a cost of $525,000within the prescribed time period. How much is the temporary difference before any depreciation is taken onthe new asset? (Page 141)

a. $0. [This answer is incorrect. Since the casualty gain is deferred for tax purposes and the gain is recognizedfor GAAP, there is a difference between the tax basis and GAAP basis of the new building. A basis differenceresults from the deferred gain that offset against the replacement property.]

b. $200,000. [This answer is correct. The warehouse was replaced at a cost of $525,000 within theprescribed time period. The basis of the warehouse for GAAP is $525,000 and the basis for tax is$325,000 ($525,000 cost of the new building less the $200,000 deferred gain). The temporarydifference is $200,000 (GAAP basis less the tax basis of the new warehouse). The temporarydifference will reverse through depreciation in each subsequent year.]

c. $325,000. [This answer is incorrect. This is the tax basis of the new building. This amount is determinedby taking the cost of the new building of $525,000 and subtracting the deferred gain amount of $200,000on the old building.]

d. $525,000. [This answer is incorrect. $525,000 is the GAAP basis of the new building. This is the purchaseprice of the new building which will be depreciated on the GAAP financial statements.]


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Lesson 1 (PFSTG092)


1. Which of the following examples follows the guidance in FSP FIN 48�1, �Definition of Settlement in FASBInterpretation No. 48?"

a. Company A's return for year 2 was examined, but the tax position in question was not examined. CompanyA can consider the position to be settled.

b. Company B's deduction was examined and accepted in year 1, therefore, it is assumed by the entity thatthe same deduction will be accepted in year 3.

c. Once Company C decides its stance on a tax position, the entity may not change its assessment if the taxposition has not been examined.

d. Company D's liability for year 1 can be recognized when the tax position in question is accepted by thetaxing authority.

2. A taxing authority recently examined Bass Corporation's tax return, and disallowed a deduction which Bass haddetermined would not meet the �more likely than not" criterion. What action must Bass now take in regard toits financial reporting?

a. Bass would not need to take any action since it did not defer the realized tax benefit.

b. Bass will pay the additional tax assessed and debit the liability account for the previously deferred taxbenefit.

c. Bass will pay the additional tax assessed and debit the current tax provision for the current year.

d. Bass will debit the current tax provision and credit a liability for the deferred tax benefit.

3. Lucky Company changed its year end for tax reporting and financial reporting purposes. Which of the followingactions correctly discloses the change in the financial statements?

a. The comparative financial statements are presented that include the statements of income for the yearsended December 31, 20X1 and December 31, 20X2 and the balance sheets for December 31, 20X1 andDecember 31, 20X2.

b. The period in which Lucky changed its year end for tax and financial reporting purposes, the notes to thefinancial statements include a disclosure concerning the change in fiscal year, but financial statementsmay not be presented in comparative form.

c. Comparative financial statements are presented that include the statements of income for the six monthsended December 31, 20X1 and the year ended June 30, 20X1 and the balance sheet for December 31,20X1.

d. In the year of the change, the financial statement presentation covers less than 12 months. Additionally,a disclosure is made in the notes to the financial statements regarding the change including any seasonaleffects to net income.


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4. What change made by the Tax Reform Act of 1986 would require consideration for financial reporting purposes?

a. Category three costs are now mostly required to be capitalized for tax purposes.

b. Category one costs are now required to be included in inventory for tax purposes.

c. Category three costs are now to be accounted for according to GAAP for tax purposes.

d. Category two costs are no longer required to be included in inventory for tax purposes.

5. EITF Issue No. 86�46 states that:

a. Costs capitalizable for tax purposes should preferably be capitalized for financial reporting purposes.

b. The nature of operation and industry practice should be considered for asset capitalization purposes.

c. Costs capitalizable for tax purposes must be capitalized for financial reporting purposes.

d. Generally accepted accounting principles were incorrectly applied in prior periods.

6. Usually, temporary differences are recorded on the financial statements due to the differences in taxrequirements and GAAP requirements for construction period interest and taxes incurred on current projects.

a. True.

b. False.



7. Sherry's Staples has been encountering some financial difficulties and a liquidation of the company is on thehorizon. Which of the following is true regarding the liquidation?

a. The company's financials should be prepared assuming the liquidation will occur.

b. The assets should be reported at historical value when a liquidation is pending.

c. If the company has the resources to wait for a specific price, the financials should still be presented usingliquidation basis.

d. Gains and losses should not be recognized in the financial statements until they are realized under aliquidation.

8. Calico Company filed a petition for Chapter 11 bankruptcy on February 1, 20X3. How would this event affectthe December 31, 20X2 financial statements being prepared in March?

a. The presentation of liabilities in the financial statements will reflect the status of the creditors (i.e., secured,undersecured, and unsecured claims).

b. The results of cash flows from operations will be presented separately from the cash flows related to thebankruptcy proceedings.

c. A disclosure will be included in the financial statements concerning the subsequent event, but no otherconsiderations would be presented.

d. The company should not present financial statements for earlier years in comparison to the December 31,20X2 financial statements.


152

9. Which type of liability is not subject to compromise and, therefore, will be classified as such on the balance

sheet?

a. Undersecured claim.

b. Unsecured claim.

c. Prepetition liability.

d. Postpetition liability.

10. Which of the following choices is correctly presented in the financial statements of a company in Chapter 11

proceedings?

a. Reorganization items should be presented net of income taxes.

b. Reorganization items should be disclosed as unusual or infrequently occurring items.

c. The presentation of assets is generally no different in Chapter 11 proceedings.

d. The presentation of stockholders' equity is generally not different in Chapter 11 proceedings.

11. SOP 90�7 requires companies in Chapter 11 proceedings to disclose such in the notes to the financial

statements.

a. True.

b. False.



12. Which of the following is one of the criteria requiring a company emerging from reorganization proceeding to

employ �fresh�start reporting?"

a. Many of the assets are considered impaired, and values are adjusted to less than 50% of pre�bankruptcyvalues.

b. Holders of voting stock before plan approval receive less than half of the voting shares of the emergingcompany.

c. The fair value of all assets after reorganization are less than the total of postpetition liabilities.

d. The fair value of the assets before the date of plan approval are less than all of the allowed claims.

13. Which one of the following is a preconfirmation contingency?

a. Environmental issues that are classified as nondischargeable claims.

b. Estimates used to allocate the reorganization value to the entity's assets.

c. Income tax related estimates covered by SFAS No. 109.



153

14. Generally, the equity method of accounting should be used when corporations, partnerships, andproprietorships own what percentage of a partnership?

a. Less than 20%.

b. 20% or more but less than 50%.

c. 50% or more but less than 80%.

d. More than 80%.

15. Generally, when should the cost method be used to account for an investment in a partnership?

a. When the investment is less than 20% of the partnership.

b. When the investment is less than 50% of the partnership.

c. When the investment is more than 50% of the partnership.

d. When the investment is less than 100% of the partnership.

16. A Company owns 15% of B Ltd. Partnership and 45% of C Ltd. Partnership. A Company accounts for theinvestment in B Ltd. using the cost method and accounts for the investment in C Ltd. using the equity method.The losses from the partnerships are not considered to be from passive activities for tax reporting. Thepartnerships have no debt. Assume a 30% tax rate and the following facts:

15% ofB Ltd.

45% ofC Ltd.

Original investment by A Co. 1/1/X1 $ 50,000 $ 50,000


Losses deducted by A Co. YE 12/31/X1 (50,000 ) (50,000 )



Losses deducted by A Co. YE 12/31/X2 (40,000 ) (40,000 )

Assuming no permanent decline in the value of the investments and that reduction of the equity methodinvestment below zero is appropriate, how should the investment in B Ltd. be presented in the financialstatements for 20X2?





17. Using the information in the previous question, how should the investment in C Ltd. be presented in the financialstatements for the year ended 12/31/X1?






154

18. Using the information in questions 15 and 16, How much is the deferred tax asset or liability resulting from thetemporary difference for the investment in B Ltd. Partnership at 12/31/X1?

a. A $15,000 deferred tax asset.

b. A $27,000 deferred tax asset.

c. A $15,000 deferred tax liability.

d. A $27,000 deferred tax liability.

19. Which of the following resembles GAAP depreciation?

a. Allocating expenses over the expected useful life of the asset while considering salvage value.

b. Stimulate investments by accelerating deductions.

c. Using statutory write�off periods for groups of various assets.

d. Specific depreciation methods are used for the various recovery periods.

20. When is the tax method of depreciation acceptable for GAAP financial statements?

a. When the tax method used is ACRS.

b. When depreciating significant pre�1987 investments in equipment.

c. When using MACRS and salvage value is immaterial.

d. When depreciating luxury vehicles used in the business.

21. ABC Company purchases and places into service a qualifying five�year property that costs $450,000 in 2009.What is the maximum depreciation amount for 2009 if ABC qualifies for a Section 179 deduction, bonusdeprecation and applies straight�line depreciation to the newly purchased property?

a. $90,000.

b. $250,000.

c. $350,000.

d. $370,000.

22. On 1/1/X1, Carter Corporation exchanges Parcel A for $100,000 plus Parcel B. The exchange is considered tonot have commercial substance and the mortgages are assumed by the new owners in each case.

Parcel A Parcel B



Mortgage 100,000 50,000

How much is the taxable gain to Carter Corporation?

a. $37,500.

b. $150,000.

c. $350,000.

d. $500,000.


155

23. Assume the same facts as the previous example. How much is the book gain to Carter Corporation?

a. $37,500.

b. $150,000.

c. $350,000.

d. $500,000.

24. Excalibur Corporation receives proceeds of $225,000 from a fire insurance policy covering a small building witha book value (and an adjusted basis for tax purposes) of $50,000. The building is replaced at a cost of $230,000within the prescribed time period. How much is the temporary difference before any depreciation is taken onthe new asset?

a. $55,000.

b. $175,000.

c. $225,000.

d. $230,000.


156


157

Lesson 2:�Selected Topics Part 2

INTRODUCTION

Lesson 2 provides additional guidance for accountants presenting specific �tax transactions" in financial state�ments in conformity with GAAP.


Completion of this lesson will enable you to:� Determine the income tax and accounting treatment for transactions involving ownership of the entity or various

other transactions.� Calculate adjustments and equity balances for ownership transactions and revenue recognition for lease

transactions for tax and financial reporting.

REDEMPTIONS OF STOCK AND RELATED TRANSACTIONS

Stock Redemptions

Brief Description. A stock redemption takes place when a corporation transfers cash or other assets to astockholder in exchange for his stock (generally all of his stock).

Tax Attributes. When the transaction meets the tax requirements of a redemption, a stockholder generally willreceive capital gains treatment on the exchange of his shares (instead of the dividend treatment usually applied tocorporate distributions), and distributions of appreciated assets will result in the corporation recognizing gains asif the property were sold to the stockholders at its fair market value. However, deducting losses on distribution ofassets is not permitted.

Uses. Stock redemptions are used to buy out stockholders and to purchase the stock of a deceased stockholderin a closely held business, e.g., when the corporation and stockholder have entered into a buy�sell agreementfunded by company�owned insurance on the life of the stockholder.

Accounting under GAAP. With respect to the corporation, the transaction is a treasury stock purchase. If thetreasury stock is to be retired (whether formally or constructively), any excess of purchase price over par or statedvalue should either be charged entirely to retained earnings or allocated between additional paid�in capital andretained earnings. If the treasury stock will not be retired but used for other purposes, e.g., for reissue to a newstockholder, or when ultimate disposition has not yet been decided, the cost of treasury stock may be shownseparately as a deduction from the total of capital stock, additional paid�in capital, and retained earnings (the costmethod) or may be treated the same as retired stock (the par value method).

Frequently, small businesses purchase treasury stock for a price in excess of retained earnings and additionalpaid�in capital of the corporation, for example, when the shares of a major stockholder are redeemed and thecompany is worth substantially more than its book value. (State law may restrict retained earnings for the amountof the cost of the treasury stock or prohibit the purchase of treasury stock in excess of retained earnings andadditional paid�in capital. Some states allow appraisal increases in assets to produce available retained earnings.Except as discussed later, such appraisal increases should not be recorded in the financial statements. Legalcounsel should be consulted when the proposed redemption price exceeds available retained earnings.) In suchsituations, recording the transaction as if the stock will be retired would most likely result in a deficit in retainedearnings. Although total stockholders' equity is the same under both methods, the cost method does not directlyreduce retained earnings and also is easier to apply. However, the par value method should be used if the companyis not considering reissuing the stock. (In addition, in some states the corporate franchise tax base includes thecost of treasury stock, and retirement of the stock would reduce state franchise costs.)

Illustration. Assume XYZ Corporation is wholly owned by two stockholders in equal percentages (50/50) and thateach has a buy�sell agreement with the corporation requiring the corporation to purchase his shares for $600,000


158

in the event of his death. Assuming one of the stockholders dies, the stockholders' equity section of the corpora�tion's balance sheet before and after the redemption would appear as follows:

Before After

CostMethod

Par ValueMethod


Common stock, $1 par value, 20,000shares authorized and issued $ 20,000 $ 20,000 $ 10,000

Additional paid�in capital 30,000 30,000 15,000

Retained earnings 280,000 280,000 (295,000 )

330,000 330,000 (270,000 )

Less cost of 10,000 shares of treasurystock � (600,000 ) �

$ 330,000 $ (270,000 ) $ (270,000 )

Other Considerations. If a buy�sell redemption is funded by life insurance proceeds, the company will record theexcess of the proceeds over the cash value of the policy as a gain for financial reporting purposes, which helpsoffset the charge to retained earnings for the excess of the redemption price over the par value.

If a redemption is accomplished through distribution of property, FASB ASC 845�10�30�2 (formerly APB OpinionNo. 29) generally requires the fair market value of the property transferred to be used as the purchase price of thetreasury stock. If the fair market value differs from the book value, the company would recognize a gain or loss forfinancial statement purposes. The gain or loss recognized in the financial statements may differ from amountsreported in the tax returns. However, that difference would always be a reversal of a temporary difference. (Sincethe difference arises from the distribution of an asset, it can never reverse and, therefore, would not be anoriginating temporary difference.) Thus, the difference could never cause deferred taxes to be set up; it only couldcause them to reverse. The following examples illustrate the accounting issues:

a. No Previous Temporary DifferencesAssume that an asset has a basis of $70,000 for financial statementand income tax reporting purposes.

(1) If its fair market value were $80,000, a $10,000 gain would be reported both in the financial statementsand the tax return on distribution.

(2) If the fair market value were $60,000, a $10,000 loss would be reported in the financial statements butwould not be deducted in the tax returns. The $10,000 difference could never reverse and should,therefore, be treated as a permanent difference.

b. Previous Temporary DifferencesAssume that using different depreciation methods caused the basis ofan asset to be $70,000 for financial statement reporting and $45,000 for tax reporting. As a result, there isa taxable temporary difference of $25,000 prior to the distribution.

(1) If the fair market value were $80,000, a gain of $10,000 would be reported in the financial statements,but the taxable gain would be $35,000. The $25,000 difference is the reversal of the taxable temporarydifference.

(2) If the fair market value were $50,000, a loss of $20,000 would be reported in the financial statements,but a gain of $5,000 would be reported in the tax returns. The $25,000 excess of taxable income overthe amount reported in the financial statements is the reversal of the taxable temporary difference.

(3) If the fair market value were $40,000, the financial statements would report a loss of $30,000, but noloss would be deducted in the tax returns. Because none of the loss is deductible, the differencebetween the $30,000 loss reported in the financial statements and the $25,000 taxable temporarydifference should be treated as a permanent difference.


159

Because of tax attribution rules, buy�out agreements prior to 1987 often included a provision under which theselling stockholder agrees not to have any management influence over the company for 10 years. Disclosure of theagreement in the notes to the financial statements may provide useful information about some companies,particularly when the seller was a key factor in the company's performance.

Covenants Not to Compete

Brief Description. Covenants not to compete are contracts that provide for compensation to be paid by one partyover a specified period for the agreement by another party not to compete in a given geographical area for aspecified time. The consideration for a covenant may be included in the purchase price for the stock or assets of abusiness, it may be paid up�front, or it may be paid in installments.

Tax Attributes. If the covenant is in connection with the purchase of a business or its assets after August 10, 1993,the cost is amortized over 15 years under IRC Section 197. Payments under a pre�August�10, 1993 covenant not tocompete are still generally deductible as an ordinary business expense over the term of the agreement providedthe covenant has economic substance (that is, it is probable that the seller would be a significant competitive threatwithout the covenant). The seller generally reports collections as ordinary income if the covenant has economicsubstance, and capital gain if it does not. Payments under post�August 10, 1993 covenants that are entered intowith a party other than the seller of a business (such as former employees of an acquired business) should continueto be deductible over the term of the agreement, as under pre�Section 197 law. However, the IRS can be expectedto argue that such covenants with non�owners are nevertheless made �in connection with" the purchase of abusiness, and therefore are subject to 15�year amortization.

Uses. Covenants are frequently used in the purchase of a closely held business to protect the new owner'sinvestment from competition.

Accounting under GAAP. It is believed the accounting considerations for a covenant not to compete are generallythe same for GAAP and income tax reporting. No value should be assigned to a covenant unless it has economicsubstance and the purchaser has either made an up�front payment or the cost of the covenant is included in theprice of the stock or assets acquired by the purchaser.

Illustrations. Assume that on January 1, 20X1, XYZ Corporation purchases all of the assets of C Division of ABCCompany for $1 million with $250,000 allocated to a five�year covenant not to compete in C Division's line ofbusiness and $750,000 allocated to property and equipment. Assume also that XYZ Corporation pays $200,000 atclosing and signs a note for $800,000, which is to be paid in four equal annual installments of principal plus 10%interest with the first payment due one year from closing. If the covenant has economic substance and its value isexpected to decline 40% the first year, 30% the second year, and 10% in each of the final three years, the financialstatements for XYZ Corporation and ABC Company would appear as follows:

ABC COMPANY (Seller)(Balance Sheet Excerpts)

January 1

20X2 20X1

ASSETS

CURRENT ASSETS

Cash (from sales proceeds, excludes interest) $ 400,000 $ 200,000

Current portion of long�term notes receivable 200,000 200,000

OTHER ASSETS

Long�term notes receivable 400,000 600,000

LIABILITIES

Deferred income 150,000 250,000


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ABC COMPANY (Seller)(Statement of Income Excerpts)

Year Ended December 31

20X2 20X1

OTHER INCOME (EXPENSES)

Revenue from covenant not to compete $ 75,000 $ 100,000

Interest income 60,000 80,000

135,000 180,000

XYZ CORPORATION (Buyer)(Balance Sheet Excerpts)

January 1

20X2 20X1

ASSETS

PROPERTY AND EQUIPMENT (before depreciation) $ 750,000 $ 750,000

OTHER ASSETS

Covenant not to compete 150,000 250,000

CURRENT LIABILITIES

Current portion of long�term debt 200,000 200,000

LONG�TERM DEBT 400,000 600,000

XYZ CORPORATION (Buyer)(Statement of Income Excerpts)

Year Ended December 31

20X2 20X1

OTHER INCOME (EXPENSES)

Amortization of covenant not to compete $ (75,000 ) $ (100,000 )

Interest expense (60,000 ) (80,000 )

(135,000 ) (180,000 )


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SELF�STUDY QUIZ


24. Which of the following is a tax attribute of a stock redemption?

a. When distributing assets having a market value less than tax basis, the loss is deductible by thecorporation.

b. When distributing assets having a market value greater than tax basis, the corporation will recognize again.

c. In a redemption, the stockholder will recognize dividends equal to the amount of assets received.

d. The stockholder never receives capital gain treatment in a stock redemption.

25. Which of the two methods (cost method or par value method) should be used if the company is not planningon reissuing the stock?

a. Cost method.

b. Par value method.

26. Medco Corporation is wholly owned by two stockholders in equal percentages. Each stockholder has a buy�sellagreement with the corporation requiring the corporation to purchase his shares for $450,000 in the event ofhis death. Assume one of the stockholders dies, how much is the retained earnings balance after theredemption using the par value method?


Common stock, $1 par value, 40,000 sharesauthorized and issued $ 40,000

Additional paid�in capital 60,000

Retained earnings 560,000

a. $110,000.

b. $160,000.

c. $280,000.

d. $560,000.

27. If property is distributed in a buy�sell redemption, what effect does the distribution have on temporarydifferences?

a. It does not affect temporary differences.

b. It will cause a temporary difference.

c. It will cause a permanent difference.

d. It may cause a temporary difference to reverse.


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28. A redemption is accomplished through a distribution of property. The distributed asset has a basis of $4,500for financial statement reporting, $3,000 for tax reporting, and a fair market value of $2,500. What is one effectof the distribution?

a. A $500 taxable loss.

b. A $1,500 temporary difference.

c. A $2,000 reversal of a taxable temporary difference.

d. A permanent difference occurs.


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24. Which of the following is a tax attribute of a stock redemption? (Page 157)

a. When distributing assets having a market value less than tax basis, the loss is deductible by thecorporation. [This answer is incorrect. In a stock redemption, deducting losses on distribution of assetsis not permitted by tax law.]

b. When distributing assets having a market value greater than tax basis, the corporation will recognizea gain. [This answer is correct. According to tax law, distributions of appreciated assets will resultin the corporation recognizing gains as if the property were sold to the stockholders at its fair marketvalue.]

c. In a redemption, the stockholder will recognize dividends equal to the amount of assets received. [Thisanswer is incorrect. When the transaction meets the tax requirements of a redemption, a stockholdergenerally will not receive the dividend treatment usually applied to corporate distributions. Stockredemptions are taxed differently than dividends.]

d. The stockholder never receives capital gain treatment in a stock redemption. [This answer is incorrect.When the transaction meets the tax requirements of a redemption, a stockholder generally will receivecapital gains treatment on the exchange of his shares per the tax law.]

25. Which of the two methods (cost method or par value method) should be used if the company is not planningon reissuing the stock? (Page 157)

a. Cost method. [This answer is incorrect. Although the cost method is easier to apply, it is not therecommended method in redemptions where the company is not planning on reissuing the stock. Inaddition, this method will prevent the redemption from resulting in a deficit in retained earnings.]

b. Par value method. [This answer is correct. Although the par value method is the more complicatedmethod to apply, this method should be used if the company is not considering reissuing the stock.]

26. Medco Corporation is wholly owned by two stockholders in equal percentages. Each stockholder has a buy�sellagreement with the corporation requiring the corporation to purchase his shares for $450,000 in the event ofhis death. Assume one of the stockholders dies, how much is the retained earnings balance after theredemption using the par value method? (Page 157)





a. $110,000. [This answer is incorrect. All of the $450,000 redemption is not allocated to retained earnings.The common stock and additional paid�in capital accounts must also be adjusted.]

b. $160,000. [This answer is correct. Of the $450,000 redemption price, $20,000 is a reduction incommon stock, $30,000 is a reduction in additional paid�in capital, and the remaining $400,000reduces retained earnings. Therefore, the common stock balance is $20,000, the additional paid�incapital balance is $30,000, and the retained earnings balance is $160,000.]

c. $280,000. [This answer is incorrect. The retained earnings amount is not divided in half to account for thestock redemption. However, using the par value method, common stock and additional paid�in capital aredivided into half.]


164

d. $560,000. [This answer is incorrect. $560,000 is retained earnings amount before the redemption and alsothe retained earnings amount after redemption using the cost method. The par value method adjusts theretained earnings amount.]

27. If property is distributed in a buy�sell redemption, what effect does the distribution have on temporarydifferences? (Page 158)

a. It does not affect temporary differences. [This answer is incorrect. It is possible that a distribution ofproperty will not affect temporary differences if the gain or loss recognized in the financial statements doesnot differ from amounts reported in the tax return. However, this is not always the case.]

b. It will cause a temporary difference. [This answer is incorrect. In this situation, when a gain or lossrecognized in the financial statements differs from amounts reported in the tax returns, a temporarydifference does not occur. A distribution of an asset cannot cause a temporary difference, because thedifference would never reverse.]

c. It will cause a permanent difference. [This answer is incorrect. A property distribution in a buy�sellredemption could, at times, cause a permanent difference. A loss cannot be deducted on the tax return,because deducting losses on distribution of assets is not permitted.]

d. It may cause a temporary difference to reverse. [This answer is correct. The gain or loss recognizedin the financial statements resulting from a distribution of property may differ from amountsreported in the tax return. However, that difference would always be a reversal of a temporarydifference. (Since the difference arises from the distribution of an asset, it can never reverse and,therefore, would not be an originating temporary difference.)]

28. A redemption is accomplished through a distribution of property. The distributed asset has a basis of $4,500for financial statement reporting, $3,000 for tax reporting, and a fair market value of $2,500. What is one effectof the distribution? (Page 158)

a. A $500 taxable loss. [This answer is incorrect. Deducting distribution losses on the tax return is notpermitted.]

b. A $1,500 temporary difference. [This answer is incorrect. Temporary differences to not arise from thedistribution of an asset.]

c. A $2,000 reversal of a taxable temporary difference. [This answer is incorrect. Since the temporarydifference prior to the distribution was $1,500, $1,500 is the amount of the reversal.]

d. A permanent difference occurs. [This answer is correct. Because none of the loss on the asset isdeductible for tax purposes, a permanent difference occurs.]


165

HOW TO ACCOUNT FOR PARTNERSHIPS

Accounting for Changes in the Equity Interests of an Entity

The consideration transferred for a change in the equity interests of a small or midsize nonpublic entity, such as thecontribution of capital by a new investor or the purchase of an existing equity interest, typically is based on the fairvalue of the entity. For example, to determine how much a new investor must pay for a small equity interest in theentity, the fair value of the entity may be multiplied by the percentage of ownership conveyed by the interest and bya factor designed to recognize that the interest does not convey control or even the ability to exercise significantinfluence. Does the transfer of consideration for a change in the equity interest mean that appreciation in the fairvalue of the entity's net assets has been realized and should be recognized?

Changes in equity interests may be between equity investors or between equity investors and the entity. Theconsideration transferred for a small or midsize nonpublic entity to acquire a major equity interest often includesenough appreciation in net assets so that the charge to equity to record the purchase reduces the carrying amountof equity below zero. That suggests that at least the appreciation included in the consideration transferred wasrealized and should be recognized through an increase in the carrying amount of the entity's net assets. It alsosuggests that the change was large enough that in effect there is a new entity, and the entity's net assets should berevalued to their fair value at the date of acquisition.

Should the answer for whether the entity should recognize appreciation in the fair value of its net assets depend onthe form of the change? For example, should the answer for the illustration mentioned above be different if theequity interest acquired is relatively small?

Should the answer as to whether the entity should recognize appreciation in the fair value of its net assets dependon the significance of the change? For example, should the answer for the illustration as mentioned above bedifferent if the equity interest acquired is relatively small?

The authoritative accounting literature has not addressed these and related questions. However, accountingtextbooks have addressed them for partnerships. Textbooks typically discuss two methods of accounting forchanges in a partnership's equity intereststhe bonus method and the goodwill method. Generally, no appreci�ation is recognized under the bonus method, but under the goodwill method all the appreciation in the fair value ofthe partnership's net assets is recognized. The EITF discussed, but did not conclude on, a third method, whichresults in recognition of some of the appreciation.

FASB ASC 805 [formerly SFAS No. 141(R), Business Combinations] was issued in December 2007 and is effectivefor years beginning on or after December 15, 2008. Earlier application is prohibited. That literature providesguidance on accounting for the acquisition of a controlling financial interest in another entity. Generally, theacquiring entity should record all of the net assets of the acquired entity at their fair value. The offsets are theconsideration transferred for the acquisition and the fair value of any noncontrolling interest in the acquired entity.Subsequent unrealized changes in fair values should be recognized only if required by other generally acceptedaccounting principles, such as for equity securities with a readily determinable fair value or for impairment oflong�lived assets.

After FASB ASC 805 [formerly SFAS No. 141(R)] becomes effective, EITF Issue No. 88�16 is nullified. Therefore, theguidance they proposed for changes in partnership equity interests based on EITF Issue No. 88�16 should bereplaced.

The guidance in FASB ASC 805 suggests that a reasonable framework for small and midsize nonpublic entities touse in deciding whether to recognize appreciation in the fair value of their net assets because of changes in equityinterests would be to push down the values recorded by the acquiring entity in a business combination. Thedecision on whether to apply push�down accounting depends on whether the primary users of the financialstatements of the entity acquired would find the resulting information helpful. However, push�down accounting isnot required.


166

Guaranteed Payments to Partners

Guaranteed payments to partners are often made as salary payments for services or interest on capital accounts.The conventional method of accounting for such payments to partners is to treat the payments as part of theallocation of partnership net income, rather than as an expense in determining net income. However, in somesituations, e.g., the payments are designed to reflect reasonable compensation for services, it may be moremeaningful to show the payments as expenses of the partnership. Whenever guaranteed payments are material,the method of accounting for them should be included in the accounting policies disclosures. An example of sucha disclosure is as follows:


Guaranteed Payments to Partners

Guaranteed payments to partners that are intended as compensation for services rendered areaccounted for as partnership expenses rather than as allocations of partnership net income.Guaranteed payments that are intended as payments of interest on capital accounts are notaccounted for as expenses of the partnership, but rather, as part of the allocation of net income.

Because guaranteed payments are deductible by the partnership and payments in liquidation of a partnershipinterest are not, guaranteed payments are frequently used as a vehicle for purchasing the interest of a partner.Amounts paid in return for the partnership interest should be accounted for following the guidance in �Liquidation(Buy Out) of a Partnership Interest."

Capital Contributions

After a partnership is formed, a partner may contribute assets to it. (For example, a partner may contributeadditional cash to fund cash flow shortages.) A partnership should record such contributions as follows:

� Cash. Cash is the simplest form of capital contribution. The contributing partner's capital account shouldbe increased by the amount of cash contributed.

� Real Estate or Other Assets. In accordance with FASB ASC 845�10�30�1 [(formerly Paragraph 18 of APBOpinion No. 29), which does not apply to companies under common control] the amount recorded for anonmonetary asset received in a nonreciprocal transfer should be the fair value of the asset received.Consequently, the contributing partner's capital account should be increased by the fair value of the assetcontributed. [FASB ASC 970�323�30�3 and 30�4 (formerly SOP 78�9, Accounting for Investments in Real

Estate Ventures) discusses situations in which an investor (a)�contributes real estate, (b) immediatelywithdraws cash or other assets, and (c) has no commitment to reinvest the amount withdrawn. Thestandard states that such transactions more closely resemble sales than capital contributions and shouldbe accounted for by the investor in accordance with FASB ASC 360�20 (formerly SFAS No. 66, Accountingfor Sales of Real Estate).]

CONSIDERATIONS FOR LIMITED LIABILITY COMPANIES

Limited liability companies (LLCs) are a creation of state law. Each state establishes its own LLC rules andcharacteristics. Generally, LLCs are owned by members and combine many of the tax advantages of a partnershipwith the liability protection of a corporation. For example, members are not personally liable for the LLC's debts orliabilities, except to the extent of their investment and any remaining capital commitment to the LLC. However,unlike a limited partner in a partnership, a member of an LLC can participate in management of the entity.

General Tax Treatment

The attractiveness of LLCs depends on their treatment as partnerships for federal income tax purposes. TheInternal Revenue Service has replaced the previous rules that made it difficult to determine whether an LLC shouldbe treated as a partnership or a corporation for federal income tax purposes with �check the box" entity classifica�


167

tion regulations. Under the �check the box" regulations, LLCs with more than one member can elect to be treatedas partnerships for federal income tax purposes, even though they have corporate characteristics. (LLCs also canelect to be treated as corporations; however, that option is attractive only in limited circumstances, such as when Scorporation status is desired to minimize the owners' liability for payroll taxes on their earnings.)

Single�member LLCs. The �check the box" regulations allow single�member LLCs, which are permitted by somestates, to elect to have their existence ignored for federal income tax purposes. For example, an LLC owned by asingle individual can elect to be treated as a sole proprietorship. An LLC wholly owned by another legal entity, suchas a corporation, can elect to be treated as an unincorporated branch of the parent entity. Alternatively, a single�member LLC can elect to be treated as a corporation in the event that choice is more attractive.

Default Classification Rules. Domestic LLCs in existence before January 1, 1997, generally retain their existing taxstatus by default. However, existing single�member LLCs that claimed partnership status under the former tax rulesare classified by default as sole proprietorships or unincorporated branches of a parent entity, rather than aspartnerships. New domestic LLCs are automatically treated as partnerships if they have more than one member, oras sole proprietorships or unincorporated branches if there is only a single member. Alternatively, LLCs can chooseto be treated as corporations by making an affirmative �check the box" election. An LLC wishing to elect aclassification different from its initial default classification must file an affirmative �check the box" election. The sameis true when an LLC later wishes to change its existing classification.

Conversion of an Existing Entity to an LLC. Internal Revenue Service private letter rulings generally have heldthat the conversion of a partnership to an LLC (whether by merger or otherwise) is treated as a continuation of thepartnership with no tax consequences, unless the conversion causes a shift in the allocation of liabilities among thepartners/members. If a shift in liabilities causes a deemed distribution of cash in excess of a member's basis in theLLC, a gain will be recognized. The conversion of a corporation to an LLC (assuming the LLC is treated as apartnership) will result in the recognized liquidation of the corporation and the formation of a new partnership forfederal income tax purposes, with all of the accompanying tax consequences. Gain or loss will be recognized bythe shareholders, as well as by the corporation on the disposition of its property upon liquidation.

Tax Uncertainties. Despite the issuance of numerous IRS revenue rulings and private letter rulings, certain taxconsequences of operating as an LLC still are uncertain. Some of the tax uncertainties relate to:

� At�risk Rules. A member may deduct LLC losses only to the extent the member is �at risk." Because thedebts of an LLC generally will not increase a member's amount at risk, many LLC members with enoughbasis to deduct their share of LLC losses may be unable to deduct the losses under the limitations imposedby the at�risk rules.

� Passive Activity Rules. Uncertainty exists about whether an LLC member will be treated as a limited partnerfor purposes of determining whether an activity is active or passive to that member. Under the passiveactivity loss rules, limited partners must meet more stringent requirements than general partners todemonstrate material participation.

� Accounting Methods. Although IRS private letter rulings have allowed LLCs to use the cash method inspecific circumstances, it is not clear whether all LLCs are eligible to use the cash method.

� General versus Limited Partner Status. By definition, all LLC members have limited liability, a majorcharacteristic of limited partners. However, while some LLC members do not participate in the company'smanagement (like limited partners), other members do significantly participate in management, which isa characteristic of a general partner. Defining a limited partner for LLC purposes currently varies underdifferent regulations.

Tax Advantages. Despite the tax uncertainties, the following are some of the advantages of LLCs for federal incometax purposes:

� An LLC, classified as a partnership, has the flexibility to make special allocations of income and loss amongits members.


168

� LLC members can include entity debt, for which they are not liable, in their equity bases for the purposeof deducting entity losses. (The debts of an LLC generally will not increase a member's amount at risk.Therefore, many LLC members with enough basis to deduct their share of LLC losses may be unable todeduct the losses under the limitations imposed by the at�risk rules.)

� An LLC can step up the basis of its assets under IRC Section 754. (The sale of a member's interest to anothermember or to a third party who becomes a member does not result in taxable gain for the LLC.Consequently, such a sale generally does not affect the LLC's books. However, IRC Section 754 allows anLLC to elect to adjust the basis of LLC assets to reflect the excess of the price paid by a new member overthat member's proportionate share of the adjusted basis of LLC assets. If such an election is made, thebasis of assets may be different for financial and tax reporting purposes.)

� An LLC generally can distribute appreciated property without the entity�level recognition of gain. [An LLC,classified as a partnership for tax purposes, is required to specifically allocate precontribution gain to themember who contributed the asset under IRC Section 704(c).]

� An LLC member can contribute appreciated property to the LLC without being subject to the 80% controlrequirement of IRC Section 351.

Accounting for LLCs

While LLCs are unique legal entities, they do not give rise to a significant number of accounting or reporting issuesthat differ from those of partnerships. FASB ASC 272�10 (formerly Practice Bulletin No. 14, Accounting and

Reporting by Limited Liability Companies and Limited Liability Partnerships) provides guidance on applying existingaccounting literature to LLCs. Although that literature generally does not impose any new accounting requirements,the paragraphs below discuss some of the unique aspects of preparing LLC financial statements, using thatguidance.

Financial Statement Headings. Practice Bulletin No. 14 requires the headings of an LLC's financial statements toclearly identify the entity as an LLC, even in jurisdictions that do not legally require LLCs to include the LLCdesignation in their names.

Equity Section of the Balance Sheet. Since owners of a limited liability company are referred to as members,FASB ASC 272�10�45�3 (formerly Practice Bulletin No. 14) states that the equity section of the balance sheet shouldbe labeled �Members' Equity." If more than one class of members exists, LLCs are encouraged to report the equityof each class separately within the equity section of the balance sheet. Otherwise, the equity amounts must bedisclosed in the notes to the financial statements. Ownership interests may be represented by membershipcertificates or shares. For example, an LLC may issue Class I shares that have unlimited voting rights and Class IIshares that have only limited rights and privileges. Different classes of shares also may have different rights as tothe distribution of assets upon dissolution of the company. If ownership interests are represented by membershipcertificates or shares, the equity section of the balance sheet will resemble that of a corporation that discloses eachclass of stock on the face of the balance sheet. If ownership interests are not represented by membershipcertificates or shares, the equity section of the balance sheet will resemble that of a partnership. Generally, only asingle amount will be shown. However, if it is desirable to disclose separately the equity accounts of those memberswho have been designated as managers, a presentation such as the following can be made:

MEMBERS' EQUITY

Managing members $ 75,000

Nonmanaging members 25,000

$ 100,000

The operating agreement of some LLCs may provide that unless the transfer (for example, by assignment orinheritance) of a member's interest is approved by the remaining members, the transferee will not be permitted toparticipate in the management of the LLC or become a member. Instead, the transferee is entitled only to receivethe share of profits or other compensation by way of income and return of contributions to which the assigning


169

member otherwise would be entitled. If desired, the portion of members' capital owned by such non�approvedtransferees also could be disclosed. In addition, FASB ASC 272�10�50�1 (formerly Practice Bulletin No. 14) statesthat if the LLC maintains separate accounts for components of members' equity (such as undistributed earnings,earnings available for withdrawal, or unallocated capital), disclosure of those components is permitted (but notrequired) either on the face of the balance sheet or in the notes.

If a member's equity account is less than zero, FASB ASC 272�10�45�4 (formerly Practice Bulletin No. 14) states thata deficit should be reported even though the member's liability may be limited. In addition, if the LLC recordsamounts due from members for capital contributions, those amounts should be presented as deductions frommembers' equity rather than as assets.

Changes in Members' Equity. FASB ASC 272�10�45�1 (formerly Practice Bulletin No. 14) requires LLCs to presentinformation related to changes in members' equity for the period. The information may be presented as a separatestatement, combined with the statement of income, or in the notes.

Federal Income Taxes. If the LLC is considered a partnership for federal income tax purposes, income is taxed tothe members rather than to the LLC. Like partnerships, the financial statements of an LLC should not include federalincome tax expense or the related liability. If the statement of income presents net income after federal incometaxes, it is not prepared in accordance with GAAP. However, it may be appropriate to record a liability for anysubstantial member withdrawals that are anticipated to pay income taxes and that are formally approved before thebalance sheet date. Although not required by GAAP, it is recommended the financial statements disclose (a) thatthe LLC does not pay income taxes and (b)�any anticipated withdrawals by members to pay income taxes, whetheror not recorded as a liability in the financial statements. With respect to item (b), the accountant should considerdisclosing any withdrawals made since the balance sheet date. An illustrative note follows:


Federal Income Taxes

The Company is not a taxpaying entity for federal income tax purposes, and thus no income taxexpense has been recorded in the statements. Income of the Company is taxed to the membersin their respective returns. The members customarily make substantial capital withdrawals in Aprilof each year to pay their personal income tax liabilities. At December 31, 20X1, $75,000 has beendeposited in a Company savings account in anticipation of member withdrawals.

Even if an LLC is taxed as a partnership, its operating agreement may require a provision for income taxes to becomputed at a specified rate and included as an expense of the LLC. The inclusion of such a tax provision is adeparture from GAAP.

State Income and Franchise Taxes. The tax status of an LLC may not necessarily be the same for both federal andstate tax purposes. In some states, LLCs are subject to state franchise or income tax even if they qualify aspartnerships for federal income tax purposes. Any state income tax should be shown in the financial statements asan expense of the LLC. Also, as specifically addressed in FASB ASC 272�10�60�2 (formerly Practice Bulle�tin�No.�14), deferred taxes should be accounted for and recorded on a jurisdiction�by�jurisdiction basis in accor�dance with GAAP. (In addition, LLCs that are subject to federal income taxes should account for those taxes inaccordance with GAAP.) The nature of any income taxes paid by the LLC also should be disclosed (if material). If theLLC's tax status in a jurisdiction changes from taxable to nontaxable, any deferred tax assets and liabilities relatedto that jurisdiction should be eliminated.

Conversion of an Existing Entity to an LLC. LLCs frequently are formed when an existing entity is converted toLLC status. The converting entity often is a partnership. However, C corporations and S corporations also maymerge with an LLC or convert to LLC status. An LLC formed by the conversion of a partnership generally isconsidered a continuation of the partnership, and no new taxable entity comes into being. However, the conversionof a corporation to LLC status results in the creation of a new entity for tax purposes. (A change in the legal form ofbusiness is not considered a change in reporting entity for financial reporting purposes.)

Comparative Financial Statements. When one or more prior years' financial statements are presented after achange to an LLC, the question arises whether the prior years' statements should be modified. As discussed,


170

changes in the legal form of business, for example, from an S�corporation or partnership to an LLC, are not changesin the reporting entity. Consequently, retrospective application is not appropriate. However, to enhance comparabil�ity, it may be necessary to modify the format of the prior year statements. If that is done, a note such as the followingcan be included to disclose the change:

NOTE XRECLASSIFICATIONS

Certain accounts in the prior�year financial statements have been reclassified for comparativepurposes to conform with the presentation in the current�year financial statements.

As a practical matter, especially when a corporation is converted to an LLC, the LLC may choose to presentsingle�period statements for the first reporting period following the change.

While changing the legal form of an entity to an LLC does not constitute a change in reporting entity, formation ofan LLC may result in a change in reporting entity in some cases. For example, if commonly�owned companies forwhich combined financial statements had not previously been presented were combined into a single LLC, achange in reporting entity would occur. In that case, the disclosures that are required by FASB ASC 250�10�45�21(formerly SFAS No. 154) should be made and financial statements for all periods presented should reflect the newreporting entity.

Specified LLC Disclosures. According to FASB ASC 272�10�50�1 through 50�5 (formerly Practice Bulletin No. 14),an LLC should disclose the following:

� A description of any limitation of members' liability. (The liability of members in most states is limited to themembers' enforceable obligation to make capital contributions and the members' obligation to return anyprohibited or illegal distributions. The identification of the entity as a limited liability company alerts financialstatement readers to the general limitation of members' liability. Therefore, the requirement to describelimitations relates to special limitations, such as those imposed by some states on the managing member'sliability or the special liability considerations for members of professional limited liability entities.)

� The different classes of members' interests (if more than one class exists), and the respective rights,preferences, and privileges of each class. (If the LLC does not report the equity amount of each classseparately in the equity section of the balance sheet, the equity amounts also must be disclosed in thenotes.)

� The date the LLC will cease to exist if it has a finite life.

� The separate components of members' equity, such as undistributed earnings, earnings available forwithdrawal, or unallocated capital, if the LLC maintains such components. (Such disclosure is permittedbut not required.)

� Any relevant income tax disclosures required by FASB ASC 740�10�50 (formerly SFAS No. 109).

Limited Liability Partnerships

Limited liability partnerships (LLPs) are a special type of partnership allowable under the laws of all states. LLPswere enacted in response to the concern that a partner of a professional firm can be held liable for the malpracticeof another partner in the same firm. The partners in an LLP remain personally liable for the commercial and otherobligations of the entity, their own acts and omissions, and for the acts and omissions of persons under theirsupervision. However, LLP partners are not liable for acts and omissions by the other LLP partners and nonsuper�vised employees. Thus, LLPs generally provide less liability protection than LLCs but more than general partner�ships.

Accounting and Reporting Issues. Similar to LLCs, LLPs do not give rise to a significant number of accounting orreporting issues that differ from those of partnerships. FASB ASC 272�10 (formerly Practice Bulletin No. 14)provides guidance on applying existing accounting literature to LLPs as well as LLCs. In fact, FASB ASC272�10�05�5 (formerly Practice Bulletin No. 14) states in its guidance that the collective term �limited liabilitycompanies" includes both LLCs and LLPs. Therefore, the unique accounting and reporting issues for LLCsdiscussed in the �Accounting for LLCs" section also apply to LLPs.


171

SELF�STUDY QUIZ


29. Which of the following partnership transactions is correctly recorded?

a. A nonreciprocal transfer of nonmonetary assets is recorded at fair value.

b. A real estate contribution followed by a cash withdrawal from the partnership with no commitment toreinvest should be recorded as a capital contribution.

c. Guaranteed payments are not deductible by the partnership.

30. Which of the following is a tax disadvantage of a company organizing as an LLC?

a. Appreciated property can be allocated in an LLC without the entity recognizing a gain.

b. The 80% control requirement is not required for members to contribute appreciated property to an LLC.

c. LLC loses can only be deducted by the member to the extent the member is �at risk."

d. Under IRC Section 754, the LLC's assets basis can be stepped up.

31. Which of the following statements applies to accounting for LLCs?

a. Owners of a limited liability company are called partners.

b. Each class of equity can be reported separately on the balance sheet.

c. A member's equity account cannot fall below zero.

d. Amounts due for capital contributions are presented as assets.

32. Forming an LLC by the conversion of what type of entity is considered a continuation of that entity?

a. Partnership.

b. S corporation.

c. C corporation.

33. Which of the following is not a required disclosure for a limited liability company in the financial statements?

a. If the LLC was only set up for a specified time period, the date that it will no longer exist.

b. If the LLC maintains their members' equity in separate components, it must be disclosed.

c. A description of the liability limitations on the members of the LLC.

d. The different classes, rights, preferences and privileges of each class of members' interest in the LLC.


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29. Which of the following partnership transactions is correctly recorded? (Page 166)

a. A nonreciprocal transfer of nonmonetary assets is recorded at fair value. [This answer is correct.In accordance with FASB ASC 845�10�30�1 (formerly Paragraph 18 of APB Opinion No. 29), theamount recorded for a nonmonetary asset received in a nonreciprocal transfer should be the fairvalue of the asset received.]

b. A real estate contribution followed by a cash withdrawal from the partnership with no commitment toreinvest should be recorded as a capital contribution. [This answer is incorrect. If an investor contributesreal estate, then immediately withdraws cash with no commitment to reinvest the amount withdrawn, theStandard states that the transaction more closely resembles a sale than a capital contribution inaccordance with FASB ASC 360�20 (formerly SFAS No. 66).]

c. Guaranteed payments are not deductible by the partnership. [This answer is incorrect. Guaranteedpayments are deductible by the partnership while payments in liquidation of a partnership interest are not.Therefore, guaranteed payments are frequently used as a vehicle for purchasing the interest of a partner.]

30. Which of the following is a tax disadvantage of a company organizing as an LLC? (Page 167)

a. Appreciated property can be allocated in an LLC without the entity recognizing a gain. [This answer isincorrect. If an LLC can distribute appreciated property without an entity�level recognition of a gain, thiswould be a tax advantage, not disadvantage, because it would keep the LLC's taxable income lower andthus, the entity would owe less taxes.]

b. The 80% control requirement is not required for members to contribute appreciated property to an LLC.[This answer is incorrect. Since an LLC member can contribute appreciate property to an LLC withoutbeing subject to the 80% control requirement cited in IRS code, a member can contribute more property,which would be a tax advantage to the LLC member.]

c. LLC loses can only be deducted by the member to the extent the member is �at risk." [This answeris correct. Because the debts of an LLC generally will not increase a member's amount at risk, manyLLC member with enough basis to deduct their share of LLC losses may be unable to deduct thelosses under the limitations imposed by the at�risk rules.]

d. Under IRC Section 754, the LLC's assets basis can be stepped up. [This answer is incorrect. IRC Section754 allows and LLC to elect to the adjust the basis of LLC assets to reflect the excess of the price paid bya new member over that member's proportionate share of the adjusted basis of LLC assets. If such anelection is made, the basis of assets may be different for financial and tax reporting purposes.]

31. Which of the following statements applies to accounting for LLCs? (Page 168)

a. Owners of a limited liability company are called partners. [This answer is incorrect. Owners of a limitedliability company are referred to as members. According to FASB ASC 272�10�45�3 (formerly PracticeBulletin No. 14), the equity section of the balance sheet should be labeled �Members' Equity."]

b. Each class of equity can be reported separately on the balance sheet. [This answer is correct. In fact,FASB ASC 272�10 (formerly Practice Bulletin No. 14) encourages LLCs to report the equity of eachclass separately within the equity section of the balance sheet. Otherwise, the equity amounts mustbe disclosed in the notes to the financial statements.]

c. A member's equity account cannot fall below zero. [This answer is incorrect. If a member's equity accountis less than zero, FASB ASC 272�10�45�4 (formerly Practice Bulletin No. 14) states that a deficit should bereported even though the member's liability may be limited.]


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d. Amounts due for capital contributions are presented as assets. [This answer is incorrect. If the LLC recordsamounts due from members for capital contributions, those amounts should be presented as deductionsfrom members' equity rather than as assets.]

32. Forming an LLC by the conversion of what type of entity is considered a continuation of that entity? (Page 169)

a. Partnership. [This answer is correct. An LLC formed by the conversion of a partnership generallyis considered a continuation of the partnership, and no new taxable entity comes into being understate laws and the Revised Uniform Limited Partnership Act.]

b. S corporation. [This answer is incorrect. S corporations may merge with an LLC or convert to LLC status.However, the conversion of an S corporation to LLC status results in the creation of a new entity for taxpurposes per the IRS.]

c. C corporation. [This answer is incorrect. A new entity is formed when a C corporation converts to an LLC.However, the change in the legal form of business is not considered a change in reporting entity for financialreporting purposes. Conversion of a C corporation into an LLC always involves the liquidation of thecorporation and results in a double tax.]

33. Which of the following is not a required disclosure for a limited liability company in the financial statements?(Page 170)

a. If the LLC was only set up for a specified time period, the date that it will no longer exist. [This answer isincorrect. Per FASB ASC 272�10�50, the date that the LLC will cease to exist, if it has a finite life, must bedisclosed by the LLC.]

b. If the LLC maintains their members' equity in separate components, it must be disclosed. [Thisanswer is correct. Although the disclosure of the separate components of members' equity for theLLC is permitted, it is not required by FASB ASC 272�10�50.]

c. A description of the liability limitations on the members of the LLC. [This answer is incorrect. A requireddisclosure of the LLC per FASB ASC 272�10�50 is a description of any limitation of members' liability. Theliability of members in most states is limited to the members' enforceable obligation to make capitalcontributions and the members' obligation to return any prohibited or illegal distributions.]

d. The different classes, rights, preferences and privileges of each class of members' interest in the LLC. [Thisanswer is incorrect. According to FASB ASC 272�10�50, a disclosure requirement of a LLC is the differentclasses of members' interest and the respective rights, preferences, and privileges of each class. If the LLCdoes not report the equity amount of each class separately in the equity section of the balance sheet, theequity amounts almost must be disclosed in the notes.]


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TAX STATUS CHANGES

General Guidance

A company generally changes its tax status in one of the following ways:

a. A corporation elects or terminates S corporation status.

b. A proprietorship or partnership incorporates.

c. A corporation converts to a partnership, an LLC taxed as a partnership, or a proprietorship.

FASB ASC 740�10�25�32 and 740�10�40�6 (formerly Paragraph 28 of SFAS No. 109) requires a change in acompany's tax status to be accounted for as follows:

a. If the change is from nontaxable to taxable, a deferred tax liability or asset should be recognized at the dateof the change through a charge or credit to income from continuing operations.

b. If the change is from taxable to nontaxable, existing deferred tax assets or liabilities should be eliminatedat the date of the change through a charge or a credit to income from continuing operations.

The remainder of this section explains how to account for specific changes in tax status.

Converting from C to S Corporation

Many C corporations have found it advantageous to convert to S corporation status. In making the conversion, thefollowing accounting issues should be considered:

� How should deferred taxes recorded by a C corporation be accounted for if an S corporation election ismade?

� May comparative financial statements that include years before and after the conversion be issued?

� Should the retained earnings components of the S corporation be segregated in the financial statements?

� How should a stub period that results from adopting a calendar year for a new S corporation be presented?

Deferred Taxes Should Be Eliminated. FASB ASC 740�10�40�6 (formerly SFAS No. 109) requires deferred taxassets and liabilities to be eliminated through a charge or credit to the tax provision for the year the companyceases to be a taxable enterprise. The following summarizes the considerations in calculating the adjustment:

a. Question 12 of the FASB Special Report, A Guide to Implementation of Statement 109 on Accounting for

Income Taxes, requires a company that changes from C corporation status to S corporation status tocontinue to recognize a deferred tax liability to the extent that it would be subject to a corporate level taxon net unrecognized �built�in gains." The deferred tax liability is based on the lesser of an unrecognizedbuilt�in gain as defined by the tax law or an existing temporary difference. However, according to the SpecialReport, since the timing of realization of a built�in gain can determine whether it is taxable, and thussignificantly affect the deferred tax liability to be recognized, actions and elections that are expected to beimplemented should be considered.

b. FASB ASC 740�10�40�6 (formerly SFAS No. 109) requires the adjustment for the change in tax status to becalculated as of the date that the change is approved by the taxing authority or on the date of filing theelection, if approval is not necessary, rather than as of the date that the election actually is effective. SinceIRS approval is rarely required when S corporation status is elected, it is believed that, as a general rule,the change in tax status occurs when the election is filed. At that date, deferred tax assets and liabilities fortemporary differences that will reverse after the effective date of the change in tax status should beeliminated.


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c. S corporation status may be elected either retroactively or prospectively. If the election is filed within 21/2months after the beginning of the fiscal year and the company meets certain eligibility requirements, theelection is effective retroactively to the beginning of the year. The election may be filed at any time duringthe year, however, to be effective prospectively for the following year. The effects of retroactive andprospective election are summarized below.

Retroactive ElectionAssume that a qualified corporation elects S corporation status by filing Form�2553within 21/2 months after its 20X0 year end. The corporation meets all of the eligibility requirements for thepre�election portion of 20X1, and all of the company's stockholders during that portion of the year consentto the election. Under current tax rules in those circumstances, the S�corporation election is effectiveretroactively as of the beginning of 20X1. Even though the change is effective at the beginning of 20X1,however, the company's 20X0 year�end financial statements should continue to report deferred taxes.(Question 11 of the FASB Special Report requires the change in tax status and the effects of the change,if material, to be disclosed in the company's 20X0 financial statements as a subsequent event.) Thecompany's existing deferred tax assets and liabilities at the date that the election is filed should beeliminated through a charge or credit to the income tax provision.

To illustrate the amounts that should be disclosed in the financial statements, assume that the companyfiles its S corporation election on February 28, 20X1. FASB ASC 740�10�40�6 (formerly SFAS No. 109)requires deferred tax assets and liabilities at that date to be calculated. The change in the company'sdeferred tax assets and liabilities from January 1, 20X1, to February 28 would be disclosed as the deferredtax provision for 20X1, and the write off of the deferred tax balance sheet account at February 28 would bethe adjustment caused by the change in tax status. In many instances, the authors believe that the filingdate and the effective date of retroactive elections are close enough that the adjustment for the change intax status approximates the deferred tax asset or liability at the beginning of the year. In those cases, interimcalculations of deferred taxes need not be made.

Prospective ElectionIf a company elects S corporation status that will be effective prospectively, it alsois necessary to determine the deferred tax asset or liability as of the interim date that the election is filedas explained in the preceding paragraphs for retroactive elections. The deferred tax asset or liability at thefiling date should be adjusted to the amount that represents the tax effect of temporary differences expectedto reverse between the filing date and the beginning of the following year. No provision should be madefor the deferred tax effect of temporary differences expected to originate between the filing date and theeffective date.

To illustrate, assume that a calendar�year company files an election on June 30, 20X1, to elect S�corporationstatus effective January 1, 20X2. At the filing date, deferred taxes that are expected to reverse during theperiod from June 30 to the end of the year should remain in the deferred tax balance sheet account; theremainder should be charged or credited to the tax provision as of the date the election is filed. In manyinstances, the filing date and the effective date of prospective elections are close enough that the changein tax status approximates the balance of the deferred tax asset or liability that would have been calculatedat the end of the year if the tax status had not been changed.

The following illustrates an example of the disclosure that would be made in the year of conversion for a companyeliminating a deferred tax asset in the amount of $110,000:


Income Taxes

The Company has elected S corporation status effective January 1, 20X2 (Note�X). Earnings andlosses after that date will be included in the personal income tax returns of the stockholders andtaxed depending on their personal tax strategies. Accordingly, the Company will not incur addi�tional income tax obligations, and future financial statements will not include a provision forincome taxes. Prior to the change, income taxes currently payable and deferred income taxesrelated primarily to differences between the financial basis of trade accounts receivable and theirtax basis were recorded in the financial statements.


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NOTE XCHANGE IN TAX STATUS

The provision for income taxes consists of the following components:

20X2 20X1

Current $ � $ 30,000

Deferred 110,000 (7,000 )

$ 110,000 $ 23,000

As discussed in Note A, the Company changed its tax status from taxable to nontaxable in 20X2.Substantially all of the deferred tax provision in 20X2 relates to the elimination of the deferred taxasset at the date the election for the change was filed.

Comparative Presentations May Include Periods before and after the Conversion. The effect of a change in taxstatus on the comparability of financial statements is clearly isolated through disclosures such as the onesillustrated in the preceding paragraph. Therefore, comparative financial statements may include periods bothbefore and after the conversion. Some accountants disclose S corporation status in the financial statementheadings. While that approach is acceptable, it is believed the critical disclosure is in the financial accountingpolicies note. Additional disclosure in statement headings is optional.

Disclosing Components of S Corporation Retained Earnings Is Optional. A corporation converting from C to Sstatus will segregate its retained earnings into the following components for tax purposes:

� Accumulated Earnings and Profits (AEP)essentially represents undistributed tax basis earnings on the

date of conversion. It differs from retained earnings reported in GAAP financial statements because AEPexcludes cumulative temporary differences. All permanent differences would be included in AEP, since itwould normally be impractical to determine cumulative permanent differences at the date of conversion.(The Small Business Job Protection Act of 1996 requires a corporation that is an S corporation for its firsttax year beginning after 1996 to eliminate any AEP accumulated in S corporation tax years beginningbefore 1983.)

� Accumulated Adjustments Account (AAA)essentially represents undistributed tax basis retainedearnings arising after the date of conversion. It excludes temporary differences that originate or reverse afterthe date of conversion and only includes permanent differences relating to nondeductible expensesincurred after the date of conversion.

� Tax Timing Adjustments (TTA)essentially represents cumulative temporary differences at any balancesheet date. The adjustment to eliminate a deferred tax asset or liability at the date of conversion should berecognized in the tax provision for the year of the conversion and closed to the TTA. Therefore, at the dateof conversion, the TTA represents cumulative temporary differences less the related deferred tax effect.Subsequently, the account is adjusted for temporary differences that originate and reverse after theconversion, but the opening adjustment for the elimination of deferred taxes is frozen.

� Other Retained Earnings (ORE)essentially is a residual amount and consists primarily of tax�exemptincome arising since the date of conversion.

To illustrate the components of retained earnings, assume that at the date a corporation converts to S status, it hasGAAP retained earnings of $500,000, a $100,000 excess of cumulative tax depreciation over GAAP depreciation,and a deferred tax liability of $40,000. Its opening retained earnings would consist of AEP and TTA computed asfollows:

AEP TTA TOTAL

GAAP retained earnings $ 500,000 $ � $ 500,000

Taxable temporary difference (100,000 ) 100,000 �

Deferred tax liability 40,000 (40,000 ) �

$ 440,000 $ 60,000 $ 500,000


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The distinctions among the components of retained earnings are important only because they affect the taxabilityof dividends to shareholders. Generally, dividends are allocated first to AAA, then to AEP, and finally to ORE. Theyare taxed only to the extent that they are allocated to AEP.

Since distinctions among the components of retained earnings deal solely with personal tax consequences to theshareholders and do not affect an evaluation of the company's financial position, results of operations, or cashflows, disclosure of the retained earnings components is optional.

Stub Period Presentations Require Special Disclosures. A company converting from C corporation to Scorporation status is required to adopt a calendar year end unless it can establish a fiscal year as a natural businessyear or pays a deposit. Generally, it is impractical to have different year ends for financial statement and income taxreporting, and this course recommends conforming the year end for both reporting purposes. The notes to thefinancial statements should disclose the change in the year end and the effect it has on the financial statementsincluding the dollar amount if determinable. The stub period presentation may be presented in comparative formwith a full year provided that the change is adequately disclosed and the statements are appropriately captioned.The tax provision for the stub period should consist of a current provision calculated by applying annualized ratesto taxable income for the period and a deferred provision consisting of the difference between the deferred taxasset or liability at the beginning of the period and the deferred tax liability at the end of the period related to built�ingains.

LIFO Reserve Recapture. A corporation electing S corporation status is required to recapture its LIFO inventoryreserve. The amount to be recaptured is the excess of the inventory's value using a first�in, first�out (FIFO) cost flowassumption over its LIFO value at the close of its last C corporation year. The amount recaptured is included inincome on the corporation's final C corporation tax return, and the tax attributable to the recapture is payable in fourequal installments beginning with the final C corporation tax return. [Based on TD 8567, C corporations transferring

inventory to S corporations in a nonrecognition transaction (i.e., in which the transferred assets constitute trans�ferred basis property) must recapture in the year that the inventory is transferred. That year may differ from the Ccorporation's final tax year.] Taxes on the LIFO reserve recapture would be calculated as follows:

Inventory value at 12/31/X1 (last day of final C corporation year):

FIFO $ 1,200,000LIFO 1,000,000

LIFO recapture amount $ 200,000

GAAP Tax

Calculation of income taxes:

GAAP pretax income $ 350,000 $ 350,000

LIFO recapture amount � 200,000

$ 350,000 $ 550,000

Income tax (34% rate) $ 119,000 $ 187,000

Income tax attributable to LIFO recapture ($200,000 � 34% or $187,000 � $119,000) $ 68,000

Schedule of required income tax payments (payments are due by due dates of the returns):

12/31/X1 ($119,000 + 25% of $68,000) $ 136,000

12/31/X2 (25% of $68,000) 17,000

12/31/X3 (25% of $68,000) 17,000

12/31/X4 (25% of $68,000) 17,000

Total $ 187,000


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Under the recapture rules, the tax basis of the inventory is increased by the recapture amount included in incomeso that income from the sale of the inventory is only taxed once at the corporate level. The company, however, is notrequired to change to the FIFO inventory method. Rather, the built�in gain on inventory is includable in income (tothe extent of the difference between LIFO and FIFO) in the last C�corporation year. If the company retains the LIFOmethod for both financial and tax purposes, a temporary difference will be created that will reverse when theinventory is liquidated. Since liquidation will occur when the company is a nontaxable entity, however, the differenceis treated as a permanent difference. If the company changes to the FIFO inventory method for tax purposes,generally it also will adopt FIFO for financial reporting. There would be no temporary difference in that case. Thefollowing journal entry would be appropriate to record income taxes calculated in either circumstance:

Current income tax expense $ 187,000Income taxes payablecurrent portion $ 136,000Income taxes payablenoncurrent

portion 51,000

Terminating S Corporation Status

If S corporation status is terminated, a deferred tax liability and asset should be recognized for the tax effects oftemporary differences that exist at the date that the termination election is filed. The procedures for determining theeffect of the change at the date of termination are similar to those for determining the effect of an S corporationelection. However, similar to Section 351 incorporations, there are certain limitations on recognizing deferred taxassets.

Section 351 Incorporation

Brief Description. In a Section 351 transaction, the assets of a proprietorship or partnership are transferred to acorporation (generally newly formed) in exchange for stock. After the exchange, the former proprietor or partnerscontrol the corporation.

Tax Attributes. The exchange, if properly constituted under Section 351, is tax free to all parties, i.e., the proprietor�ship or partnership, the corporation, and the stockholders. The basis of the assets of the proprietorship orpartnership carries over to the corporation.

Uses. A Section 351 incorporation is generally used when a small business desires the legal or tax benefits of thecorporate form.

Accounting under GAAP. The assets and liabilities received by the corporation should be recorded on the booksof the corporation at their historical costs. (See FASB ASC 805�50�30�5 [formerly Paragraphs D8�D14 of SFASNo.�141(R)].) Thus, the GAAP basis of the assets and liabilities to the former proprietorship or partnership wouldbecome their GAAP basis to the corporation. Capital stock (and frequently notes payable) in amounts equal to thenet historical cost value of the assets and liabilities transferred is issued to the stockholders.

Illustration. Assume ABC Proprietorship is incorporated on July 1, 20X2, and that 1,000 shares of $1 par valuecommon stock are issued in exchange for all assets and liabilities of the proprietorship except cash. Assume ABCProprietorship has the following assets and liabilities at June 30, 20X2:

HistoricalCost Basis Tax Basis

MarketValue

ASSETS

CURRENT ASSETS

Cash $ 40,000 $ 40,000 $ 40,000

Accounts receivable 100,000 100,000 100,000

TOTAL CURRENT ASSETS 140,000 140,000 140,000

PROPERTY AND EQUIPMENT 250,000 250,000 200,000

Less accumulated depreciation 75,000 150,000 �

$ 315,000 $ 240,000 $ 340,000


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LIABILITIES

CURRENT LIABILITIES

Accounts payable $ 50,000 $ 50,000 $ 50,000

LONG�TERM DEBT 150,000 150,000 150,000

200,000 200,000 200,000

PROPRIETOR'S NET WORTH $ 115,000 $ 40,000 $ 140,000

The initial balance sheet of ABC Incorporated on July 1, 20X2, would appear as follows:

ASSETS

Accounts receivable $ 100,000

PROPERTY AND EQUIPMENT 250,000

Less accumulated depreciation 75,000

$ 275,000

LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES

Accounts payable $ 50,000

LONG�TERM DEBT 150,000

200,000


Common Stock 1,000


75,000

$ 275,000

Other Considerations

Because both the tax basis of assets and the GAAP basis carry over to the corporation, temporary differences ariseif the former proprietorship used different book and tax accounting methods, e.g., different depreciation methodsas in the preceding illustration. GAAP requires recognizing a deferred tax asset and liability for temporary differ�ences that exist at the date an entity's tax status changes from nontaxable to taxable and requires them to beestablished through a charge or credit to earnings in the period that the tax status changes. However, any lossesand tax credits incurred by a proprietorship are passed through to the proprietor and cannot be carried forward toa C corporation. Thus, deferred tax assets should not be recognized for unused losses or tax credits. Furthermore,when determining the need for a valuation allowance for a deferred tax asset, income from carryback years beforeincorporation should not be considered as a source of future income because losses of the C corporation cannotbe carried back to years when the entity was a proprietorship.

In a Section 351 incorporation, it is believed that the financial statements before and after the incorporation arecomparable with the exception of the provision for income taxes. Therefore, comparative statements may includeperiods before and after the incorporation, provided the incorporation and the change in tax status are disclosed.The following is an example of appropriate disclosure using the facts in the previous illustration and assuming a30% tax rate:


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Income Taxes

Effective with the incorporation discussed in Note X, the Company became a taxable entity. Priorto incorporation, no provision was made for income taxes because earnings and losses wereincluded in the personal tax return of the proprietor, and were taxed based on his personal taxstrategies. As discussed in Note X, a deferred tax liability was provided for the cumulative excessof depreciation for tax reporting over depreciation for financial statement reporting at the date ofincorporation. After incorporation, provision has been made for the tax effects of transactionsreported in the financial statements, and consists of taxes currently due plus deferred taxesrelated to the difference between the basis of property and equipment for financial and incometax reporting.

NOTE XINCORPORATION AND CHANGE IN TAX STATUS

Effective July 1, 20X2, the Company was incorporated by issuing 1,000 shares of $1 par valuecommon stock in exchange for all assets and liabilities of ABC Proprietorship except cash. Thoseassets and liabilities were recorded in the accompanying financial statements at the proprietor�ship's historical cost basis as summarized below:

Accounts receivable $ 100,000Property and equipment 175,000Accounts payable (50,000)Long�term debt (150,000)

$ 75,000

Common stock of $1,000 and additional paid�in capital of $74,000 were recorded.

The 20X2 provision for income taxes consists of the following components:

Current $ 15,000Deferred 25,000

$ 40,000

The deferred tax liability related to temporary differences at the date of incorporation was estab�lished through a charge of $22,500 to the 20X2 tax provision.

If the tax basis of accounting was used by the proprietorship for financial reporting and GAAP will be used forfinancial reporting by the corporation, opening balances of the current�period financial statements should beadjusted to conform with generally accepted accounting principles.

Converting from Corporation to Partnership

Some corporations may convert to a partnership. In making the conversion, the following accounting issues shouldbe considered:

� How should deferred taxes recorded by a corporation be accounted for if a partnership election is made?

� Should the corporation's basis in assets and liabilities be carried over to the partnership?

� May comparative financial statements that include years before and after the conversion be issued?

� How should a stub period that results from adopting a calendar year be presented?

Deferred Taxes Should Be Eliminated. When a corporation converts to partnership status, any deferred tax assetsand liabilities at the date of the change should be eliminated through a charge or credit to the tax provision for the


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year the company ceases to be a taxable enterprise. The procedures for determining the effect of the change at thedate of conversion are similar to those for determining the effect of an S�corporation election.

Assets and Liabilities Distributed to the Partnership Normally Should Be Valued at the Predecessor Corpo�ration's GAAP Values. TRA's repeal of the General Utilities doctrine imposes corporate taxes on the appreciationof net corporate assets distributed to the partnership. For tax reporting, the appreciated values may be the openingvalues for the partnership. Authoritative accounting literature does not address partnership accounting. However,current thinking generally precludes establishing a new GAAP basis unless there has been a change in control.Therefore, in a true conversion, there is no change in control, and it is believed that the corporation's GAAP basisshould carry forward to the partnership. If the partners elect to reflect the appreciated values at the partnership levelfor tax reporting, a difference in basis for income tax and financial statement reporting will arise.

Although partnerships are not subject to income taxes, it is believed that the notes to the partnership's financialstatements should disclose any differences between the basis of assets and liabilities for financial statement andincome tax reporting. The following illustrates appropriate disclosure:


Income Taxes

The financial statements do not include a provision for income taxes, because the partnershipdoes not incur federal or state income taxes. Instead, its earnings and losses are included in thepartners' personal income tax returns and are taxed based on their personal tax strategies. Thetax basis of assets transferred from the predecessor corporation differs from their basis forfinancial reporting.

Comparative Presentations May Include Periods before and after the Conversion. In a true conversion,financial statements before and after the conversion are comparable with the exception of the absence of aprovision for income taxes. Therefore, comparative statements may include periods before and after the conversionprovided the conversion and the change in tax status are disclosed. The following is an example of appropriatedisclosure:


Income Taxes

The Partnership was formed through the conversion of ABC Company effective January 1, 20X2(Note X). Earnings and losses after that date will be included in the personal income tax returnsof the partners and taxed depending on their personal tax strategies. Accordingly, the Partnershipwill not incur additional income tax obligations, and future financial statements will not include aprovision for income taxes. Prior to the change, income taxes currently payable and deferredincome taxes based on differences between the financial basis of assets and liabilities and theirtax basis were recorded in the financial statements.

NOTE XFORMATION OF THE PARTNERSHIP AND CHANGE IN TAX STATUS

Effective January 1, 20X2, ABC Company was converted to ABC Partnership through anexchange of Company shares for Partnership units. For financial statement reporting, assets andliabilities transferred to the Partnership were recorded at the predecessor corporation's historicalcost basis. However, for income tax reporting, the partners elected to record the assets at theirappreciated values at the date of distribution. As a result, the basis of property and equipmentwas approximately $175,000 higher for income tax reporting than for financial statement report�ing.


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The provision for income taxes consists of the following components:

20X2 20X1

Current $ � $ 30,000

Deferred 110,000 (7,000 )

$ 110,000 $ 23,000

As a result of the conversion, the Company's deferred tax asset in the amount of $110,000 atDecember 31, 20X1, was eliminated through a charge to the 20X2 tax provision.

Stub Period Presentations Require Special Disclosures. Current tax law requires a corporation converting to apartnership to adopt a calendar year end unless it can establish a fiscal year as a natural business year or pays adeposit. Generally, it is impractical to have different year ends for financial statement and income tax reporting, andit is recommended conforming the year end for both reporting purposes. As discussed, the notes to the financialstatements should disclose the change in the year end and the effect it has on the financial statements including thedollar amount, if determinable. The stub period presentation may be presented in comparative form with a full yearprovided that the change is adequately disclosed and the statements are appropriately captioned.

The tax provision for the stub period should consist of a current provision calculated by applying annualized ratesto taxable income for the period and a deferred provision that will eliminate the deferred tax asset or liability at thebeginning of the period.

OWNERS' TRANSACTIONS

Equity Interests for Services

For both corporations and partnerships, equity interests are sometimes given for services associated with thestarting of a business. As an example, attorneys are sometimes given equity interests as consideration for legalservices in setting up the entity, in obtaining patents, or in arranging financing. For financial reporting, it isrecommended expensing the fair value of services related to setting up the entity as organization costs [FASB ASC720�15�25�1 (formerly SOP 98�5, Reporting on the Costs of Start�Up Activities)] requires organization costs to beexpensed as incurred) and charging the fair value of other services to an amortizable asset, e.g., patents orfinancing costs. The offsetting credits would be to capital stock for the par value of the stock and to additionalpaid�in capital for the difference (or to partners' capital as appropriate). As an example, if a lawyer receives 100shares of $50 par value common stock in exchange for setting up a company and the fee at standard billing rateswould be $10,000, the company would expense the organization costs for $10,000 and credit common stock for$5,000 and additional paid�in capital for $5,000. For tax reporting, organization costs associated with forming a newcompany are not deductible when paid or incurred. Such costs must be capitalized unless the company makes anelection to amortize them. For organization costs incurred through October 22, 2004, the amortization period is 60months. However, the American Jobs Creation Act of 2004 (the 2004 Jobs Act), extends the amortization period to180 months but provides a maximum additional $5,000 first�year deduction that is phased out as organization costsexceed $50,000.

Established practices of professionals, such as accountants, doctors, and lawyers, often add partners or stock�holders through buy�in agreements that provide for nominal or below market cash payments for the stock orpartnership interests. Many elements may enter into the determination of the price to be paid, e.g., the value of pastefforts, salary differentials between existing professionals and the new associate, special skills, and the ability togenerate new business. Since the value is negotiated between the parties involved, accounting for the new partneror stockholder for financial accounting purposes generally should follow the agreement, i.e., recorded assetsshould follow stated contract terms. However, when the price of the stockholder or partnership interest has beenreduced in return for a reduced salary for the new stockholder or partner, the accountant should consider whethervalues different from the amounts specified in the agreement should be used to record the transaction. In any suchtransaction, there is some latitude in the values to be placed on the equity interest as well as the compensationvalue of the new partner or stockholder. Thus, it is suggested that the accountant follow the terms of the agreement


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unless the �bargained�for compensation level" of the new partner or stockholder is clearly materially different fromthe actual compensation value of the new partner or stockholder.

If the bargained�for compensation level appears unreasonable, at the effective date of such agreement, an entryshould be made charging the �reduced" compensation to a stock subscription receivable account, crediting thepar value of stock to be acquired to the capital stock account, and crediting additional paid�in capital for thedifference. Payment of the �reduced" compensation would be recorded by crediting subscriptions receivable andcharging compensation expense. Deferred taxes should be recorded if there is a temporary difference betweenamounts recorded for financial and tax purposes.

Receivables from Stockholders

Stockholders of closely held businesses sometimes borrow from the corporation under informal arrangements asa means of acquiring �tax free" cash. Such receivables from owners of closely held businesses are frequent targetsof the IRS. The IRS often asserts that the stockholder does not intend to repay the receivable and that thereceivable, therefore, should be taxed on the stockholder's personal tax return as a dividend. While most accoun�tants recognize the tax dangers of large receivables from stockholders, many overlook the GAAP measurementproblems also associated with such receivables.

Under GAAP, stockholder receivables are subject to the same measurement principles as other receivables, andaccordingly, consideration should be given to providing an allowance for amounts considered uncollectible and toreclassify the amount as a noncurrent asset. A large stockholder receivable with no formal repayment plan mayplace accountants in a difficult situation with their clients. If the stockholder either cannot or does not intend torepay such loans, the working capital and net worth of the company may be grossly overstated. But, if thereceivable is removed by recording dividends or additional compensation to the stockholder, the stockholder mayincur a large tax liability. For financial statement reporting, forgiveness of a related party receivable should typicallybe recorded as a charge to equity. If the accountant determines that a portion of the stockholder receivable shouldbe written off in the financial statements because the client cannot or does not intend to repay the receivable, healso should determine what he believes the appropriate tax treatment of the offsetting debit will be, e.g., bad debtdeduction (although the deduction would be subject to close scrutiny by the IRS to determine if there is a validdebtor�creditor relationship), dividends, or compensation. Deferred taxes should be provided for differencesbetween the book and tax treatment.

Stockholder Agreements to Reimburse Corporations for Excessive Compensation or DisallowedExpenses

Some corporations have agreements with their stockholders under which the stockholders agree to reimburse thecorporation for excess compensation and certain other expenses that may be disallowed as a deduction. If thetypes of expenses covered by the agreements are disallowed, they usually are required to be treated as dividends.Thus, the stockholder reimbursement agreements are an attempt to avoid the associated double taxation. How�ever, some court cases have held that the existence of the agreements was evidence that the corporations believedthe expenses were questionable deductions and have found adversely. If they exist, it is believed they are a gaincontingency and should, therefore, be disclosed.

When expenses or compensation are disallowed by the IRS, the corporation should record the additional taxassessment. If an agreement to reimburse disallowed deductions exists between the stockholder and the corpora�tion, the corporation also should record a receivable and a reduction to the appropriate expense categories in theyear that the amount of the RAR and resulting reimbursement can be reasonably estimated. It is believed that thereimbursement does not qualify as a prior�period adjustment.

Accrued Liabilities to Stockholders and Partners

Accrual basis taxpayers may not deduct accrued expenses payable to cash basis stockholders and partners untilpaid. Generally accepted accounting principles, however, require recognizing expenses in the period incurredwithout regard to whether the creditor is related. Common examples of such transactions are rent for buildings andequipment owned by a stockholder and leased to the company and interest on obligations due to a stockholder.Similar situations also could exist for accrued bonuses. Since the expenses would be recognized in the statements


184

when incurred and deducted in the returns when paid, a temporary difference would arise, and deferred taxesshould be provided.

ACCOUNTING FOR LEASING TRANSACTIONS

Accounting for Bargain Rentals

For tax reporting, accrual basis lessors usually recognize rent income under operating leases when earned, andaccrual basis lessees recognize rent expense under operating leases when payments are due. (Exceptions occurin certain deferred rental agreements of over $250,000.) To illustrate, assume a three�year lease requires a tenantto pay monthly rentals of $1,000, but waives the requirements for the first six months to provide an incentive for thetenant to take the space. For tax reporting the lessor would report no income from the lease for the first six months,and the lessee would deduct no rent expense during the period.

GAAP requires lessors and lessees to recognize rent under noncancelable operating leases on a straight�linemethod over the period the lessee controls the use of the leased property. Accordingly, rent expected under thenoncancelable period is computed and recognized evenly over the lease term. In the preceding example, pay�ments actually due under the lease total $30,000, which averages $833 per month (or $30,000 � 36). Rent for thefirst six months would, therefore, be $5,000 (or $833 � 6).

Accounting for Other Lease Incentives

Other lease incentives can consist of incentive payments by lessors or the lessor's assumption of a lessee's lease.The following summarizes differences in accounting for those incentives for financial and income tax reporting:

a. Incentive payments include up�front payments to the lessee and payments to reimburse the lessee forspecific costs such as moving costs or abandoned leasehold improvements. The lessor and the lesseeshould amortize incentive payments against rental income or expense over the term of the lease forfinancial reporting. Since the incentive payment is taxable or deductible when due, a temporary differencearises between income for financial and income tax reporting.

b. It is believed a temporary difference arises if a lessor makes leasehold improvements for a lessee and thenbills the lessee for its cost less an allowance. For financial reporting, the lessee should record the leaseholdimprovements at the full cost, and record an offsetting credit to the deferred lease incentive account for theallowance. Both the lessor and the lessee should amortize the deferred lease incentive against rentalincome or rental expense over the term of the lease. For tax reporting, the leasehold improvements wouldbe recorded at their net cost, and rental income and payments would be included in taxable income whendue.

c. If the lessor assumes a pre�existing lease of the lessee, the related loss incurred by the lessor is a rentincentive by both the lessor and the lessee that is amortized against rental income and expense over thelease term. Since rental income and payments are included in taxable income when due, a temporarydifference arises.

Leases with Scheduled Increases

Tax rules for leases with scheduled annual increases are similar to those described in �Accounting for BargainRentals." To illustrate, assume a three�year lease provides for an annual base rent of $10,000 with increases duringthe second two years of at least 5% (that is, to at least $10,500 in the second year and $11,025 in the third year). Fortax purposes, the lessor would report income of $10,000 during the first year, and the lessee would report rentexpense of $10,000. However, since minimum payments of $31,525 are scheduled over the lease term, GAAPrequires recognizing rent expense of $10,508 (or $31,525 � 3) on a straight�line basis during each of the threeyears.

Differences between rent income and rent expense recognized for financial statement and income tax reporting aretemporary differences, and deferred taxes should be provided accordingly.


185

Tax Indemnifications in Lease Agreements

Some leases include indemnification clauses that protect lessors from the loss of any tax benefits as a result of taxlaw changes. For example, some equipment lessors wrote agreements that provided for an additional paymentupon repeal of investment tax credits. FASB ASC 840�10�25�10 and 25�11 (formerly Issue No. 86�33, Tax Indemnifi�cations in Lease Agreements) provides the following guidance on accounting for such payments:

Accounting by the lessor

1. The payments should be allocated into two parts: the part resulting from lost ITC and the partrelated to all other tax effects.

2. The portion of the payments that relates to ITC should be recognized in earnings followingthe lessor's normal policy for accounting for ITC. Therefore, if the flow�through method wasnormally used, the portion of the payment related to indemnification for lost ITC would becredited to the tax provision in the period earned.

3. The portion of the payment that related to the other tax issues should be considered as a leasepayment and accounted for according to the classification of the lease. Therefore, if the leasewere classified as a sales type or a direct financing lease, the payment would be accountedfor as an adjustment of the lessor's investment in the lease. If the lease were classified as anoperating lease, the payment would be recognized over the remaining lease term as anadjustment of rent income using the straight�line method.

Accounting by the lesseeThe payments should be considered as a lease payment andaccounted for according to the classification of the lease. Therefore, if the lease were classified asa capital lease, the payment would be recorded as an adjustment of the basis of the leased asset.If the lease were classified as an operating lease, the payment would be recognized over theremaining lease term as an adjustment of rent expense using the straight�line method.

ACCOUNTING FOR OTHER TAX TRANSACTIONS

Vacation Pay

GAAP requires recognizing vacation pay on an accrual basis. Generally an accrual basis taxpayer may elect todeduct accrued vacation pay provided it is actually paid within a prescribed period after the close of the tax year. Tobe currently deductible the vacation pay must be paid within the tax year or paid within two and one�half monthsfollowing the end of the tax year. Amounts paid after two and one�half months following the end of the tax year aredeductible in the tax year that they are actually paid. The amount of the accrued vacation pay not deductible in thecurrent tax year is a temporary difference that will reverse as the accrued vacation pay is disbursed in future taxyears.

Simplified LIFO

Current tax law allows businesses to use a simplified LIFO method that provides them with the option of dividingtheir inventory into pools for each major category of inventory items and applying a single published index for eachpool. It is believed that using externally published indexes usually provides a reasonable approximation of thecompany's own experience and that simplified LIFO usually is acceptable for GAAP reporting.

Generally, changes from a non�LIFO approach of accounting for inventories to a LIFO approach are appliedsimultaneously for financial statement and income tax reporting. If a company changes its method of accounting forinventories, either from a non�LIFO approach to a LIFO approach or from a LIFO method based on actual results tosimplified LIFO, the change should be accounted for as a change in accounting principle.


186

Limits on Deductible Expenses

Current tax law limits the deductibility of certain expenses, e.g., interest expense on life insurance loans, club dues,and business meals and entertainment. The excess of expenses incurred above the deductible amount should berecognized in the financial statements in the year that they are incurred but would never be deducted for income taxreporting and should, therefore, be accounted for as a permanent difference for which no deferred tax benefit isrecognized.


187

SELF�STUDY QUIZ


34. Which of the following is accurate concerning conversion from a C corporation to S corporation status?

a. By the end of the tax year, the S corporation must make the adjustment for the change in tax status.

b. Retroactive election must be made by February 15 for a calendar year corporation.

c. Prospective election for the following year may be made anytime during the year.

d. Retained earnings components must be disclosed in the financial statements.

35. A requirement of a C corporation to elect S corporation status is to recapture its LIFO inventory reserve. Whichof the following is true in relation to a LIFO reserve recapture?

a. The built�in gain on inventory from changing from LIFO to FIFO is included in income on the first Scorporation return.

b. In a nonrecognition transaction between a C corporation and a S corporation, inventory must berecaptured in the year of transfer.

c. The tax attributable to the LIFO recapture must be paid in full on the final return.

d. A S corporations creates a double taxation effect when the inventory is recaptured using the LIFO inventoryreserve.

36. Stanley Furnishings has decided to change their election from a C corporation to a S corporation. The last dayof the final C corporation year will be 12/31/X6. The inventory values at that date are:

FIFO $ 2,500,000

LIFO 2,000,000


Stanley's GAAP pretax income at 12/31/X6 is $600,000. Based on a tax rate of 34%, what is the income taxattributable to the LIFO recapture?

a. $42,500.

b. $170,000

c. $246,500.

d. $374,000.

37. The definition of a Section 351 Incorporation is when the assets of a proprietorship or partnership are allocatedto a corporation in exchange for stock. Which of the following is an attribute of a Section 351 transaction?

a. Financial statements before and after a Section 351 incorporation are equivalent, excluding the provisionfor income taxes.

b. A Section 351 incorporation is tax free to the corporation, but not to the stockholders.

c. Assets and liabilities contributed to a corporation in a Section 351 exchange are recorded at market value.

d. The corporation is controlled by the board of directors after Section 351 incorporation.


188

38. Occasionally, equity interests may be given in exchange for services. How might this be recorded?

a. An attorney is given equity interest in exchange for legal services to set up an entity. The entity willautomatically deduct the expense for tax reporting.

b. An attorney is given equity interest in exchange for legal services to arrange financing. The entity willautomatically deduct the expense for financial reporting.

c. An attorney is given equity interest in exchange for legal services to set up an entity. The entity will capitalizethe expense for financial reporting.

d. An attorney is given equity interest in exchange for legal services to obtain patents. The entity will creditcapital stock and additional paid�in capital or partners' capital, if appropriate.

39. Robert is a stockholder in PKU Imports, Inc. Robert owns many businesses, one of which rents warehousespace to PKU Imports. The rent expense for the warehouse space is an example of a:

a. Stockholder agreement to reimburse corporation for disallowed expenses.

b. Receivable from stockholder.

c. Accrued liability to stockholder.

40. On July 1, Alligator Corp. leases equipment to Crocodile Corp. for a term of five years. Both corporations havecalendar year ends. The lease is a noncancelable operating lease that requires Crocodile Corp. to pay monthlyrentals of $1,000, but waives the requirements for the first eight months. Which of the following choices correctlyreports this transaction?

a. For tax reporting purposes, Alligator Corp. will record rental income of $6,000 for months one through six.

b. For financial reporting purposes, Crocodile Corp. will record rental expense of $1,000 for month twelve.

c. For tax reporting purposes, Crocodile Corp. will record rental expense of $12,000 for year two (monthsseven through eighteen).

d. For financial reporting purposes, Alligator Corp. will record rental income of $5,200 for the first calendaryear.


189



34. Which of the following is accurate concerning conversion from a C corporation to S corporation status?(Page 174)

a. By the end of the tax year, the S corporation must make the adjustment for the change in tax status. [Thisanswer is incorrect. FASB ASC 740�40�10�6 (formerly SFAS No. 109) requires the adjustment for thechange in tax status to be calculated as of the date that the change is approved by the taxing authority oron the date of filing the election , if approval is not necessary, rather than as of the date that the electionactually is effective.]

b. Retroactive election must be made by February 15 for a calendar year corporation. [This answer isincorrect. If the election is filed within 2½ months after the beginning of the fiscal year and the companymeets certain eligibility requirements, the election is effective retroactively to the beginning of the year.February 15 is roughly 1½ months for a calendar year corporation.]

c. Prospective election for the following year may be made anytime during the year. [This answer iscorrect. The election may be filed at any time during the year to be effective prospectively for thefollowing year according to the Form 2553 instructions.]

d. Retained earnings components must be disclosed in the financial statements. [This answer is incorrect.A corporation converting from C to S status will segregate its retained earnings into the followingcomponents for tax purposes: accumulated earnings and profits (AEP), accumulated adjustmentsaccount (AAA), tax timing adjustments (TTA), and other retained earnings (ORE). Since distinctions amongthe components of retained earnings deal solely with personal tax consequences to the shareholders anddo not affect an evaluation of the company's financial position, results of operations, or cash flows,disclosure of the retained earnings components is optional.]

35. A requirement of a C corporation to elect S corporation status is to recapture its LIFO inventory reserve. Whichof the following is true in relation to a LIFO reserve recapture? (Page 177)

a. The built�in gain on inventory from changing from LIFO to FIFO is included in income on the first Scorporation return. [This answer is incorrect. Under the LIFO recapture rules, the built�in gain on inventoryis included in income (to the extent of the difference between LIFO and FIFO) in the last C corporation year.]

b. In a nonrecognition transaction between a C corporation and a S corporation, inventory must berecaptured in the year of transfer. [This answer is correct. Based on IRS regulation TD 8567, Ccorporations transferring inventory to S corporations in a nonrecognition transaction (i.e., in whichthe transferred assets constitute transferred basis property) must recapture in the year that theinventory is transferred. That year may differ from the C corporation's final tax year.]

c. The tax attributable to the LIFO recapture must be paid in full on the final return. [This answer is incorrect.Per IRS code, the tax attributable to the recapture is payable in four equal installments.]

d. A S corporations creates a double taxation effect when the inventory is recaptured using the LIFO inventoryreserve. [This answer is incorrect. Under the recapture rules, the tax basis of the inventory is increased bythe recapture amount included in income so that income from the sale of the inventory is only taxed onceat the corporate level.]


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FIFO $ 2,500,000

LIFO 2,000,000


Stanley's GAAP pretax income at 12/31/X6 is $600,000. Based on a tax rate of 34%, what is the income taxattributable to the LIFO recapture? (Page 177)

a. $42,500. [This answer is incorrect. This is the amount of the quarterly payment that would be due on theLIFO recapture.]

b. $170,000. [This answer is correct. The amount attributable to the LIFO recapture is the 34% incometax rate multiplied by the LIFO recapture amount.]

c. $246,500. [This answer is incorrect. This would be the amount due on the first installment of the incometax.]

d. $374,000. [This answer is incorrect. This amount is the total income tax due from Stanley Furnishings forthe entire year for 12/31/X6.]

37. The definition of a Section 351 incorporation is when the assets of a proprietorship or partnership are allocatedto a corporation in exchange for stock. Which of the following is an attribute of a Section 351 transaction?(Page 179)

a. Financial statements before and after a Section 351 incorporation are equivalent, excluding theprovision for income taxes. [This answer is correct. In a Section 351 incorporation, the financialstatements before and after the incorporation are comparable with the exception of the provisionfor income taxes. This is because any losses and tax credits incurred by the proprietorship arepassed through to the proprietor and cannot be carried forward to the new corporation and theassets and liabilities are recorded at historical cost.]

b. A Section 351 incorporation is tax free to the corporation, but not to the stockholders. [This is incorrect.The exchange, if properly constituted under Section 351, is tax free to all parties, i.e., the proprietorshipor partnership, the corporation and the stockholders per IRS code.]

c. Assets and liabilities contributed to a corporation in a Section 351 exchange are recorded at market value.[This answer is incorrect. The assets and liabilities received by the corporation should be recorded on thebooks of the corporation at their historical costs according to the rules of a Section 351 transaction.]

d. The corporation is controlled by the board of directors after Section 351 incorporation. [This answer isincorrect. After a Section 351 transaction, the former proprietor or partners control the corporation, not aboard of directions.]

38. Occasionally, equity interests may be given in exchange for services. How might this be recorded? (Page 182)

a. An attorney is given equity interest in exchange for legal services to set up an entity. The entity willautomatically deduct the expense for tax reporting. [This answer is incorrect. For tax reporting,organization costs associated with forming a new company are not deductible when paid or incurred. Suchcosts must be capitalized unless the company makes an election to amortize them.]

b. An attorney is given equity interest in exchange for legal services to arrange financing. The entity willautomatically deduct the expense for financial reporting. [This answer is incorrect. When an attorney isgiven equity interests as consideration for legal services in arranging financing, the fair value of serviceswill be charged to an amortizable asset, such as financing costs, for financial reporting.]


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c. An attorney is given equity interest in exchange for legal services to set up an entity. The entity will capitalizethe expense for financial reporting. [This answer is incorrect. For financial reporting, the company willexpense the fair value of services related to setting up the entity as organization costs. FASB ASC720�15�25�1 (formerly SOP 98�5, Reporting on the Costs of Start�Up Activities) requires organization coststo be expensed as incurred.]

d. An attorney is given equity interest in exchange for legal services to obtain patents. The entity willcredit capital stock and additional paid�in capital or partners' capital, if appropriate. [This answeris correct. For financial reporting, the entity will charge the fair value of services to patents, anamortizable asset. The offsetting credits would be to capital stock for the par value of the stock andto additional paid�in capital for the difference (or to partners' capital as appropriate).]

39. Robert is a stockholder in PKU Imports, Inc. Robert owns many businesses, one of which rents warehousespace to PKU Imports. The rent expense for the warehouse space is an example of a: (Page 182)

a. Stockholder agreement to reimburse corporation for disallowed expenses. [This answer is incorrect. Acorporation may have an agreement with their stockholder for which the stockholder agrees to reimbursethe corporation for certain expenses that may be disallowed and should be treated as dividends for thestockholder. The rent expense for the warehouse is not a disallowed expense for PKU Imports and is alegitimate business expense for the corporation.]

b. Receivable from stockholder. [This answer is incorrect. Stockholders of closely held businessessometimes borrow from the corporation under informal arrangements as a means of acquiring �tax free"cash. The rental of the warehouse space by PKU Imports from the stockholder does not qualify as areceivable from the stockholder.]

c. Accrued liability to stockholder. [This answer is correct. When a stockholder owns a building andleases it to the company, this is an example of an accrued liability to stockholder. Accrual basistaxpayers may not deduct accrued expenses payable to cash basis stockholders and partners untilpaid and GAAP required recognized expenses in the period incurred without regard to whether thecreditor is related, for example, a current stockholder.]

40. On July 1, Alligator Corp. leases equipment to Crocodile Corp. for a term of five years. Both corporations havecalendar year ends. The lease is a noncancelable operating lease that requires Crocodile Corp. to pay monthlyrentals of $1,000, but waives the requirements for the first eight months. Which of the following choices correctlyreports this transaction? (Page 184)

a. For tax reporting purposes, Alligator Corp. will record rental income of $6,000 for months one through six.[This answer is incorrect. For tax reporting the lessor would report no income from the lease for the firsteight months, and the lessee would deduct no rent expense during the period.]

b. For financial reporting purposes, Crocodile Corp. will record rental expense of $1,000 for month twelve.[This answer is incorrect. For financial reporting purposes, GAAP requires lessors and lessees to recognizerent under noncancelable operating leases on a straight�line method over the period the lessee controlsthe use of the leased property.]

c. For tax reporting purposes, Crocodile Corp. will record rental expense of $12,000 for year two (monthsseven through eighteen). [This answer is incorrect. For tax reporting, accrual basis lessors usuallyrecognize rent income under operating leases when earned, and accrual basis lessees recognize rentexpense under operating leases when payments are due. Therefore, Crocodile Corp. will recognize rentexpense of $10,000 for year two ($0 for months seven through eight and $1,000 each month for monthsnine through eighteen).]

d. For financial reporting purposes, Alligator Corp. will record rental income of $5,200 for the firstcalendar year. [This answer is correct. For financial reporting purposes, lessors and lessees willrecognize rent on a straight�line method over the five years. Alligator Corp. will record $5,200 rentalincome for the first calendar year. The lease began on July 1, therefore, six months' of income willbe recognized. Each month, Alligator Corp. will recognize $866.67 rental income ($52,000 totalrents/60 months).]


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Lesson 2 (PFSTG092)


25. When a stock redemption is used to buy out a stockholder, it is in effect a treasury stock purchase.

a. True.

b. False.

c. Do not choose this answer choice.

d. Do not choose this answer choice.

26. Artco Corporation is wholly owned by two stockholders in equal percentages. Each stockholder has a buy�sellagreement with the corporation requiring the corporation to purchase his shares for $500,000 in the event ofhis death. Assume one of the stockholders dies, how much is the retained earnings balance after theredemption using the cost method?





a. $(100,000).

b. $(85,000).

c. $200,000.

d. $400,000.

27. Assume the same facts as the previous example. How much is the retained earnings balance after theredemption using the par value method?

a. $(100,000).

b. $(85,000).

c. $200,000.

d. $400,000.

28. A redemption is accomplished through a distribution of property. The distributed asset has a basis of $8,000for financial statement reporting, $3,000 for tax reporting, and a fair market value of $5,000. What is one effectof the distribution?

a. A $5,000 taxable gain results from the distribution.

b. A $5,000 temporary difference results from the distribution.

c. A $5,000 temporary difference reverses due to the distribution.

d. A $5,000 permanent difference occurs due to the distribution.


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29. How is the cost of a covenant not to compete (entered into in connection with the purchase of a business onJuly 1, 2009) recorded on the tax return?

a. It is written off if impaired.

b. It is depreciated over 5 years.

c. It is amortized over 15 years.

d. It is amortized over the term of the agreement.

30. Push�down accounting is a framework for small and midsize nonpublic entities to use to recognize appreciationin the fair value of net assets due to changes in equity interests. Which of the following statements about pushdown accounting is correct?

a. Push�down accounting is required.

b. If the users of the financial statements of the entity acquired would find the information helpful, then itshould be used.

c. Push�down accounting is applied to the appreciation in the fair value of net assets of the company beingacquired.


31. Which of the following is correct regarding guaranteed payments to partners?

a. Guaranteed payments that are payments of interest on capital accounts should always be treated as asalary expense when determining net income.

b. A disclosure about the accounting method used should be included in the accounting policies if theguaranteed payments are material.

c. If the guaranteed payment is interest on capital accounts, then the payment should be treated as anallocation of partnership net income.


32. What is the default classification of a new domestic LLC for federal income tax purposes if the LLC has twomembers?

a. Sole proprietorship.

b. Partnership.

c. An unincorporated branch of a parent entity.

d. Corporation.

33. Which of the following is a GAAP departure when reported for an LLC?

a. Recording a liability for anticipated substantial member withdrawals to pay income taxes.

b. Not including federal income tax expense on the financial statements of an LLC.

c. The statement of income should present net income after federal income taxes.

d. Not reporting a liability for federal income tax expense.


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34. LLPs follow the same guidance for reporting purposes as LLCs.

a. True.

b. False.



35. Which of the following changes in tax status would cause recognition of a deferred tax liability or asset?

a. A corporation terminates its S corporation status.

b. A corporation converts to a proprietorship.

c. A corporation elects S corporation status.

d. A corporation converts to a partnership.

36. Match the following components of retained earnings with their description.

a. Accumulated Earnings and Profits (AEP)

b. Accumulated Adjustments Account (AAA)

c. Tax Timing Adjustments (TTA)

d. Other Retained Earnings (ORE)

i. Essentially is a residual amount and consists primarily of tax�exempt income arising since the dateof conversion.

ii. Essentially represents undistributed tax basis earnings on the date of conversion.

iii. Essentially represents cumulative temporary differences at any balance sheet date.

iv. Essentially represents undistributed tax basis retained earnings arising after the date of conversion.

a. a.iv., b.ii., c.iii., d.i.

b. a.iv., b.ii., c.i., d.iii.

c. a.i., b.iii., c.iv., d.ii.

d. a.ii., b.iv., c.iii., d.i.


FIFO $ 2,500,000

LIFO 2,000,000


Stanley's GAAP pretax income at 12/31/X6 is $340,000. Based on a tax rate of 34%, what is the income tax duein the first installment of required income tax payments?


195

a. $42,500.

b. $115,600.

c. $158,100.

d. $170,000.

38. If a corporation converts to a partnership, it must adopt a calendar year end or pay a deposit per the currenttax laws.

a. True.

b. False.



39. Which of the following choices accurately accounts for leasing transactions?

a. Lease incentives may cause temporary differences.

b. Leases with scheduled increases cause permanent differences.

c. Tax indemnifications do not affect reporting for lease agreements.

d. Tax and financial statement reporting are essentially the same.

40. Parish Manufacturing pays out any remaining vacation pay to their employees after year end and after thecompany income taxes are paid for the year. Employees accrued vacation for the 2009 calendar year in 2008.Parish paid out the accrued vacation pay on March 10, 2010. Parish Manufacturing follows a calendar tax year.In what year would the vacation pay be deductible to the company?

a. 2008.

b. 2009.

c. 2010.



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197

GLOSSARY

Accounting Period: The period which a taxpayer uses to determine federal income tax liabilities. Absent a choiceto the contrary, individuals and entities are automatically relegated to the calendar year (§441). Taxpayers maygenerally select other periods, in particular fiscal years, such as June 1 to May 30, or in special circumstances,fifty�two, fifty�three week taxable years, and shorter periods, in cases of changes of accounting periods and taxpayersin existence for less than a 12�month period [§441(f), 443]. Partnerships and S corporations' taxable years arestatutorily controlled and generally preclude adoption of a taxable year for the enterprise different from that of itsmajority partners, or a noncalendar year, respectively [§706, 1378(b)]. Changes in the accounting period call for theIRS approval.

Basis in Partnership Interest: A partner's basis in his or her share of a partnership, a dynamic account that beginswith the amount of money plus the adjusted basis of property contributed to a partnership (§722). The partner's shareof the partnership's liabilities for which the partner is liable and those that no partner is liable for are deemed to bea contribution of money and increase the partner's basis (§752). Liabilities of the partnership are generally allocatedamong the partners according to loss�sharing ratios, except for nonrecourse liabilities of limited partnerships, whichallocate partnership debt according to profit�sharing ratios [Reg. §1.752�1(e)]. Direct assumption of the partnership'sliabilities increases a partner's basis in the partnership interest. Basis is also increased by the partner's share ofpartnership income and the excess of depletion deductions over the basis of the depletable property; however, basisis reduced by partnership distributions and losses, nondeductible, noncapitalized expenditures, and limited oil andgas depletion (see §705, 722, 742 and 752). Reductions in a partner's share of liabilities are treated as distributionsof money to the partner, and correspondingly reduce basis [§752(b)]. The partner's basis in the partnership interestserves to limit loss deductions [§704(d)], and to determine gain or loss on sale or liquidation of the interest or ondistributions of money in excess of basis (§731 and 732).

Change of Accounting Method: A switch by the taxpayer from one overall method of accounting to a differentmethod or the alteration in the treatment of a material item (basically, any regularly recurring incidence of incomeor expense which involves the time when it is reported) [Reg. §1.446�1(e)(2)(i)]. The term includes the following: aswitch from the cash method to the accrual method or vice versa; a switch from cash or accrual method to one ofthe long�term contract methods or vice versa; a switch to a depreciation method other than straight�line depreciation;a switch from one inventory valuation method to another; and a switch to or from a specialized basis method (e.g.,crop method by farmers) [Reg. §1.446�1(e)(2)(ii)]. The term can also encompass a change in accounting methodsfrom an incorrect method to a correct method unless the erroneous method was not used consistently.

Complete Liquidation, Corporate: A transfer by all shareholders of their stock to the corporation that issued thestock in exchange for the corporation's property (§331). A status of complete liquidation exists when the corporationceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts,and distributing any remaining balance to its shareholders. A complete liquidation may be completed prior to theactual dissolution of the liquidating corporation, and in any event a legal dissolution of the corporation is not required.

Deferred Income Tax Asset: A deferred tax asset is recognized for temporary differences that will result in deductibleamounts in future years and for carryforwards.

Deferred Income Tax Liability: Excess of income tax amount shown on an income statement over the actual taxamount, which occurs when book�income exceeds taxable income. This excess is recognized as a liability in thetaxpayer's balance sheet, and is written of the following accounting period.

Like�kind Exchange: An exchange of business or investment property pursuant to §1031. Recognition of gains andlosses on such exchanges is tax�deferred, except to the extent of nonqualifying property (boot) received or paid over(to the extent of any built�in gain or loss). For example, if a taxpayer exchanges investment land with an adjusted basisof $10,000 and worth $100,000 for an apartment (business) worth $100,000, the transaction will result in noimmediate taxation. However, the apartment will have a basis of $10,000. Such exchanges may be simultaneous ordeferred, but if the exchange was with a related taxpayer, it generally does not qualify for nonrecognition of gain orloss if either party disposes of the property within two years, or longer if and to the extent there is a diminution of riskof loss with respect to the property [§1031(f)]. The extent of delay permissible in deferred exchanges is generallylimited to 180 days [§1031(a)(3)]. Section 1031 is mandatory, and that the price exacted is a basis in the acquired


198

property which is reduced to the extent of any deferred gain. The exchange is evaluated property�by�property; forexample, an exchange of assets of a business for the assets of a similar business does not qualify (Rev. Rul. 89�121,1989�2 CB 203).

Limited Liability Company: An organization no member of which is personally liable for the debts of the enterprise,often formed under foreign law [see, e.g., PLR 8317018 (January 21, 1983)], and that may have the characteristicsof partnerships and corporations under United States law. The IRS used to maintain that a limited liability companycould not be a partnership but has withdrawn that position, which interpreted [§7701(a)(3)]. The current rules giveLLCs with two or more owners to elect to be treated either as a partnership or as a corporation for taxation purposes[§301.7701�3(a)]. Single�member LLCs may choose to be taxed as a corporation or disregarded as an entityseparate from their owner.

Liquidation, Partnership Interest: The redemption of a partner's interest in the partnership by the partnership . Itcan occur at once or in stages [see Reg. §1.761�1(d)]. It is sometimes difficult to distinguish a liquidation from a saleof a partnership interest; the key issue is who is primarily responsible for paying the retiring partner or his or her estate.Section 736 controls the taxation of liquidating distributions.

Partnership Liquidation: In general, an event which occurs when no part of any business, financial operation orventure of a partnership continues to be carried on by any of the partners [§708(b)(1)(A)]. It also occurs for technicaltax purposes if 50 percent of the interests in capital and profits of the partnership are transferred by sale or exchangein any 12�month period, such that there is a termination [Reg. §1.708�1(b)(1)(iv)].

Stock Redemption: A transaction in which a corporation acquires its stock from a shareholder in exchange forproperty other than the corporation's stock, or rights to acquire such stock. Once the stock is acquired by thecorporation, it may cancel or retire the stock, or hold it as treasury stock [§317(b)]. A corporate distribution inredemption of its stock is treated as a §301 distribution of property if the distribution does not fit into any one of fourspecific categories. If a distribution does fall within a special category, the distribution is treated as an exchange,hence potentially taxable as a long�term capital gain [§302(a) and (d)]. The four categories in which a redemptionis treated as a sale of stock are: (1) redemption not essentially equivalent to a dividends [§302(b)(1)]; (2) asubstantially disproportionate redemption of stock [§302(b)(2)]`; (3) a redemption in complete termination of theshareholder interest [§302(b)(3)]; and (4) a redemption in partial liquidation of the corporation [§302(b)(4), a ruleapplicable only to noncorporate shareholders].

Tax Attributes, Bankruptcy Tax Act: A series of tax characteristics that may be reduced in bankruptcy or outsideof bankruptcy as a result of not recognizing discharge of indebtedness income. These characteristics include: (1)net operating losses and their carryovers; (2) carryovers of general business credits; (3) capital losses and theircarryovers; (4) the basis of the taxpayer's assets (both depreciable and nondepreciable ); and (5) carryovers of theforeign tax credit; minimum tax credits; passive losses and credits; passive loss and credit carryovers [§108(b)(2)].The provisions calling for application of the reductions are intricate.


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INDEX

A

ACCOUNTING CHANGE� Change in basis of accounting 110. . . . . . . . . . . . . . . . . . . . . . . . . � Change in depreciation method 111. . . . . . . . . . . . . . . . . . . . . . . . � Change in estimate 111. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in fiscal year 110. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in principle

�� For tax purposes 109. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Correction of an error 116. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cumulative effects of adjustment 111. . . . . . . . . . . . . . . . . . . . . . . � Disclosures 111. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Inventory pricing method 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Prospective application 111, 116. . . . . . . . . . . . . . . . . . . . . . . . . . .

ASSETS� Capitalization and valuation for certain tax transactions 116. . . .

B

BANKRUPTCY� Chapter 11 proceedings

�� Balance sheet considerations 120. . . . . . . . . . . . . . . . . . . . . . . �� Consolidated financial statements 123. . . . . . . . . . . . . . . . . . . �� Disclosures 123. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� General financial statement considerations 120. . . . . . . . . . . �� Income statement considerations 121. . . . . . . . . . . . . . . . . . . �� Statement of cash flows considerations 122. . . . . . . . . . . . . .

� Emergence from reorganization proceedings 123. . . . . . . . . . . .

BUSINESS COMBINATIONS� Covenants not to compete 159. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Tax basis 125. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Transfer of assets from proprietorship or partnership to

corporation 178. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

C

CASUALTY GAINS 141. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONSOLIDATED OR COMBINED FINANCIAL STATEMENTS� Investments in partnerships 134. . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONSTRUCTION CONTRACTORS� Income tax considerations 117. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interest

�� Capitalized 117. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONTINGENCIES AND COMMITMENTS� Agreements to reimburse disallowed deductions 183. . . . . . . . .

D

DEPRECIATION� ACRS 137. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Basis reduction 137. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Departures from GAAP 138. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated useful life 111. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax considerations 137. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Luxury autos 138. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Section 179 deduction and bonus depreciation 138. . . . . . . . . . .

DISCLOSURES� Bankruptcy proceedings 123. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Comparative financial statements 169. . . . . . . . . . . . . . . . . . . . . . . � Guaranteed payments to partners 166. . . . . . . . . . . . . . . . . . . . . . � Income taxes

�� Change in tax status 175, 179, 181. . . . . . . . . . . . . . . . . . . . . . �� Examination by a taxing authority 107. . . . . . . . . . . . . . . . . . . . �� Limited liability company tax status 169. . . . . . . . . . . . . . . . . . �� Partnership tax status 181. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Stub period presentations 182. . . . . . . . . . . . . . . . . . . . . . . . . . � Limited liability companies 170. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Liquidating companies 118. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � S corporations 175. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stock redemptions 159. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

E

EXPENSES� Casualty gains 141. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Limits on deductibility 186. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

G

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES� Departures from 138. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

I

INCOME TAXES� Accrued liabilities to related parties 183. . . . . . . . . . . . . . . . . . . . . � Deferred, liability method

�� Change in tax status 174. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Depreciation of luxury autos 138. . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures

�� Change in tax status 175, 179, 181. . . . . . . . . . . . . . . . . . . . . . �� Limited liability company tax status 169. . . . . . . . . . . . . . . . . . �� Partnership tax status 181. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stub period presentations 182. . . . . . . . . . . . . . . . . . . . . . . . . .

� Examination by a taxing authority 107. . . . . . . . . . . . . . . . . . . . . . . � Like�kind exchanges 139. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Limited liability companies 166, 169. . . . . . . . . . . . . . . . . . . . . . . . . � Loss carryforwards 135. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Permanent differences 158, 186. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stockholder agreements to reimburse disallowed

deductions 183. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Temporary differences, examples of

�� Casualty gains 141. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Construction period interest 117. . . . . . . . . . . . . . . . . . . . . . . . �� Deferred condemnations 141. . . . . . . . . . . . . . . . . . . . . . . . . . �� Depreciation and Section 179 deductions 137. . . . . . . . . . . . �� Equity interests for services 183. . . . . . . . . . . . . . . . . . . . . . . . . �� Inventories 177. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Investments in partnerships 135, 137. . . . . . . . . . . . . . . . . . . . �� Leases 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Liabilities to owners 183. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Like�kind exchanges 140. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Liquidations 118, 119. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Long�term contracts 118. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Partnership conversions 181. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Passive losses 135. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� S corporations 178. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Section 351 incorporation 179. . . . . . . . . . . . . . . . . . . . . . . . . . �� Stockholder receivables 183. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Stock redemptions 158. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Vacation pay 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTANGIBLE ASSETS� Covenants not to compete 159. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTEREST� Capitalization

�� Income tax considerations 117. . . . . . . . . . . . . . . . . . . . . . . . . .

INVENTORIES� Accounting changes 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Costs 116. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax considerations 116. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � LIFO

�� Recapture 177. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Simplified 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Uniform capitalization rules 116. . . . . . . . . . . . . . . . . . . . . . . . . . . .


200

INVESTMENTS� Partnerships 133. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Passive losses from partnerships and S corporations 133. . . . . .

L

LEASES� Bargain rentals 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Incentives 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Indemnification clauses 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Leasehold improvements 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Operating leases

�� Assumption of lease 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Incentive payments 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Scheduled rent increases 184. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Tax indemnification in lease agreements 185. . . . . . . . . . . . . . . . .

LIABILITIES� Accrued liabilities

�� Vacation and sick pay 185. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Noncompete agreements 159. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIMITED LIABILITY COMPANIES OR PARTNERSHIPS� Accounting for LLCs 168. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Changes in members' equity 169. . . . . . . . . . . . . . . . . . . . . . . �� Comparative financial statements 169. . . . . . . . . . . . . . . . . . . �� Conversion of an existing entity to an LLC 169. . . . . . . . . . . . �� Disclosures 170. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Equity section of the balance sheet 168. . . . . . . . . . . . . . . . . . �� Financial statement headings 168. . . . . . . . . . . . . . . . . . . . . . . �� Income taxes 169. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Limited liability partnerships 170. . . . . . . . . . . . . . . . . . . . . . . . . . . � Tax treatment 166. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIQUIDATION� Accounting for gains and losses 118. . . . . . . . . . . . . . . . . . . . . . . . � Tax accounting 118. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

M

MATERIALITY� ACRS 138. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Investments in partnerships 136. . . . . . . . . . . . . . . . . . . . . . . . . . . .

N

NONMONETARY TRANSACTIONS� Like�kind exchanges 139. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

O

OTHER COMPREHENSIVE BASIS OF ACCOUNTING� Change in basis of accounting 110, 180. . . . . . . . . . . . . . . . . . . . .

P

PARTNERSHIPS� Accounting under GAAP 133. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � At�risk rules 133. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Capital contributions 166. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Converting from corporation to partnership 180. . . . . . . . . . . . . . � Deferred taxes eliminated 180, 182. . . . . . . . . . . . . . . . . . . . . . . . . � Earnings on partnership investments 133. . . . . . . . . . . . . . . . . . . . � Guaranteed payments to partners 166. . . . . . . . . . . . . . . . . . . . . . � Interest in exchange for services 182. . . . . . . . . . . . . . . . . . . . . . . � Investment in partnerships 133. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Passive losses 133. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Transfer of assets to corporation 178. . . . . . . . . . . . . . . . . . . . . . . .

PROPERTY AND EQUIPMENT� Condemnation 141. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Distributions 158. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated useful life 137. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanges 139. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax considerations 137. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Section 179 deduction and bonus depreciation 138. . . . . . . . . . .

PROPRIETORSHIPS� Transfer of assets to corporation 178. . . . . . . . . . . . . . . . . . . . . . . .

R

RECEIVABLES� Income tax considerations 183. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Stockholder 183. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RELATED PARTY TRANSACTIONS� Deductibility of accrued liabilities 183. . . . . . . . . . . . . . . . . . . . . . .

RETAINED EARNINGS� Restrictions 157. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

S

S CORPORATION� Calendar year 177. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Converting from C to S corporation 174. . . . . . . . . . . . . . . . . . . . . � Disclosures 174. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � LIFO reserve recapture 177. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Passive losses 133. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Terminating election 178. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

STOCKHOLDERS' EQUITY� Stock issued in exchange for services 182. . . . . . . . . . . . . . . . . . . � Stock redemptions 157. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Treasury stock 157. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


201


COURSE 3

THE STATEMENT OF INCOME (PFSTG093)

OVERVIEW

COURSE DESCRIPTION: This interactive self�study course examines the statement of income. Users will learnthe basic format and style of the statement; when to recognize revenues, expenses,gains, and losses; as well as specific issues and accounting for income taxes.

PUBLICATION/REVISIONDATE:

November 2009


PREREQUISITE/ADVANCEPREPARATION:

Basic knowledge of financial statements.






LEARNING OBJECTIVES:

Lesson 1General Considerations Related to the Statement of Income

Completion of this lesson will enable you to:� Identify the components of net income.� Identify the correct form and style for the statement of income.� Determine when to recognize revenues, expenses, gains, and losses.� Determine issues related to items that are required to be presented separately on the statement of net income.

Lesson 2The Accounting and Presentation of Certain Expenses Related to the Statement of Income

Completion of this lesson will enable you to:� Determine accounting and presentation issues related to depreciation, start�up costs, research and

development, and computer software.� Determine accounting and presentation issues related to rent expenses, advertising costs, and retroactive

adjustment of workers' compensation and other expenses.

Lesson 3Income Tax Accounting

Completion of this lesson will enable you to:� Identify issues related to accounting for income taxes.� Calculate various income tax amounts, including deferred taxes, loss carryforwards, and others.


202








203

Lesson 1:�General Considerations Related to theStatement of Income

INTRODUCTION

SAS No. 29 (AU 551) lists the statement of income as one of the basic financial statements necessary to present acompany's financial position and results of operations in conformity with generally accepted accounting principles.The statement of income and the statement of retained earnings, individually or in combination, are designed toreflect, in a broad sense, the results of an entity's operations. This course discusses preparing income statements.



� Identify the components of net income.

� Identify the correct form and style for the statement of income.

� Determine when to recognize revenues, expenses, gains, and losses.

� Determine issues related to items that are required to be presented separately on the statement of netincome.

COMPONENTS OF NET INCOME

Each item presented in the statement of income may be categorized according to one of the four components ofnet income. Statement of Financial Accounting Concepts (SFAC) No. 6, Elements of Financial Statements, uses theterm �comprehensive income" rather than the traditional �net income" or �earnings" to describe all changes in acompany's equity (net assets) except those resulting from investments by owners and distributions to owners.According to SFAC No. 6 the components of net income are:

a. Revenues. Actual or expected cash inflows (or the equivalent) that have occurred or will eventuate as aresult of an entity's ongoing major or central operations

b. Expenses. Outflows or other using up of assets or incurrences of liabilities (or a combination of both) fromdelivering or producing goods, rendering services, or carrying out other activities that constitute the entity'songoing major or central operations

c. Gains. Increases in equity (net assets) from peripheral or incidental transactions of an entity and from allother transactions and other events and circumstances affecting the entity except those that result fromrevenues or investments by owners

d. Losses. Decreases in equity (net assets) from peripheral or incidental transactions of an entity and fromall other transactions and other events and circumstances affecting the entity except those that result fromexpenses or distributions to owners

Statements of Financial Accounting Concepts do not establish accounting standards that are enforceable underthe AICPA Code of Professional Conduct. However, they may be considered in the absence of establishedaccounting principles. SFACs are considered nonauthoritative accounting literature at this time and, therefore, arenot included in the FASB Accounting Standards Codification.

Classifying amounts as revenues, gains, expenses, or losses varies among companies and depends on the natureof a company's operations. Events or circumstances that are sources of revenues for one company may be gainsfor another. The primary differences between revenues and gains and between expenses and losses are that (a)


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revenues and expenses result from an entity's ongoing major or central operations such as producing or deliveringgoods or rendering services, while gains and losses result from incidental or peripheral events or circumstancesand (b) revenues and expenses usually are recorded at their gross amounts while gains and losses usually arerecorded at net amounts.

Accounting and presentation principles for specific items of revenue, expense, gain, or loss are discussed in moredetail in the remainder of this course.

FORM AND STYLE CONSIDERATIONS FOR THE STATEMENT OF INCOME

Alternative Formats

The income statement is usually presented in one of the following formats:

� Single�step Format. The single�step format groups the components of net income into two categories: (a)revenues and gains and (b) expenses and losses. The difference between the two subtotals is net incomeor loss for the period. In practice, the strict single�step format is often modified to show income taxes, orequity in net earnings or losses of investees as a separate caption preceding net income (or income beforeextraordinary items), rather than including those amounts among operating items.

� Multiple�step Format. The multiple�step format shows various intermediate components of net income.Generally, operating results are presented separately from nonoperating results, e.g., costs and expensesare deducted from sales followed by nonoperating revenues, gains, expenses, and losses, and expensesare grouped by type or function. Intermediate components of net income that are frequently presented inmultiple�step statements are gross profit, income from operations, and other income and expenses.

Classifying Items

Disclosure of the important components of the financial statements, such as sales or other sources of revenue, costof sales, depreciation, selling and administrative expenses, interest expense, and income taxes, makes the infor�mation more useful. The following guidelines about grouping (or presenting separately) items of revenues,expenses, gains, and losses in income statements were proposed by the FASB in a Concepts Statement. While theStatement was not adopted, the guidelines are believed useful.

� It is useful to report separately items that have been unusual in amount judged by the experience ofprevious periods.

� It is useful to distinguish among revenues, expenses, gains, losses, receipts, and payments, the amountsof which are affected in different ways by changes in economic conditions.

� It is useful, when cost justified, to give enough detail to enable users to understand the main relationshipamong revenues, expenses, gains, and losses, and between cash receipts and payments. In particular, itis relevant to report separately (a) expenses that vary with volume of activity or with various componentsof income, (b) expenses that are discretionary, and (c)�expenses that are stable over time or that dependon other factors, such as the level of interest rates and the rate of taxation.

� The reporting of the net amounts of items, some of which have positive effects on comprehensive incomeand some of which have negative effects (as in the reporting of gains and losses), is acceptable only ifknowledge of the relationships between the gross and net amounts is not likely to be particularly useful forthe prediction of future results.

� Reporting should distinguish among revenues, expenses, gains, and losses, the measurement of whichis subject to different levels of reliability.

� Reporting should distinguish items, the amounts of which must be known, for the calculation of summaryindicators that users are known to use frequently; for example, for computations to be made of rate of return.Similarly, information should be provided to permit users to calculate interest coverage, debt servicecoverage, etc.


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Statement Title

Authoritative literature does not prescribe a title for the income statement. The following titles are found mostfrequently in practice:

� Statement of Income

� Statement of Operations

� Income Statement

� Statement of Earnings

�Statement of Income" is the most frequently used title by nonpublic companies. Cash and tax basis statementsshould not use one of the preceding titles without modification.

When the statement shows a net loss, some firms use the title �Statement of Operations" rather than �Statement ofIncome," although �Statement of Income" is acceptable.

Captions

Captions within the income statement will vary based on the nature of a company's operations, the way revenuesand expenses are recognized, the detail presented, and the format of the income statement, i.e., single�step ormultiple�step. The following are some practical guidelines:

� If the income statement includes more than one revenue account, they are ordinarily listed under a headingsuch as �Revenues" (single�step format) or �Operating revenues" (multiple�step format).

� Amounts deducted in arriving at revenue presented on the income statement (for example, sales returnsand allowances or discounts) should be disclosed on the face of the income statement or in the notes tothe financial statements, if material.

� For single�step formats, expenses are ordinarily listed under a heading such as �Costs and expenses" or�Expenses."

� Multiple�step formats usually present �Cost of sales" either as (a) a separate line item, (b) a heading belowwhich are listed elements of costs, or (c) as a separate line item under a heading such as �Operatingexpenses." Other operating expenses may be listed under a heading such as �Operating expenses" or maybe classified by principal type, e.g., selling or administrative, and presented as separate line items withouta heading.

� Other income and expenses should be identified, if material, either on the face of the income statement orin the notes to the financial statements. Material income and expense items should not be obscured byclassifying them under captions such as �Other incomenet" or �Other expensenet."

THE RECOGNITION OF REVENUES, EXPENSES, GAINS, AND LOSSES

Revenues

SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue isrecorded in financial statements when the following conditions are met:

a. Amounts are realized or realizable, i.e., converted or convertible into cash or claims to cash.

b. Amounts are earned, i.e., activities that are prerequisite to obtaining benefits have been completed.

Accordingly, as a general rule, revenue from selling products is recognized at the date of sale, and revenue fromrendering services is recognized when they have been performed and are billable.


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Paragraph 84 of SFAC No. 5 provides the following additional guidelines on recognizing revenue:

� If sale or cash receipt (or both) precedes production and delivery (for example, magazine subscriptions),revenues may be recognized as earned by production and delivery.

� If product is contracted for before production, revenues may be recognized by a percentage�of�completionmethod as earnedas production takes placeprovided reasonable estimates of results at completionand reliable measures of progress are available.

� If services are rendered or rights to use assets extend continuously over time (for example, interest or rent),reliable measures based on contractual prices established in advance are commonly available, andrevenues may be recognized as earned as time passes.

� If products or other assets are readily realizable because they are salable at reliably determinable priceswithout significant effort (for example, certain agricultural products, precious metals, and marketablesecurities), revenues and some gains or losses may be recognized at completion of production or whenprices of the assets change.

� If product, services, or other assets are exchanged for nonmonetary assets that are not readily convertibleinto cash, revenues or gains or losses may be recognized on the basis that they have been earned andthe transaction is completed.�.�.�. Recognition in both kinds of transactions depends on the provision thatthe fair values involved can be determined within reasonable limits.

� If collectibility of assets received for product, services, or other assets is doubtful, revenues�.�.�. may berecognized on the basis of cash received.

Various pronouncements provide specific guidance on revenue recognition for certain transactions or in certainindustries. The AICPA has also published an Audit Guide, Auditing Revenue in Certain Industries, that practitionersmay find useful. The Audit Guide is available on Checkpoint or may be ordered from the AICPA. Revenue recogni�tion principles for cash and tax basis financial statements do not necessarily conform to the principles cited in theprevious two paragraphs.

The FASB and IASB are currently conducting a joint revenue recognition project with the aim of issuing a revenuerecognition standard that companies can consistently apply across various industries and transactions. In Decem�ber 2008, the Boards published a Discussion Paper, Preliminary Views on Revenue Recognition in Contracts withCustomers. The comment period ended in June 2009, and the Boards anticipate issuing an exposure draft in thefirst half of 2010 with a final document in 2011. The effective date of the requirements will be considered as theproject progresses. Future editions of this course will update the status of this project. FASB ASC 605�10�S99[formerly SEC Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements] providesadditional guidance on recognizing, presenting, and disclosing revenue in financial statements filed with the SEC.Although SABs are not applicable to the financial statements of nonpublic entities, this specific guidance may beuseful to all financial statement preparers. It does not change any existing guidance on revenue recognition, butexplains how the SEC staff applies that guidance to transactions not specifically addressed in the existing guid�ance.

Whether to Recognize Revenue as a Principal or an Agent. Generally, principals recognize as revenue theamount charged to the customer and agents recognize as revenue the portion of the amount charged to thecustomer that they retain. While the issue of whether an entity should recognize revenue as a principal or an agentis not new, it is becoming more pronounced as entities adopt more of a virtual approach to business. For example,entities selling products over the Internet may keep no inventory but instead have an arrangement with a supplierto ship the product directly to the customer. FASB ASC 605�45�45�1 through 45�18 (formerly EITF Issue No.�99�19,�Reporting Revenue Gross as a Principal versus Net as an Agent") says that whether the entity should recognizerevenue as a principal or an agent depends on the facts and circumstances and provides a variety of indicators thatthe entity should evaluate in reaching a decision. However, none of the indicators should be considered presump�tive or determinative, and instead, the relative strength of each should be considered.


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The following are possible indicators that the entity should recognize revenue as a principal:

a. The entity is the primary obligor in the arrangement.

b. The entity has general inventory risk, either before the customer order or upon customer return.

c. The entity has latitude in establishing price.

d. The entity changes the product or performs part of the service.

e. The entity has discretion in supplier selection.

f. The entity is involved in the determination of product or service specifications.

g. The entity has physical loss inventory risk, either after the customer order or during shipping.

h. The entity has credit risk.

In addition, the following are listed as possible indicators that the entity should recognize revenue as an agent:

a. The supplier, not the entity, is the primary obligor in the arrangement.

b. The amount the entity earns is fixed.

c. The supplier, not the entity, has credit risk.

Whether to Recognize Charges for Shipping and Handling as Revenue. FASB ASC 605�45�45�19 through45�21 and 605�45�50�2 (formerly EITF Issue No. 00�10, �Accounting for Shipping and Handling Fees and Costs")requires entities to record as revenue charges to customers for shipping and handling, without regard to whetherthose charges are designed solely as cost recovery or to generate a profit. In addition, entities are required todisclose the following:

a. The policy for classifying shipping and handling costs.

b. If shipping and handling costs are significant and are not included in cost of sales, the total of those costsand the line items in which they are included in the income statement.

The Effect of Sales Incentives on the Amount of Revenue Recognized. Entities may offer a variety of salesincentives, some of which are passed on by their primary vendors. For example, the incentives may entitle thecustomer to receive:

a. a reduction in the price of a product or service at the point of sale, typically by presenting a coupon thatwas distributed through print media or by direct mail.

b. a price reduction by subsequently submitting a refund or rebate claim, often to the manufacturer of theproduct.

FASB ASC 605�50 [formerly EITF Issue No. 01�9, �Accounting for Consideration Given by a Vendor to a Customer(Including a Reseller of the Vendor's Products)"] provides guidance on (a) how the entity should account for thesetypes of incentives and (b) how the entity should recognize costs associated with sales incentives in which theentity gives the customer a free product or service such as a kitchen appliance or a gift certificate for use at anotherentity.

Presentation of Sales and Other Similar Taxes in the Statement of Income. Entities often collect taxes (such assales, use, value added, and certain excise taxes) from customers and send the amounts collected to the appropri�ate taxing authority. FASB ASC 605�45�15�2; 605�45�50�3 and 50�4 [formerly EITF Issue No. 06�3, �How TaxesCollected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income State�ment (That Is, Gross versus Net Presentation)"] addresses the presentation of such taxes in the statement of


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income. This guidance applies to any tax a governmental authority assesses that is imposed on and occurssimultaneously with a specific transaction between a seller and a customer that produces revenue. It does notapply to certain tax schemes imposed during the inventory procurement process.

Some entities present sales and similar taxes on a gross basis. That is, they record the amount of taxes collectedas revenues and the amount remitted to taxing authorities as costs. Other entities use a net presentation and do notreport the taxes in revenues. The presentation of such taxes is an accounting policy decision to be disclosed inaccordance with FASB ASC 235�10�50 (formerly APB Opinion No. 22, Disclosure of Accounting Policies). However,entities that report sales and similar taxes on a gross basis are required to disclose the amount of those taxes if theyare significant. Such disclosure may be done on an aggregate basis.

Expenses

The term �matching" is sometimes used to describe the process of recognizing expenses in the same accountingperiod as the revenues associated with those costs. SFAC No. 6 describes three broad expense recognitionprinciples as follows:

� Costs and revenues that result directly and jointly from the same transaction or event are recognized in thesame accounting period, such as sales revenue, cost of goods sold, and certain selling expenses.

� Costs that are incurred to obtain benefits that are exhausted in the period in which the costs are incurredare recognized in that period, for example, salesmen's monthly salaries and utilities.

� Costs that provide benefits over several periods are allocated to those periods, for example, prepaidinsurance and depreciation. Costs are generally allocated to accounting periods when no directrelationship between revenues and costs exists, and the costs cannot be identified with a particularaccounting period.

Accounting for particular types of expenses is discussed in Lesson 2.

Gains and Losses

SFAC No. 6 indicates that gains and losses generally result from one of the following events or circumstances:

a. Netting costs and proceeds of incidental transactions, such as sales of investments in marketablesecurities or equipment

b. Nonreciprocal transfers other than those between the company and its owners, for example, donations,winning a lawsuit, or thefts

c. Holding assets or liabilities while their values change, for example, causing inventory to be written downfrom cost to market

d. Environmental factors, such as damage or destruction of property by fire or flood


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SELF�STUDY QUIZ


1. FAD Corporation manufactures women's accessories as its ongoing central operation. These accessories aresold to department stores with the terms 2%/10, net/45. Which component of income would FAD record relatingto the increase in accounts receivable resulting from the sale of the accessories?

a. Revenue.

b. Expense.

c. Gain.

d. Loss.

2. Which of the following items would be classified as an expense on FAD Corporation's statement of income?

a. The increase in accounts payable resulting from the purchase of a new manufacturing machine.

b. The use of raw materials in the manufacturing process for accessories sold in the current period.

c. The outflow of cash resulting from the issuance of dividends to the corporation's stockholders.

d. The total loss of a warehouse due to a tornado.

3. Which of the following is the most frequently used title for the income statement by nonpublic companies?

a. Statement of Income.

b. Statement of Operations.

c. Income Statement.

d. Statement of Earnings.

4. Captions within the income statement are not:

a. Prescribed by authoritative literature.

b. Determined by the income statement format.

c. Based on the nature of the company's operations.

5. According to the additional guidelines provided in SFAC No. 5, Recognition and Measurement in Financial

Statements of Business Enterprises:

a. Magazine subscriptions may be recognized as revenue when cash is received.

b. Revenues from precious metals may be recognized at completion of production.

c. Revenue from selling an automobile is recognized on the date cash is received.

d. Revenues from non�contracted construction may be recognized by a percentage�of�completion method.


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6. Generally, principals recognize as revenue the amount charged to the customer and agents recognize asrevenue the portion of the amount charged to the customer that they retain. Which of the following providesguidance on whether to recognize revenue as a principal or agent?

a. FASB ASC 605�45�45�1 through 45�18.

b. FASB ASC 605�10�S99.

c. FASB ASC 605�45�45�19 through 45�21 and 605�45�50�2.

7. The bookkeeper at Alberto's Roofing is preparing the financial statements for the month. According to theexpense recognition principles in the Statement of Financial Accounting Concepts No. 6, which of the followingexpenses would be allocated over several accounting periods?

a. Utilities for the office.

b. Cost of goods sold for a small residential roofing job.

c. Monthly payment for a local billboard advertisement.

d. Depreciation on the work truck.


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1. FAD Corporation manufactures women's accessories as its ongoing central operation. These accessories aresold to department stores with the terms 2%/10, net/45. Which component of income would FAD record relatingto the increase in accounts receivable resulting from the sales of the accessories? (Page 203)

a. Revenue. [This answer is correct. Revenues are reported on the statement of income. Revenuesinclude the expected cash inflows that will occur as a result of an entity's ongoing major or centraloperations. The increase in accounts receivable is properly classified as an expected cash inflow.]

b. Expense. [This answer is incorrect. FAD Corporation will need to record the cost of goods sold for theaccessories; however, the increase in accounts receivable does not result in an expense on the statementof income.]

c. Gain. [This answer is incorrect. An increase in accounts receivable as a result of an entity's ongoing centraloperations is not recorded on the statement of income as a gain. A gain would be recorded in the eventof a profitable sale of a machine used in the manufacture of the accessories.]

d. Loss. [This answer is incorrect. The sale of accessories will not produce a component of income classifiedas a loss. A loss might occur upon the sale of a copy machine used in the business office of FADCorporation.]

2. Which of the following items would be classified as an expense on FAD Corporation's statement of income?(Page 203)

a. The increase in accounts payable resulting from the purchase of a new manufacturing machine. [Thisanswer is incorrect. The purchase of a machine used in the manufacture of a product is recorded on thebalance sheet.]

b. The use of raw materials in the manufacturing process for accessories sold in the current period.[This answer is correct. Expenses are defined as the outflows or other using up of assets orincurrences of liabilities from delivering or producing goods, rendering services, or carrying outother activities that constitute the entity's ongoing major or central operations per SFAC No. 6.]

c. The outflow of cash resulting from the issuance of dividends to the corporation's stockholders. [Thisanswer is incorrect. The payment of dividends is not an item recorded on the statement of income.Distributions are recorded on the balance sheet.]

d. The total loss of a warehouse due to a tornado. [This answer is incorrect. The casualty loss is not a resultof an ongoing major or central operation. This event would be classified as a loss on the statement ofincome.]

3. Which of the following is the most frequently used title for the income statement by nonpublic companies?(Page 205)

a. Statement of Income. [This answer is correct. The authoritative literature does not provide a specifictitle. However, �Statement of Income" is the most frequently used title by nonpublic companies.]

b. Statement of Operations. [This answer is incorrect. �Statement of Operations" is an acceptable title for theincome statement. Some companies use this title when the statement shows a net loss.]

c. Income Statement. [This answer is incorrect. �Income Statement" is not the most frequently used title bynonpublic companies. It is, however, one of the four most common.]

d. Statement of Earnings. [This answer is incorrect. �Statement of Earnings" is an acceptable title for theincome statement, but it is not the most frequently used title by nonpublic companies.]


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4. Captions within the income statement are not: (Page 205)

a. Prescribed by authoritative literature. [This answer is correct. Captions within the income statementwill vary based on the nature of a company's operations, the way revenues and expenses arerecognized, the detail presented, and the format of the income statement.]

b. Determined by the income statement format. [This answer is incorrect. The captions within the incomestatement will vary based on whether the single�step or multiple�step formats are used.]

c. Based on the nature of the company's operations. [This answer is incorrect. The nature of the company'soperations affects the captions within the income statement. A manufacturing company will have differenttypes of revenues and expenses than a professional service company.]

5. According to the additional guidelines provided in SFAC No. 5, Recognition and Measurement in Financial

Statements of Business Enterprises: (Page 206)

a. Magazine subscriptions may be recognized as revenue when cash is received. [This answer is incorrect.Paragraph 84 of SFAC No. 5 provides that if sale or cash receipt precedes production and delivery,revenues may be recognized as earned by production and delivery.]

b. Revenues from precious metals may be recognized at completion of production. [This answer iscorrect. Per paragraph 84 of SFAC No. 5, if products or other assets are readily realizable becausethey are salable at reliably determinable prices without significant effort, revenues and some gainsor losses may be recognized at completion of production or when prices of the assets change.]

c. Revenue from selling an automobile is recognized on the date cash is received. [This answer is incorrect.As a general rule, revenue from selling products is recognized at the date of sale.]

d. Revenues from non�contracted construction may be recognized by a percentage�of�completion method.[This answer is incorrect. Paragraph 84 of SFAC No. 5 provides that if the product is contracted for beforeproduction, revenues may be recognized by a percentage�of�completion method as production takesplace.]

6. Generally, principals recognize as revenue the amount charged to the customer and agents recognize asrevenue the portion of the amount charged to the customer that they retain. Which of the following providesguidance on whether to recognize revenue as a principal or agent? (Page 206)

a. FASB ASC 605�45�45�1 through 45�18. [This answer is correct. FASB ASC 605�45�45�1 through 45�18(formerly EITF Issue No. 99�19) addresses the issue of whether the entity should recognize revenueas a principal or agent. The relative strength of each indicator should be evaluated. None of theindicators should be considered presumptive or determinative.]

b. FASB ASC 605�10�S99. [This answer is incorrect. FASB ASC 605�10�S99 (formerly SEC Staff AccountingBulletin No. 101) was issued by the SEC staff to provide additional guidance on revenue recognition infinancial statements filed with the SEC. The SAB does not change any existing guidance on revenuerecognition, but explains how the SEC staff applies that guidance to transactions not specificallyaddressed in the existing guidance.]

c. FASB ASC 605�45�45�19 through 45�21 and 605�45�50�2. [This answer is incorrect. FASB ASC605�45�45�19 through 45�21 and 605�45�50�2 (formerly EITF Issue No. 00�10) addresses the issue ofwhether to recognize charges for shipping and handling as revenue. This guidance requires entities torecord as revenue charges to customers for shipping and handling, without regard to whether thosecharges are designed solely as cost recovery or to generate a profit.]


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7. The bookkeeper at Alberto's Roofing is preparing the financial statements for the month. According to theexpense recognition principles in the Statement of Financial Accounting Concepts No. 6, which of the followingexpenses would be allocated over several accounting periods? (Page 208)

a. Utilities for the office. [This answer is incorrect. A monthly utility bill will be expensed in full each month.Costs that are incurred to obtain benefits that are exhausted in the period in which the costs are incurredare recognized in that period.]

b. Cost of goods sold for a small residential roofing job. [This answer is incorrect. The expenses for the jobwill be recognized in the same period that the revenue was recognized. Costs and revenues that resultdirectly and jointly from the same transaction or event are recognized in the same accounting period.]

c. Monthly payment for a local billboard advertisement. [This answer is incorrect. The advertising expensewould not be expensed each month as paid or allocated over several accounting periods. The advertisingcost should be expensed the first time the advertising occurs.]

d. Depreciation on the work truck. [This answer is correct. Costs that provide benefits over severalperiods are allocated to those periods, such as depreciation.]


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ELEMENTS OF NET INCOME THAT MUST BE PRESENTED SEPARATELY

As noted in the preceding section, there are few strict rules regarding the appropriate format for an incomestatement. Presenting a company's results of operations in a meaningful way that allows users to evaluate pastperformance and assess future performance should be the goal. Generally accepted accounting principles dorequire certain elements of net income to be presented separately, however. Those items are as follows:

a. Extraordinary items

b. Unusual or infrequent items

c. Discontinued operations of a component of an entity

d. Equity in operations of investees

e. Consolidated net income and the amounts attributable to the parent and the noncontrolling interest

If more than one of the items in the preceding paragraph exists, the appropriate order of presentation is as follows:

a. Income from continuing operations, including, if applicable, unusual or infrequently occurring items, andequity in operations of investees

b. Discontinued operations of a component of an entity

c. Extraordinary items

d. Consolidated net income

e. Net income attributable to the noncontrolling interest

f. Net income attributable to the parent

GAAP also permits, but does not require, amounts attributable to the parent for income from continuing operations,discontinued operations, and extraordinary items to be disclosed on the face of the consolidated income state�ment. If such amounts are not presented on the face of the income statement, they should be disclosed in the notesto the financial statements. The following paragraphs discuss accounting and presentation for the elements of netincome that must be presented separately.

Extraordinary Items

Identifying Extraordinary Items. FASB ASC 225�20�45�2 (formerly APB Opinion No. 30, Reporting the Results of

Operations) defines extraordinary items as events or transactions that meet both of the following criteria:

a. Unusual Nature. The underlying event or transaction should possess a high degree of abnormality and beof a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity,taking into account the environment in which the entity operates. (An event or transaction is not consideredto be unusual merely because it is beyond the control of management.)

b. Infrequency of Occurrence. The underlying event or transaction should be of a type that would notreasonably be expected to recur in the foreseeable future, taking into account the environment in whichthe entity operates.

A presumption underlying the definition of extraordinary items is that an event or transaction should be consideredordinary and usual unless the evidence clearly supports its classification as extraordinary. Thus, classifying anevent or transaction as extraordinary would occur only in rare circumstances. In making that determination, theenvironment in which a company operates, including such factors as the characteristics of its industry, the geo�


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graphical location of its operations, and the nature and extent of governmental regulation, should be a primaryconsideration. Thus, as a general rule, particular events or transactions do not, of themselves, require classificationas extraordinary items. (However, there are exceptions to that rule, which will be discussed later in this lesson.) Anevent or transaction that may be considered an extraordinary item for one company may not be considered anextraordinary item for another.

The materiality of an event or transaction should be considered in deciding whether to present it as an extraordinaryitem. Materiality should be considered as it relates to individual items, except that the effects of a series of relatedtransactions from a single specific and identifiable event or plan of action should be considered in the aggregate.

Examples of Items That Are Not Extraordinary Items. The following events or transactions generally should not

be considered to be extraordinary items:

� Write�down or write�off of receivables, inventories, equipment leased to others, or intangible assets

� Gains or losses from sale or abandonment of property, plant, or equipment used in the business

� Gains or losses from exchange or translation of foreign currencies including those relating to majordevaluations and revaluations

� Effects of a strike, including those against competitors and major suppliers

� Adjustments of accruals on long�term contracts

� Disposals of a component of an entity

� Proceeds from life insurance on an officer

� Environmental remediation obligations

The presentation of unusual or infrequent items that are not considered to be extraordinary items is discussed laterin this lesson.

Examples of Extraordinary Items. Catastrophic events and natural disasters, such as earthquakes and floods,continue at record levels. The frequency of those occurrences have brought into question whether they generallymeet the criteria to be classified as extraordinary items in the income statement. It is believed that whether an eventshould be considered extraordinary depends on the facts and circumstances. Therefore, an event that is consid�ered extraordinary in one set of facts and circumstances may not be considered extraordinary in others. An AICPATechnical Practice Aid at TPA 5400.05 discusses accounting and disclosures related to losses from natural disas�ters. According to the TPA, a natural disaster is not considered unusual in nature or unlikely to recur because of themagnitude of the loss from the disaster.

To illustrate, a catastrophic flash flood caused by rainfall of an unprecedented intensity that scientists say wouldlikely occur only once in hundreds of years probably should be considered extraordinary. However, a flood causedby a river overflowing in a flood plain probably should not be considered extraordinary. It is also believed that therewill be times when it is appropriate to classify the gains and losses that are a direct result of such events asextraordinary items. That treatment will usually be appropriate when the particular event is not reasonably expectedto recur in the foreseeable future in the environment in which the entity operates. FASB ASC 225�20�45�5 (formerlyAPB Opinion No. 30) prohibits any portion of such gains and losses that would have resulted from a valuation of theassets on a going concern basis to be included in the extraordinary item. For example, in the case of a fire thatdestroys a warehouse, any extraordinary loss should not include an adjustment to write�down inventory to marketvalue.

In addition, the net effect of discontinuing the application of regulatory operations accounting according to FASBASC 980�20�40 (formerly SFAS No. 101, Regulated EnterprisesAccounting for the Discontinuation of Application

of FASB Statement No. 71), has been designated by authoritative pronouncements as an extraordinary item eventhough it may not meet the unusual nature or infrequency of occurrence criteria.


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Income Statement Presentation. Extraordinary items are presented in the following income statement. The FASBASC 225�20�45�9 through 45�12 (formerly APB Opinion No. 30) requirements are explained further in the notes tothe following illustration.

INCOME BEFORE INCOME TAXESAND EXTRAORDINARY ITEM 305,000

INCOME TAXES 91,500

INCOME BEFORE EXTRAORDINARY ITEM a 213,500

EXTRAORDINARY ITEMSettlement of class actioncustomer suit,b net of insurance proceeds (lessapplicable income taxes of $30,600)c 71,400

NET INCOME $ 142,100

Notes:

a A caption such as �Income before extraordinary item" is to be used. If the income statement also shows thecumulative effect of an accounting change and discontinued operations, an appropriate caption is �Incomefrom continuing operations before extraordinary item and cumulative effect of a change in accountingprinciple."

b Descriptive captions for individual extraordinary items are to be used in the income statement or, if that is notpracticable, extraordinary items are to be described in the notes to the financial statements.

c Income taxes applicable to the extraordinary item, if any, are to be disclosed, preferably on the face of theincome statement. Disclosure in the notes to the financial statements is an acceptable alternative, in whichcase the appropriate caption would be �.�.�.�(less applicable income taxes)."

Income Taxes Allocated to Extraordinary Items. The income tax allocated to an extraordinary item is a residualamount. In other words, income taxes for the tax effect of pretax income or loss from continuing operations thatoccurred during the year are allocated to continuing operations and the remainder is allocated to the extraordinaryitem. In the preceding illustration, assuming a tax rate of 30%, the amount of income taxes allocated to theextraordinary item is calculated as follows:

Total Income Taxes

Income from continuing operations and extraordinaryitem ($305,000 � $102,000) $ 203,000

Income taxes at 30% $ 60,900

Income Taxes Allocated to Continuing Operations

Income from continuing operations $ 305,000

Income taxes allocated to continuing operations $ 91,500

Income Tax Benefit Allocated to Extraordinary Loss

Total income taxes $ 60,900

Income taxes allocated to continuing operations $ 91,500

Income tax benefit allocated to extraordinary loss($60,900 � $91,500) $ 30,600


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

Adjustment of Prior�period Extraordinary Items. In many circumstances, amounts reported as extraordinaryitems are based on estimates and require adjustments in subsequent periods. In those cases, unless the adjust�ments meet the criteria for prior�period adjustments, they also should be reported as extraordinary items.

Unusual or Infrequent Items

FASB ASC 225�20�45�16 (formerly APB Opinion No. 30) requires material events or transactions that are eitherunusual or infrequent, but not both (and therefore, do not meet the criteria for extraordinary items), to be presentedin the income statement as separate elements of income from continuing operations. The income statementpresentation should not imply that the amounts are extraordinary items; for example, they should not be presentednet of tax as separate line items following income from continuing operations. The nature and effects of the eventsor transactions should be disclosed on the face of the income statement or in the notes to the financial statements.

Examples of items that may be considered as unusual or infrequent, but not both, were listed previously.

The following income statement presentation is appropriate for unusual or infrequent items.

NET SALES $ 350,000

COSTS AND EXPENSES

Cost of sales 165,000

Selling and administrative 95,000

Loss from foreign currency exchange 83,000

343,000

INCOME BEFORE INCOME TAXES 7,000

Captions such as �Nonrecurring items" or �Unusual items" may be used if disclosure of the unusual or infrequentevent or transaction is made in the notes to the financial statements.

Discontinued Operations

FASB ASC 205�20 (formerly SFAS No. 144, Accounting for the Impairment or Disposal of Long�Lived Assets)provides guidance on accounting for and reporting discontinued operations. Generally, an entity is required topresent the results of discontinued operations of a component separate from continuing operations in the incomestatement.

The FASB and the IASB presently have a joint project on reporting discontinued operations. In September 2008, theFASB issued an exposure draft of proposed guidance that would, among other things, revise the definition of adiscontinued operation. The comment period ended in January 2009. The Boards are seeking additional user inputregarding the future direction of the project and are continuing to refine the definition of a discontinued operation.However, they have tentatively decided that discontinued operations should continue to be separately presented inthe income statement. At the time this course was completed, the FASB technical plan indicated the final guidancewould be issued in the fourth quarter of 2009. The exposure draft included an effective date of fiscal yearsbeginning after December 15, 2009, with earlier application permitted. However, that effective date could change asthe project progresses. Future editions of this course will update the status of this project.

Identifying a Component. A component of an entity is a part of the entity for which operations and cash flows canbe clearly distinguished from the rest of the entity, operationally and for financial reporting purposes. Any of thefollowing may be a component of an entity:

a. An operating segment, as defined by FASB ASC 280�10�50�1 (formerly SFAS No. 131, Disclosures aboutSegments of an Enterprise and Related Information)


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b. A reporting unit under FASB ASC 350�20�35�33 through 35�38 (formerly SFAS No. 142, Goodwill and Other

Intangible Assets)

c. A subsidiary

d. A group of assets.

As a practical matter, for most small and midsize entities, it is believed that a component is the smallest center theentity uses to accumulate components of financial position and results of operations. For example, it may beindividual stores, divisions, or product lines. To illustrate considerations in identifying a component, assume that anentity manufactures men's and women's clothing and accessories through separate divisions and distributes themthrough manufacturers' representatives and directly through company�owned retail stores.

� Closing all of the retail stores in a state probably would constitute disposal of a component.

� Discontinuing the manufacture and sale of men's clothing most likely would constitute disposal of acomponent.

� Discontinuing distribution through marketing representatives most likely would not constitute disposal ofa component.

� Downsizing operations would not constitute disposal of a component.

� Shutting down the clothing division would most likely constitute disposal of a component.

The results of operations of a component of an entity already disposed of or classified as held for sale are reportedas discontinued operations if

a. As a result of the disposal transaction, the operations and cash flows of the component have been, or willbe, eliminated from the ongoing operations of the entity, and

b. after the disposal transaction, the entity will not be significantly involved on an ongoing basis in theoperations of the component.

As with all accounting pronouncements, the provisions for accounting and reporting discontinued operations neednot be applied to immaterial items. Accordingly, it is believed that the results of a component that meet therequirements for discontinued operations need not be presented as a discontinued operation if they are notmaterial to the results of the entity's total operations.

As a practical matter, however, the separate presentation of the results of a discontinued component provide theprimary financial statement users with information helpful in assessing the entity's financial performance. As anillustration, assume that a distributor of beer and soft drinks finds that its soft drink sales have become considerablyless profitable than its beer sales and decides to dispose of the division. Presenting results of the soft drink divisionas the results of discontinued operations shows the reader that management has identified and eliminated lessprofitable products and is concentrating on the more profitable ones.

Presentation Considerations. In financial statements that include the period in which a component of the entitymeets the criteria for its results of operations to be reported as discontinued operations under FASB ASC 205�20,the statement of income should report the results of the component's operations as discontinued operations for allperiods presented. The results of discontinued operations should include impairment losses and subsequentrecoveries recognized prior to realization, as well any additional gains and losses recognized on disposal. Anyadjustments of amounts previously reported in discontinued operations should be classified separately in theresults of discontinued operations in the period during which those adjustments were made. In addition, thefinancial statements should disclose the nature and amount of the adjustments.

The results of operations, net of applicable income taxes, are required to be reported immediately after the resultsof continuing operations, and before extraordinary items and the cumulative effect of accounting changes (if any).


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According to FASB ASC 250�10 (formerly SFAS No. 154, Accounting Changes and Error Corrections), voluntarychanges in accounting principle are no longer reported as a cumulative�effect adjustment through the incomestatement of the period of change. The provision for income taxes related to the results of discontinued operationsneed not be allocated to components of the results of those operations. For example, there is no need to allocatethe tax provision to the results of operating the component and the gain or loss on disposal of the component. Thefollowing is an example of presenting discontinued operations in the statement of results of operations:

INCOME FROM CONTINUING OPERATIONSBEFORE INCOME TAXES 296,000

INCOME TAXES 88,800

INCOME FROM CONTINUING OPERATIONS 207,200

DISCONTINUED OPERATIONS

Loss from operations of discontinued component,including loss on disposal of $90,000 (42,000 )

Provision for income tax benefit 12,600

(29,400 )


If the income statement also shows extraordinary items or the cumulative effect of an accounting change, appropri�ate captions are �Income from continuing operations before extraordinary item" or �. . . before extraordinary itemand cumulative effect of a change in accounting principle."

Costs Associated with Exit or Disposal Activities

The discussion earlier in this lesson provides accounting guidance when discontinuing an entire component of anentity. Historically, guidance on accounting for costs incurred to discontinue an activity that is less than an entiresegment has been limited. As a result, the tendency by many companies was to take significant, one�time charges(often called restructuring charges) before management had a specific plan to alter a company's operations. Thosecharges often included writing off certain expenses that would otherwise reduce earnings over a longer period oftime. The resulting effect was almost always dramatically improved earnings in a short period of time. Restructuringcharges continue to be subjected to increased scrutiny, as many companies have accrued unsupported orundersupported reserves for planned exit activities and then charged operating expenses against the inflatedrestructuring reserves in subsequent periods.

GAAP for exit or disposal cost obligations at FASB ASC 420�10 (formerly SFAS No. 146, Accounting for Costs

Associated with Exit or Disposal Activities), applies to the following costs:

� Costs associated with disposal activities accounted for under FASB ASC 205�20 (formerly SFAS No. 144,Accounting for the Impairment or Disposal of Long�Lived Assets).

� Costs associated with exit activities, such as restructurings and exit activities related to an entity recentlyacquired in a business combination.

� Costs related to the consolidation of facilities or the relocation of employees.

� Costs to terminate a contract, other than a capital lease.

� Costs associated with one�time employee termination benefits.

FASB ASC 420�10 does not apply to costs related to the retirement of long�lived assets. Such costs are accountedfor according to GAAP for asset retirement obligations at FASB ASC 410�20 (formerly SFAS No. 143, Accounting forAsset Retirement Obligations).


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The timing of the recognition and the measurement of exit or disposal costs differ depending on the type of costsassociated with the activity. However, costs are accrued only when the definition of a liability is met. FASB ConceptsStatement No. 6, Elements of Financial Statements, defines a liability as:

. . . probable future sacrifices of economic benefits arising from present obligations of a particularentity to transfer assets or provide services to other entities in the future as a result of pasttransactions or events.

One�time Employee Termination Benefits. One�time employee termination benefits represent benefits providedto involuntarily terminated employees under an arrangement associated with a specified termination event or aspecified future period. To be considered �one�time," the benefits must not be provided according to an ongoingbenefit arrangement or an individual deferred compensation contract. FASB ASC 420�10�55�1 (formerly FASB StaffPosition No. FAS 146�1, Determining Whether a One�Time Termination Benefit Offered in Connection with an Exit or

Disposal Activity Is, in Substance, an Enhancement to an Ongoing Benefit Arrangement), clarifies this requirementby providing that if additional termination benefits represent a revision to an ongoing benefit arrangement that is notlimited to a specified termination event or specified future period, the benefits should be accounted for accordingto the provisions of FASB ASC 712; 715�3; 715�60 (formerly SFAS Nos. 87, 88, 106, or 112).

A one�time benefit arrangement is deemed to exist when a termination plan has been communicated to employeesand meets all of the following criteria (this event is referred to as the �communication date"):

� Management has committed to a plan of termination.

� The plan establishes an expected completion date and identifies specific information regarding theemployees to be terminated. The number of employees, their job classification, and their location shouldbe included.

� The plan includes sufficient information to allow employees to figure the benefits to which they will beentitled if they are terminated under the plan. This information should include the type and amount ofbenefits to be provided.

� It is unlikely that the plan will be altered significantly or withdrawn altogether prior to execution.

The requirements for recognizing and measuring a liability for one�time termination benefits differ depending on thelevel of continued service affected employees are required to provide to receive the benefits. If continued service isrequired, GAAP differentiates between plans that require continued service beyond a minimum retention periodand those that do not. For purposes of this analysis, the minimum retention period must be less than or equal to anylegal notification period applicable to the entity or 60 days if no legal requirement exists. A legal notification periodmay be established pursuant to an existing law or statute, or a contract between the entity and another party (suchas a labor union).

a. Future Service Is Required beyond the Minimum Retention Period. The initial liability should be measuredat the communication date and should be recognized ratably over the future service period. It should bebased on the fair value of the benefits as of the termination date. Subsequent changes to the plan shouldbe recognized as follows:

(1) Changes in the liability prior to the termination date due to revised expected cash flows should bemeasured using the same credit�adjusted risk�free rate used in the initial measurement. Thecumulative effect of the change should be recognized in the period of change.

(2) Changes subsequent to the termination date resulting from the passage of time should be recordedas an expense (e.g., accretion expense) and an increase in the carrying amount of the liability. Thecharges should not be considered interest cost for purposes of capitalization or classification in theincome statement.

(3) Changes subsequent to the termination date due to revised expected cash flows should berecognized in the period of change. The cumulative effect should be reported in the same line on theincome statement used to record the initial costs.


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b. Future Service Is Not Required or Is Required But the Service Period Is Less Than the Minimum Retention

Period. The initial liability should be measured and recorded at the fair value of the benefits at thecommunication date. Subsequent changes to the plan should be recognized as follows:

(1) If the plan is amended subsequent to the communication date resulting in the retention of employeesbeyond the minimum period, the initial liability should be recomputed using the same guidelines forplans that require continued employee service beyond the minimum retention period as discussedin item a. The cumulative effect of the change should be recognized in the period of the change.

(2) Changes subsequent to the termination date resulting from the passage of time should be recordedas an expense (e.g., accretion expense) and an increase in the carrying amount of the liability. Thecharges should not be considered interest cost for purposes of capitalization or classification in theincome statement.

(3) Changes subsequent to the termination date due to revised expected cash flows should berecognized in the period of change. The cumulative effect should be reported in the same line on theincome statement used to record the initial costs.

Certain one�time termination benefit plans may also include termination benefits offered briefly to employees inexchange for their voluntary termination. Such voluntary termination benefits should be measured and accountedfor in accordance with FASB ASC 712�10�25�1 (formerly SFAS No. 88, Employers' Accounting for Settlements andCurtailments of Defined Benefit Pension Plans and for Termination Benefits). In these cases, a liability should berecognized when employees accept the offer for the termination benefits and the amount of the benefits can bereasonably estimated. Involuntary benefits offered under these plans should be measured as discussed previously.

Contract Termination Costs. FASB ASC 420�10 (formerly SFAS No. 146) applies to costs associated with thetermination of an operating lease and other contracts prior to the end of the contract's term. It also applies to costsunder a contract that continue to be incurred until the end of the term without providing ongoing benefit to the entity,such as early termination penalties and remaining lease commitments. The guidance does not apply to costsassociated with the termination of a capital lease. Those costs should be accounted for using the guidanceprovided by FASB ASC 840�30 (formerly SFAS No. 13, Accounting for Leases).

The liability associated with contract termination costs should be measured at fair value. The timing of the recogni�tion of the liability differs based on the timing of the termination as follows:

� Contracts Terminated Prior to the End of a Contract. The liability should be measured at fair value andrecognized at the date of termination when a contract is terminated in accordance with the provisions ofthe contract.

� Contracts That Continue for the Remaining Term. The liability for costs that continue to be incurred shouldbe recorded when an entity no longer has the right to the property, goods, or services to which the contractapplies. The liability should be measured at fair value and should include consideration of remainingcontract payments, prepaid or deferred costs recognized under a lease, and a reduction for estimatedsublease rentals that could be obtained for the property under lease. The reduction for sublease rentalsshould be applied regardless of the entity's intention to sublease the property.

� Changes Subsequent to Initial Measurement. For both types of contracts, changes to the liabilitysubsequent to the initial determination date should be calculated using the same credit�adjusted risk�freerate used in the initial measurement. The cumulative effect of any adjustment to the liability resulting fromrevisions to the timing or amount of benefits to be provided should be recognized in the period of change.The cumulative effect should be reported in the same line on the income statement used to record the initialcosts. Changes resulting from the passage of time are to be recognized as an expense and an increasein the carrying amount of the liability. However, those costs should not be considered interest cost forpurposes of capitalization of interest costs or for purposes of classification in the income statement.

Costs to Consolidate or Close Facilities, Relocate Employees, and Other Associated Costs. Costs other thanthose related to one�time termination benefits and contract terminations should be measured at fair value onlywhen incurred. Earlier recognition is not permitted.


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Presentation and Disclosure. Costs related to exit or disposal activities should be included in income fromcontinuing operations unless the costs are associated with a discontinued operation. In that case, the costs shouldbe included in the results of discontinued operations. If an entity's obligation for the liability is eliminated in asubsequent period, the liability should be removed from the entity's balance sheet. All previously�recognized costsshould be reversed and presented in the same income statement line in which the costs were originally presented.

FASB ASC 420�10 requires a number of disclosures relating to costs associated with exit or disposal activities.

Equity in Operations of Investees

The basic principles to be observed in recording an investor's share of earnings or losses of such an investee are:

a. An investor's equity in the operating results of an investee should be based on the shares of common stockheld.

b. Intercompany profits and losses should be eliminated until realized.

c. Dividends on the investee's cumulative preferred stock should be deducted in computing an investor'sshare of earnings whether or not such dividends are declared.

d. The investor ordinarily should discontinue applying the equity method when accounting for its share oflosses reduces the investment to zero and should not provide for additional losses unless the investor hasguaranteed obligations of the investee or is otherwise committed to provide further financial support for theinvestee. If the investee subsequently reports net income, the investor should resume applying the equitymethod only after its share of that net income equals the share of net losses not recognized during theperiod the equity method was suspended.

FASB ASC 323�10�35�23 through 35�26 (formerly EITF Issue No. 98�13, �Accounting by an Equity Method Investorfor Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee"), statesthat if previous losses have reduced an equity investment to zero and the investor is not required to advanceadditional funds to the investee, the investor should continue to report its share of equity method losses to theextent of any other investments in the investee. Other investments in the investee include (but are not limited to)preferred stock, debt securities, and loans to the investee. The equity method losses should reduce the adjustedbasis in other investments in the order of their priority in liquidation. The basis of the other investments should beadjusted for the equity method losses before adjusting their basis for fair value adjustments required by otheraccounting pronouncements [such as adjustments required by FASB ASC 310�10�35 (formerly SFAS No. 114) forloans and FASB ASC 320�10�35 (formerly SFAS No.�115) for unrealized gains and losses on debt securities]. Equitymethod losses should not be recorded after the adjusted basis of the other investments reaches zero. However, theinvestor should continue to track the amount of equity method losses so that if the investee subsequently reportsnet income, the investor can resume applying the equity method after its share of that net income equals the shareof net losses not recognized during the period the equity method was suspended (as described in item d. above).The subsequent recording of equity method income should be applied to the adjusted basis of the other invest�ments in reverse order of the application of the equity method losses.

FASB ASC 323�10�35�27 and 35�28 (formerly EITF Issue No. 99�10, �Percentage Used to Determine the Amount ofEquity Method Losses"), address how the investor should calculate the amount of equity method losses whenprevious losses have reduced the equity investment to zero. In concluding that equity method losses should not berecognized based solely on the investor's percentage of common stock in the investee, the EITF discussed (but didnot reach a consensus on) two possible methods investors could use to recognize equity method losses whenprevious losses have reduced the equity investment to zero. Those methods are:

a. Using the Ownership Percentage of the Security or Loan That Is Being Reduced for the Equity Method

Losses. For example, after reducing its common stock investment in an equity method investee to zero,an investor that owns 50% of an investee's preferred stock could reduce the preferred stock investment by50% of the investee's losses. Similarly, after reducing its common stock investment (as well as any preferredstock investment) to zero, an investor that has made a loan to the investee that represents 60% of all loansextended to the investee could reduce the basis of the loan by 60% of the investee's losses.


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b. Using the Change in the Investor's Claim on the Investee's Book Value (Calculated as If the Investee

Liquidated Its Assets and Liabilities at Book Value). After reducing its common stock investment in an equitymethod investee to zero, an investor would subtract its claim on the investee's book value from the amountthe investor would receive if the investee liquidated its assets and liabilities at book value. The investorwould recognize the difference as its share of the investee's losses and correspondingly reduce anypreferred stock investment in the investee or the basis in any loan made to the investee.

The EITF noted that other methods of calculating equity method losses after previous losses have reduced acommon stock investment to zero also may be acceptable. However, the investor should apply only one methodentity�wide to determine the amounts of such equity method losses. Investors are required to disclose the selectedmethod in the notes to the financial statements.

Income Statement Presentation. FASB ASC 323�10�45�1 and 45�2 (formerly APB Opinion No. 18, The Equity

Method of Accounting for Investments in Common Stock) states that an investor's share of earnings or losses of aninvestee should ordinarily be shown as a single amount except that the investor's share of extraordinary items andaccounting changes reported in the investee's financial statements should be reported separately in the investor'sfinancial statements.

GAAP does not address whether the equity in the operating results of investees should be presented before or afterthe tax provision. Although practice varies, it is typically presented after the provision as illustrated below. Asdiscussed previously, FASB ASC 740�10�50�11 through 50�14 (formerly SFAS No. 109) requires certain disclosureswhenever the tax provision attributable to continuing operations varies from the amount that would be obtained byapplying federal statutory rates to pretax income from continuing operations. For that purpose, it is believed thatpretax income from continuing operations should be considered to include the equity in the operating results ofinvestees, even if it is reported after the tax provision.

The following income statement illustrates recording equity in earnings of investees as a separate item after thecaption for income taxes:

INCOME TAXES 186,000

INCOME BEFORE EQUITY IN INCOME OFINVESTEE AND EXTRAORDINARY ITEM 279,000

EQUITY IN INCOME OF INVESTEE, EXCLUSIVE OF EXTRAORDINARY ITEM 103,000

INCOME BEFORE EXTRAORDINARY ITEM 382,000

EQUITY IN EXTRAORDINARY ITEM OF INVESTEE (60,000 )


Captions should describe the circumstances. For example,

� Income before earnings of affiliates

� Income before earnings of nonsubsidiary companies

and

� Equity in net income of ABC Company

� Equity in earnings of affiliates

� Equity in net earnings of

XYZ CompanyOther affiliated companies


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Different Fiscal Year. In some cases, an investor and investee may have different fiscal years. FASB ASC323�10�35�6 (formerly APB Opinion No. 18), however, permits the investor's share of earnings to be recognizedbased on the �most recent available" financial statements of the investee. While GAAP for equity method invest�ments does not indicate the time lag that is acceptable, FASB ASC 810�10�45�12 (formerly ARB No. 51) states thata difference between fiscal years of a parent and a subsidiary of three months or less is acceptable for consolida�tions. With respect to investments accounted for by the equity method, it is believed that (a) the length of the timelag becomes more significant as the equity in the results of operations of the investee becomes more material to theinvestor's financial statements and (b) the three�month provision should be used as a general guideline.

When the year ends of an investor and an investee differ, GAAP does not address how to account for transactionsthat occur in the intervening period. FASB ASC 810�10�45�12 (formerly Paragraph 4 of ARB No. 51) discusses asimilar situation in the consolidated financial statements of a parent and a subsidiary, however, and states that�recognition should be given by disclosure or otherwise to the effect of intervening events that materially affect thefinancial position or results of operations." While some accountants believe that disclosure of intervening events issufficient, if a significant transaction occurs during the intervening period, this course takes the point of view that thetransaction should be reflected in the financial statements. As an example, assume that a corporation issuing itsannual financial statements at June 30, 20X1, owns a 30% interest in a real estate trust that reports on a calendar�year basis. Historically, transactions in the trust have consisted primarily of interest income and interest expenseand, since those amounts generally did not fluctuate significantly during the year, the company has reported itsequity in the trust using the calendar year information provided by the trust. However, in March 20X1, the trust soldreal estate at a substantial gain, and the corporation's equity in the gain is material to its financial statements. It isrecommended that the equity pick�up in the corporation's June 30, 20X1, financial statements reflect its 30%interest in the operations for the year ended December 30, 20X0, plus its 30% interest in the March 20X1 gain. (Thatsame conclusion would apply if the real estate had been sold at a substantial loss.)

FASB ASC 810�10�45�13 [formerly EITF Issue No. 06�9, �Reporting a Change in (or the Elimination of) a PreviouslyExisting Difference between the Fiscal Year�End of a Parent Company and That of a Consolidated Entity or betweenthe Reporting Period of an Investor and That of an Equity Method Investee"], indicates a parent or an investorshould report a change to or elimination of a previously existing difference between the parent's or investor'sreporting period and the reporting period of a consolidated entity or equity method investee as a change inaccounting principle in accordance with FASB ASC 250 (formerly SFAS No. 154.).

Noncontrolling Interests

GAAP defines a noncontrolling interest as the portion of a subsidiary's equity that is not directly or indirectlyattributable to a parent. Noncontrolling interests are sometimes referred to as minority interests. FASB ASC810�10�50�1A (formerly ARB No. 51, Consolidated Financial Statements) requires a reporting entity that is the parentof one or more less�than�wholly�owned subsidiaries to separately disclose on the face of the consolidated incomestatement the following amounts: consolidated net income, consolidated net income attributable to the parent, andconsolidated net income attributable to the noncontrolling interest. The revenues, expenses, gains, losses, and netincome or loss are required to be reported at consolidated amounts. The following example illustrates the presenta�tion of consolidated net income and the amounts attributable to the parent and the noncontrolling interest on theface of a consolidated income statement:

CONSOLIDATED NET INCOME $ 160LESS:�NET INCOME ATTRIBUTABLE TO THE NONCONTROLLING INTEREST (18)

NET INCOME ATTRIBUTABLE TO THE PARENT $ 142

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


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SELF�STUDY QUIZ


8. According to generally accepted accounting principles, all of the following items are required to be presentedseparately in the income statement except:

a. Losses.

b. Discontinued operations.

c. Unusual items.

d. Extraordinary items.

9. An extraordinary item is an event or transaction that is:

a. Beyond the control of management.

b. Unusual in nature and occurs infrequently.

c. Unexpected by management.

10. Which of the following is considered an extraordinary item?

a. Disposals of a component of an entity.

b. Gains or losses from exchange or translation of foreign currencies including those relating to majordevaluations and revaluations.

c. The net effect of discontinuing the application of regulatory operations accounting.

d. Write�down or write�off of receivables.

11. Team Sports, Inc. is a corporation consisting of several major sports related divisions. The entity decides to exitits uniform sales business and commits to a plan to sell the division with its operations. The uniform divisionis classified as held for sale at that date. The operations and cash flows of the division will be eliminated fromthe ongoing operations of the entity as a result of the sale transaction, and the entity will not have any continuinginvolvement in the operations of the division after it is sold. Team Sports may report the uniform division indiscontinued operations.

a. True.

b. False.

12. FASB ASC 420�10 (formerly SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities),applies to which of the items below?

a. Costs related to the retirement of long�lived assets.

b. Costs associated with the termination of a capital lease.

c. Costs associated with the termination of an operating lease.


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8. According to generally accepted accounting principles, all of the following items are required to be presentedseparately in the income statement except: (Page 214)

a. Losses. [This answer is correct. Losses are a component of net income according to SFAS No. 6.Therefore, they are not presented separately in the income statement.]

b. Discontinued operations. [This answer is incorrect. Discontinued operations of a component of an entityare to be presented separately in the income statement. If all of the elements of net income are presented,discontinued operations of a component of an entity is presented second.]

c. Unusual items. [This answer is incorrect. Generally accepted accounting principles require unusual orinfrequent items to be presented separately in the income statement. If all of the elements of net incomeare presented, income from continuing operations, including unusual items, is presented first.]

d. Extraordinary items. [This answer is incorrect. Extraordinary items are required to be presented separatelyin the income statement per generally accepted accounting principles. If all of the elements of net incomeare presented, extraordinary items are presented third.]

9. An extraordinary item is an event or transaction that is: (Page 214)

a. Beyond the control of management. [This answer is incorrect. An event or transaction is not consideredto be extraordinary just because it is beyond the control of management, such as union worker strikes.]

b. Unusual in nature and occurs infrequently. [This answer is correct. An extraordinary item is an eventor transaction that is both unusual in nature and occurs infrequently per FASB ASC 225�20�45�2(formerly APB Opinion No. 30). This permits the classification of an event or transaction asextraordinary only in rare circumstances.]

c. Unexpected by management. [This answer is incorrect. Although many extraordinary items are notexpected by management, some transactions such as the write�down of inventory, which may not havebeen expected is generally not an extraordinary item.]

10. Which of the following is considered an extraordinary item? (Page 215)

a. Disposals of a component of an entity. [This answer is incorrect. The disposal of a component of an entityshould not be classified as an extraordinary item per FASB ASC 225�20�45�4.]

b. Gains or losses from exchange or translation of foreign currencies including those relating to majordevaluations and revaluations. [This answer is incorrect. Extraordinary items generally should not includegains or losses from exchange or translation of foreign currencies including those relating to majordevaluations and revaluations per FASB ASC 225�20�45�4.]

c. The net effect of discontinuing the application of regulatory operations accounting. [This answeris correct. This is an extraordinary item even though the transaction may not meet the unusual natureor infrequency of occurrence criteria per FASB ASC 980�20�40.]

d. Write�down or write�off of receivables. [This answer is incorrect. FASB ASC 225�20�45�4 states that thewrite�down or write�off of receivables, inventories, equipment leased to others, or intangible assets shouldgenerally not be considered an extraordinary item.]


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11. Team Sports, Inc. is a corporation consisting of several major sports related divisions. The entity decides to exitits uniform sales business and commits to a plan to sell the division with its operations. The uniform divisionis classified as held for sale at that date. The operations and cash flows of the division will be eliminated fromthe ongoing operations of the entity as a result of the sale transaction, and the entity will not have any continuinginvolvement in the operations of the division after it is sold. Team Sports may report the uniform division indiscontinued operations. (Page 218)

a. True. [This answer is correct. A component of an entity consists of operations and cash flows thatcan be clearly distinguished, operationally and for financial reporting purposes, from otheroperations and cash flows of the entity (FASB ASC 205�10�20).]

b. False. [This answer is incorrect. The operating results of a component of an entity that is classified as heldfor sale that has been disposed of should be presented in discontinued operations if the operations andcash flows of the component will be (or have been) eliminated from the ongoing operations of the entityand the entity will not have any significant involvement in the component's operations (FASB ASC205�20�45�1).]

12. FASB ASC 420�10 (formerly SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities),applies to which of the items below? (Page 221)

a. Costs related to the retirement of long�lived assets. [This answer is incorrect. FASB ASC 420�10 (formerlySFAS No. 143, Accounting for Asset Retirement Obligations), covers costs related to the retirement oflong�lived assets. FASB ASC 420�10 (formerly SFAS No. 146) does not provide guidance on this subject.]

b. Costs associated with the termination of a capital lease. [This answer is incorrect. The costs associatedwith the termination of a capital lease should be accounted for using the guidance provided by FASB ASC840�30 (formerly SFAS No.�13, Accounting for Leases). This subject is not covered under FASB ASC420�10 (formerly SFAS No. 146).]

c. Costs associated with the termination of an operating lease. [This answer is correct. FASB ASC420�10 (formerly SFAS No. 146) applies to costs associated with the termination of an operatinglease and other contracts prior to the end of the contract's term.]


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Lesson 1 (PFSTG093)


1. Which one of the following choices is a characteristic of gains and losses?

a. They are a result of rendering services.

b. They are usually recorded at their gross amounts.

c. They are a result of peripheral events.

d. They are a result of producing goods.

2. In which of the following scenarios would revenue be recorded on the statement of income?

a. The Coffee Cup Café sold old restaurant equipment while remodeling.

b. Pet Paradise, a retail pet store, sold a luxurious pet bed.

c. Ink Jet City, a printer cartridge store, sold used store fixtures.

d. Dr. Hurt, a dentist, sold two filing cabinets.

3. An income statement may be presented in which of the following formats?

a. Direct format.

b. Indirect format.

c. Single�step format.

d. Two�step format.

4. Which of the following captions is used in the single�step format?

a. Revenues.

b. Gross profit.

c. Income from operations.

d. Other income and expenses.

5. According to SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, whatis(are) the requirements for recording revenue from rendering services in the financial statements?

a. When the amounts are possible and reasonably estimated.

b. When the amounts are probable and reasonably estimated.

c. When the amounts are billable.



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6. According to FASB ASC 605�45�45 (formerly EITF Issue No. 99�19), which of the following is a possible indicatorthat the entity should recognize revenue as a principal?

a. The supplier has the credit risk.

b. The primary obligor in the arrangement is the supplier.

c. The entity has discretion in supplier selection.

d. The entity earns a fixed amount.

7. How are taxes, such as sales taxes, required to be reported on the financial statements?

a. Recorded as revenue received from the customer and as an expense paid to the taxing authority (grosspresentation).

b. Recorded as a payable to the taxing authority when collected from the customer, not recorded as revenue(net presentation).

c. Recorded using either gross or net presentation.

d. Recorded according to the rules of the state/local collection authority.

8. If all the following elements of net income exist, which one will be presented last in the income statement?

a. Extraordinary items.

b. Unusual or infrequent items.

c. Discontinued operations of a component of an entity.

d. Equity in operations of investees.

9. What should be considered in deciding whether to present an event or transaction as extraordinary?

a. The effect of the event or transaction.

b. The materiality of the event or transaction.

c. The classification of the event by other companies.

d. The size of the event or transaction.

10. Which of the following would not be a component of an entity?

a. A subsidiary.

b. An operating segment defined by FASB ASC 280�10�50�1 (formerly SFAS No. 131).

c. A reporting unit defined by FASB ASC 350�20�35�33 through 35�38 (formerly SFAS No. 142).

d. A group of assets dependent on the cash flows from other assets.


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11. Pink Ribbon, Inc. has classified one of its components, Red, as held for sale. How are the operating results ofRed presented on the income statement if Red has been eliminated from the ongoing operations of Pink, andPink will not have significant continuing involvement in Red's operations?

a. Along with operating results until Pink officially sells Red.

b. Along side the results from continuing operations, in columnar form.

c. After the income from continuing operations.

d. After any extraordinary items Pink is presenting.

12. XYZ Company is in the process of restructuring and will be involuntarily terminating employees. Which of thefollowing sources of accounting guidance should be followed?

a. FASB ASC 712�10�25�1 (formerly SFAS No. 88, Employers' Accounting for Settlements and Curtailmentsof Defined Benefit Pension Plans and for Termination Benefits).

b. FASB ASC 712�10 and 715�10 through 60 (formerly SFAS No. 112, Employers' Accounting for

Postemployment Benefitsan amendment of FASB Statements No. 5 and 43).

c. FASB ASC 420�10 (formerly SFAS No. 146, Accounting for Costs Associated with Exit or Disposal

Activities).

d. FASB ASC 250�10�45�5 (formerly SFAS No. 154, Accounting Changes and Error Corrections).


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Lesson 2:�The Accounting and Presentation ofCertain Expenses Related to the Statement ofIncome

INTRODUCTION

This lesson will highlight particular types of expenses and the timing for recognition in the income statement. Inaddition, the required disclosures of these expenses will be covered.



� Determine accounting and presentation issues related to depreciation, start�up costs, research anddevelopment, and computer software.

� Determine accounting and presentation issues related to rent expenses, advertising costs, and retroactiveadjustment of workers' compensation and other expenses.

Depreciation

FASB ASC 360�10�50�1 (formerly Paragraph 5 of APB Opinion No. 12, Omnibus Opinion1967), requires thefollowing disclosures to be made about depreciable assets and depreciation:

a. Depreciation expense for the period

b. Balances of major classes of depreciable assets at the balance sheet date by nature or function

c. Accumulated depreciation, either by major classes of depreciable assets or in total at the balance sheetdate

d. A general description of the method or methods used in computing depreciation with respect to majorclasses of depreciable assets

While determination of the amount of depreciation expense for a period is usually straightforward, it may be difficultif some depreciation is included in overhead and distributed to various inventory accounts and ultimately expensedthrough cost of sales. An AICPA technical practice aid at TIS 5210.02 indicates that, in those circumstances, it hasbecome recognized practice to report the amount of depreciation charged to manufacturing costs and to expenseaccounts as the depreciation expense for the period even though depreciation included in inventories at thebeginning and end of the period varies sufficiently to affect depreciation included in cost of sales.

The amount of depreciation expense for the period may be disclosed:

a. as a separate line item in the income statement;

b. parenthetically in the income statement;

c. in the notes to the financial statements; or

d. in the statement of cash flows' reconciliation of net income to net cash flows from operating activities.

Recording depreciation for financial accounting purposes in accordance with the (modified) Accelerated CostRecovery System required for tax purposes is a departure from GAAP. Calculating depreciation for financialaccounting purposes in accordance with one of the methods acceptable under GAAP would, if the differences arematerial, require the tax effects of the differences to be reflected in income tax expense.


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Start�up Costs

FASB ASC 720�15�25�1 (formerly SOP 98�5, Reporting on the Costs of Start�Up Activities), requires the costs ofstart�up activities, including organization costs, to be expensed as incurred. This guidance applies to all nongov�ernmental entities, including development stage companies. Start�up activities are broadly defined as activitiesrelated to organizing a new business, as well as one�time activities associated with:

� Opening a new facility

� Introducing new products or services

� Conducting business with a new class of customers or in a new territory

� Starting a new process in an existing facility or starting a new operation

Organization costs, preopening costs, and preoperating costs are specifically identified as start�up costs. Organi�zation costs represent costs incurred in establishing a legal entity and include the costs of preparing such items asthe company charter, a partnership agreement, bylaws, minutes of organizational meetings, and original stockcertificate terms. The accounting requirements do not distinguish between organization costs and other start�upcosts; however, companies are not prohibited from separately reporting such costs in their income statements orseparately disclosing such costs in the notes to the financial statements to emphasize the nature of the costs.

Activities that are part of ongoing routine efforts to refine, enrich, or improve an existing product, service, process,or facility are not considered start�up activities and are not within the scope of GAAP for start�up costs. Likewise,activities related to a merger or acquisition or to ongoing customer acquisition are not considered start�up activities.In addition, the following costs are outside the scope of GAAP for start�up costs, even though such costs may beincurred in connection with a company's start�up activities:

� Costs of acquiring or constructing long�lived assets and preparing them for their intended uses

� Costs of acquiring or producing inventory

� Costs of acquiring intangible assets

� Costs related to internally developed assets (e.g., internal�use computer software costs)

� Research and development costs that are within the scope of FASB ASC 730�10�15 (formerly SFAS No. 2,Accounting for Research and Development Costs), and regulation costs within the scope of FASB ASC980�10�15 (formerly SFAS No. 71, Accounting for the Effects of Certain Types of Regulation).

� Costs of fund raising incurred by nonprofit organizations

� Costs of raising capital

� Costs of advertising

� Costs incurred in connection with existing contracts as specified in FASB ASC 605�35�25�41(d) (formerlyparagraph 75d of SOP 81�1, Accounting for Performance of Construction�Type�and Certain Production�

Type Contracts).

The preceding costs should be accounted for in accordance with other existing authoritative accounting literatureand should not be capitalized unless they qualify for capitalization under those generally accepted accountingprinciples. The costs of using long�lived assets (e.g., depreciation), intangible assets (e.g., amortization of apurchased patent), or internally developed assets that are allocated to start�up activities are within the scope ofGAAP for start�up costs.

Although ongoing efforts to acquire customers are not considered start�up activities, conducting business with anew class of customer is considered a start�up activity. For example, a manufacturer that previously sold all of its


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products to retailers would be conducting a start�up activity if the manufacturer attempted to sell its productsdirectly to the public. In contrast, attempting to sell to new retailers would not be considered a start�up activity.

FASB ASC 720�15�55 (formerly the appendix to SOP 98�5) includes several examples of start�up costs that aresubject to the provisions of the SOP, including the following:

� Travel, salary, and consulting costs related to feasibility studies, accounting, legal, tax, and governmentalaffairs when opening a plant in a new market

� Training costs for new employees when opening a new plant

� Recruiting, organizing, and training costs when establishing a distribution network in a new market

� Salary, training, and travel costs for new employees and management when opening new stores (in bothexisting and new markets)

In addition, the implementation guidance provides the following examples of costs that are outside the scope ofGAAP for start�up costs:

� Costs of a new plant and production equipment

� Internal�use computer software development costs related to opening a new plant

� Inventory costs

� Advertising costs related to opening of a new store

� Costs of furniture and equipment for a new store

Research and Development Costs

FASB ASC 730�10�25�1 (formerly SFAS No. 2, Accounting for Research and Development Costs), generallyrequires all research and development costs to be charged to expense when incurred, rather than recording themas inventory, elements of overhead, or otherwise deferring them to future periods. Costs incurred for research anddevelopment contracts (e.g., government contracts with defense contractors) are generally recorded as inventoryor a receivable until the related revenue is recorded. In addition, FASB ASC 730�20�25�13 (formerly EITF Issue No.07�3, �Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in FutureResearch and Development Activities,") requires certain advance payments for goods or services that will be usedor rendered for future research and development activities and that are nonrefundable to be deferred and capital�ized. Costs that should be expensed as research and development are as follows:

a. Intangible assets purchased from others and materials, equipment, and facilities acquired or constructedfor a particular research and development project that have no alternative future uses.

Intangible assets purchased from others and materials, equipment, and facilities that have alternative futureuses, including use in other research and development projects, should be capitalized. Reduction ofcapitalized costs should be considered research and development costs.

b. Salaries and related costs of personnel engaged in research and development activities.

c. Services performed by others in connection with research and development activities.

d. Reasonable allocation of indirect costs (except general and administrative costs not clearly related toresearch and development activities).

Total research and development costs charged to expense are required to be disclosed for each period for whichan income statement is presented. Disclosure of total research and development costs may be made (a) by


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separate line�item presentation in the income statement, (b) parenthetically in the income statement, or (c) in thenotes to the financial statements. If research and development costs are a significant element of expense, theyusually are disclosed as a separate line item in the income statement. The following are two methods of presentingresearch and development costs in the income statement:

a.

Costs and expenses


Selling 90,000

General and administrative 125,000

Research and development 25,000

b.

Costs and expenses


Selling 90,000

General and administrative (including research and developmentexpense of $25,000) 150,000

Assets acquired in a business combination that are used in research and development activities should berecognized and measured at fair value in accordance with GAAP for business combinations at FASB ASC 805�20[formerly SFAS No. 141(R)] regardless of whether they have an alternative future use.

Computer Software Costs

Computer Software to Be Sold, Leased, or Marketed. FASB ASC 985�20�25 (formerly SFAS No. 86, Accounting

for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed), requires companies to classify thecosts of planning, designing, and establishing the technological feasibility of a computer software product asresearch and development costs and to charge those costs to expense when incurred. After the technologicalfeasibility has been established, costs of producing product masters should be capitalized and amortized. (Capital�ized costs should be evaluated at each balance sheet date and amounts that exceed net realizable value should bewritten off.) Costs incurred for duplicating the computer software, documentation, and training materials from theproduct masters and for physically packaging the product for distribution should be capitalized as inventory andcharged to cost of sales when revenue is recognized. Costs of maintenance and customer support should becharged to expense when related revenue is recognized or when those costs are incurred, whichever occurs first.

GAAP for the costs of computer software to be sold, leased, or marketed does not apply to software created forothers under a contractual arrangement or to software created or obtained for internal use. In addition, assetsacquired in a business combination that are used in research and development activities should be recognized andmeasured at fair value. However, costs incurred after the date of a business combination related to computersoftware to be sold, leased, or otherwise marketed as a separate product or as part of a product or process,whether internally developed and produced or purchased, should be accounted for in accordance with FASB ASC985�20 (formerly SFAS No. 86).

The following are required to be disclosed:

a. Total research and development costs incurred for a computer software product to be sold, leased, orotherwise marketed, charged to expense for each period for which an income statement is presented

b. Unamortized computer software costs included in each balance sheet presented

c. Total amount charged to expense in each income statement presented for amortization of capitalizedcomputer software costs and for amounts written down to net realizable value

Guidance on disclosing total research and development costs was given previously in this lesson. The otherdisclosures generally are made in the notes to the financial statements.


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Internal�use Computer Software. FASB ASC 350�40 (previously SOP 98�1, Accounting for the Costs of Computer

Software Developed or Obtained for Internal Use), provides guidance on accounting for the costs of software thatentities purchase or develop for their own use. (Costs related to software to be sold or leased to others as a productor part of a separate process are discussed above.) In addition, costs incurred for internal�use software used inresearch and development activities are discussed in a prior paragraph. Companies must properly classify applica�ble software costs as part of research and development activities to meet GAAP's requirements to expenseresearch and development costs and disclose the amount of such expense for each period. GAAP specifies thatcosts for the following internal�use software should be included as research and development expenses:

� Software purchased or leased for use in research and development activities if the software has noalternative future uses.

� Internal�use software developed as a pilot project or for use in a specific research and development project,regardless of whether the software has alternative future uses [the software may be internally developedor developed by third parties (such as programmer consultants)].

Software must meet both of the following criteria to be considered internal�use software:

a. The software must be acquired, internally developed, or modified solely to meet the entity's needs.

b. While the software is being developed or modified, no substantive plans can exist or be under developmentto market the software externally.

A joint development arrangement with another entity for mutual internal use of the software is notconsidered a substantive plan to market the software. Likewise, routine market feasibility studies are notconsidered substantive plans to market software.

Accounting for internal�use software depends on when the costs are incurred. FASB ASC 350�40�20; 350�40�25(formerly SOP 98�1) defines the following stages of software development:

� Preliminary Project Stage. Includes costs incurred for conceptualizing and evaluating software alternatives,determining existence of needed technology, and selecting final alternatives. Costs incurred during thepreliminary project stage should be expensed as incurred.

� Application Development Stage. Includes costs related to designing the chosen alternative (includingsoftware configuration and interfaces), coding, installing hardware, and testing. Costs incurred during theapplication development stage generally must be capitalized. However, training costs incurred during thatstage should be expensed as incurred.

� Post�implementation/Operation Stage. Includes costs related to training and software applicationmaintenance. Post�implementation costs should be expensed as incurred.

Costs incurred for the development or purchase of software necessary for access or conversion of old data by thenew system may be capitalized. However, the actual costs of converting the data (for example, salaries ofemployees involved in performing data conversion duties such as reconciling data between the old and newsystems) should be expensed as incurred. Even though the costs of �bridging" software used to facilitate dataconversion may be capitalized, the software may not have an alternative future use if it can only be used for aspecific data conversion effort. In that case, the software's useful life may be so short that capitalization is effectivelyprecluded. Consequently, when capitalizing �bridging" software, companies should assess whether the softwarehas an alternative future use.

Entities must capitalize the following types of costs if they otherwise meet the criteria for capitalization discussed inthe previous paragraph:

� Direct external costs of materials and services used in developing or obtaining internal�use software (forexample, fees paid to consultants for services provided to develop the software during the applicationdevelopment stage)


236

� Payroll and related costs for employees who are directly involved with and devote time to the developmentof the internal�use software project (for example, salaries and benefits for programmers writing code duringthe application development stage)

� Interest costs incurred during the development of internal�use software [in accordance with FASB ASC835�20 (formerly SFAS No. 34, Capitalization of Interest Cost)]

FASB ASC 350�40�30�3 (formerly SOP 98�1) specifically precludes capitalizing general and administrative costsand other overhead costs as costs of internal�use software. Additionally, how capitalized internal�use softwareshould be classified on the balance sheet is not addressed, other than to state that such software is a long�livedasset covered by FASB ASC 360�10 (formerly SFAS No. 144). Therefore, capitalized software could be presentedwith other long�lived assets or with intangible assets.

Capitalization should begin when the preliminary project stage is complete and management authorizes andcommits to fund the project. In addition, it must be probable that the project will be completed and the software willperform its intended function. Capitalization should end when the project is substantially complete and ready for itsintended use (i.e., testing and installation are complete). If it becomes probable that the project will not becompleted and placed in service, no further costs should be capitalized and the guidance on impairment discussedlater in this lesson should be followed. The following conditions may indicate that the software project is no longerexpected to be completed and placed in service:

� No expenditures are budgeted or incurred for the project.

� Programming problems cannot be resolved in a timely manner.

� Cost overruns are significant.

� Information indicates that costs of the internally developed software will significantly exceed the cost ofcomparable third�party software.

� New technologies in the marketplace indicate that management may decide to buy third�party softwarerather than authorize completion of the internally developed software.

� The business segment to which the software is related is unprofitable or will be discontinued.

The capitalized costs of internal�use software should be amortized on the straight�line basis (unless anothersystematic and rational basis is more representative of the software's use) over the estimated useful life of thesoftware. The amortization period depends on how long the company plans to use the software, consideringtechnology and obsolescence. Amortization should begin for each module or component of a software projectwhen the module or component is ready for its intended use (that is, after all substantial testing is completed for themodule or component).

Impairment of capitalized internal�use software should be determined and measured in accordance with FASB ASC360�10�35 (formerly SFAS No. 144, Accounting for the Impairment or Disposal of Long�Lived Assets). FASB ASC350�40�35�1 (formerly SOP 98�1) states that impairment may be present when one of the following conditions existsrelated to internal�use software currently in use or under development:

� The software is not expected to provide substantive service potential.

� The extent or manner in which the software is used or expected to be used significantly changes.

� The entity has made or intends to make a significant change in the software program.

� The costs to develop or modify the software significantly exceed the amounts originally estimated.


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After internal�use software is placed into service, subsequent changes to the software should be capitalized orexpensed depending on (a) whether the costs are incurred internally or externally, and (b)�whether the costs are formaintenance or upgrades and enhancements.

� Internal costs for upgrades and enhancements should be capitalized or expensed according to the criteriafor the preliminary project, application development, and post�implementation/operation stages.

� Internal maintenance costs should be expensed as incurred.

� Internal costs for minor upgrades and enhancements that cannot be reasonably separated frommaintenance costs should be expensed as incurred.

� External costs incurred under agreements for specified upgrades and enhancements should becapitalized or expensed according to the criteria for the preliminary project, application development, andpost�implementation/operation stages.

� External costs for specified upgrades and enhancements that are combined with maintenance in a singlecontract should be allocated between the components, and the maintenance costs should be expensedover the contract period.

� External costs for maintenance, unspecified upgrades and enhancements, and costs under agreementsthat combine the costs of maintenance and unspecified upgrades and enhancements should be expensedon a straight�line basis over the contract period (unless another systematic and rational basis betterrepresents the services received under the contract).

� External costs for purchased software that includes multiple components (such as training, maintenancefees for routine maintenance, data conversion, or rights to future upgrades and enhancements) in thepurchase price should be allocated to the various components, based on the fair value of each component(which may not be the stated contract price for each separate component). The allocated costs should beaccounted for as discussed.

Upgrades and enhancements are defined as modifications that increase the functionality of existing internal�usesoftware. (That is, the modifications allow the software to perform new tasks.) Upgrades and enhancements mustincrease the software's functionality (rather than merely extend its useful life) to be considered for capitalization. Ifthe software does not function significantly differently than it did before the upgrade or enhancement, the costsshould be expensed as maintenance. New internal�use software that replaces previously existing internal�usesoftware is considered a new purchase, not an upgrade or enhancement.

Entities may decide to market internal�use software after it is developed. In such cases, the carrying amount of thecapitalized software should be reduced by the proceeds from licensing the software (net of direct marketing costs,such as commissions, software reproduction costs, warranty costs, etc.). Revenue should not be recognized untilthe net carrying amount has been reduced to zero. If an entity decides to market the software during its develop�

ment, the provisions previously discussed apply.

Determining the Proper Accounting for Software Costs. The accounting treatment for the costs of purchasing ordeveloping software depends on its ultimate use. Further, costs for a software project cannot be accounted forunder multiple standards. The flowchart at Exhibit 2�1 may be used to determine which accounting standards applyto software costs.


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Exhibit 2�1

Applying Accounting Standards to Software Costs

FASB ASC 985�20 (formerlySFAS No. 86) applies.

FASB ASC 730�10 (formerlySFAS No. 2) applies.

FASB ASC 350�40 (formerlySOP 98�1) applies.

Is software to besold, leased, ormarketed?

Is software developeda

as a pilot project or for

use in a specific R&D

project?

Is purchased or leasedsoftware to be used inR&D activities?

Does the software havealternative future uses?

Yes

Yes Yes

Yes

No No

No

No

Note:

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

* * *


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Software Developed as Part of a Reengineering Project. Many companies are entering into consulting contractsthat combine software projects and business process reengineering. The costs for developing internal�use soft�ware must be accounted for as discussed. However, reengineering activities (even though they are often associ�ated with new or upgraded software applications) follow FASB ASC 720�45 (formerly EITF Issue No. 97�13,�Accounting for Costs Incurred in Connection with a Consulting Contract or an Internal Project That CombinesBusiness Process Reengineering and Information Technology Transformation"). This guidance requires compa�nies to expense the costs of business process reengineering activities, regardless of whether the activities areundertaken as separate projects or as part of projects to acquire, develop, or implement internal�use software. Therequirement applies whether the company or a third�party consultant performs the reengineering. The followingactivities are typically associated with business process reengineering:

� Preparing a request for proposal.

� Documenting the company's current business processes (except for the company's software structure).

� Reengineering the company's processes to increase efficiency and effectiveness.

� Restructuring the company's employees to operate the reengineered processes.

If a third�party consultant performs the business process reengineering project, the total contract price must beallocated to each component of the contract based on the relative fair values of the separate activities. The portionof the costs relating to internal�use software must be accounted for under FASB ASC 350�40 (formerly SOP 98�1),while the portion relating to reengineering processes must be expensed as incurred.


240


241

SELF�STUDY QUIZ


13. Which of the following is an inappropriate method of disclosing depreciation expense for the period coveredin the financial statements?

a. Disclosing depreciation in the notes to the financial statements.

b. Disclosing depreciation in cost of sales.

c. Disclosing depreciation in the statement of cash flow.

d. Disclosing depreciation as a separate line item in the income statement.

14. The costs of start�up activities should be:

a. Amortized.

b. Expensed up to $5,000 and the remainder must be amortized.

c. Expensed as incurred.

15. Which of the following computer software costs should be capitalized and amortized according to FASB ASC985�20�25 (formerly SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, orOtherwise Marketed)?

a. Maintenance and customer support costs.

b. Costs of producing product masters.

c. Duplication costs.

d. Planning costs.

16. Costs related to software developed by an organization for use solely by the organization can be classified ascosts of one of three stages of software development. Testing falls within which stage?

a. Preliminary project stage.

b. Application development stage.

c. Post�implementation/operation stage.


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13. Which of the following is an inappropriate method of disclosing depreciation expense for the period coveredin the financial statements? (Page 231)

a. Disclosing depreciation in the notes to the financial statements. [This answer is incorrect. Reportingdepreciation in the notes to the financial statements or parenthetically in the income statement areappropriate methods of disclosing depreciation expense per guidance in FASB ASC 360�10�50�1.]

b. Disclosing depreciation in cost of sales. [This answer is correct. An AICPA technical practice aidstates that it has become recognized practice to report the amount of depreciation charged tomanufacturing costs and to expense accounts as the depreciation expense for the period eventhough depreciation included in inventories at the beginning and end of the period varies sufficientlyto affect depreciation included in cost of sales.]

c. Disclosing depreciation in the statement of cash flows. [This answer is incorrect. The amount ofdepreciation expense for the period may be disclosed in the statement of cash flows' reconciliation of netincome to net cash flows from operating activities per guidance in FASB ASC 360�10�50�1.]

d. Disclosing depreciation as a separate line item in the income statement. [This answer is incorrect. FASBASC 360�10�50�1 (previously Paragraph 5 of APB Opinion No. 12) requires depreciation expense to bedisclosed. Depreciation expense may be disclosed as a separate line item in the income statement.]

14. The costs of start�up activities should be: (Page 232)

a. Amortized. [This answer is incorrect. FASB ASC 720�15�25�1 (formerly SOP 98�5, Reporting on the Costsof Start�Up Activities) does not allow for the amortization of the expenses associated with start�up activities.]

b. Expensed up to $5,000 and the remainder must be amortized. [This answer is incorrect. This is the currentmethod of treating start�up activities for tax purposes, it is not the correct method of accounting for andpresenting start�up costs in the statement of income.]

c. Expensed as incurred. [This answer is correct. The costs associated with start�up activities shouldbe expensed as incurred per FASB ASC 720�15�25�1 (formerly SOP 98�5, Reporting on the Costs ofStart�Up Activities).]

15. Which of the following computer software costs should be capitalized and amortized according to FASB ASC985�20�25 (formerly SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, orOtherwise Marketed)? (Page 234)

a. Maintenance and customer support costs. [This answer is incorrect. Costs of maintenance and customersupport should be charged to expense when related revenue is recognized or when those costs areincurred, whichever occurs first per FASB ASC 985�20�25�6.]

b. Costs of producing product masters. [This answer is correct. The costs of producing productmasters, after the technological feasibility has been established, should be capitalized andamortized per FASB ASC 985�20�25�3.]

c. Duplication costs. [This answer is incorrect. Duplication costs are a cost of producing the product. Costsincurred for duplicating the computer software, documentation, and training materials from the productmasters and for physically packaging the product for distribution should be capitalized as inventory andcharged to cost of sales when revenue is recognized per FASB ASC 985�20�25�11.]

d. Planning costs. [This answer is incorrect. Planning, designing, and establishing the technologicalfeasibility of a computer software product should be expensed as incurred per FASB ASC 985�20�25�1.]


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16. Costs related to software developed by an organization for use solely by the organization can be classified ascosts of one of three stages of software development. Testing falls within which stage? (Page 235)

a. Preliminary project stage. [This answer is incorrect. The preliminary project stage includes costs incurredfor conceptualizing and evaluating software alternatives, determining existence of needed technology,and selecting final alternatives.]

b. Application development stage. [This answer is correct. The application development stageincludes costs related to designing the chosen alternative, coding, installing hardware, and testingper FASB ASC 350�40�20; 350�40�25 (formerly SOP 98�1).]

c. Post�implementation/operation stage. [This answer is incorrect. The post�implementation/operation stageincludes costs related to training and software application maintenance.]


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Rent Expense under Operating Leases

FASB ASC 840�20 (formerly SFAS No. 13) generally requires rent expense under operating leases to be recognizedon a straight�line basis. FASB ASC 840�20�25�1 (formerly Paragraph 15 of SFAS No. 13) states:

Rent shall be charged to expense by lessees (reported as income by lessors) over the lease termas it becomes payable (receivable). If rental payments are not made on a straight�line basis,rental expense nevertheless shall be recognized on a straight�line basis unless anothersystematic and rational basis is more representative of the time pattern in which use benefit isderived from the leased property, in which case that basis shall be used. (Emphasis added.)

In many cases, rent payments under operating leases are made on a straight�line basis and are charged toexpense in the period they are payable to the lessor. However, the lease payments in some operating leases varyeither because the lessor offers a rent�free period or a period of reduced rent as an incentive for the lessee to signthe agreement or because the lease provides for scheduled rent increases. GAAP generally requires rent expenseto be recognized on a straight�line basis over the lease term as shown in the following example:

Lease term: 5 years

Monthly rent: First year free; $550 per month thereafter

Total rent expense during lease term:

$550 � 48 months $ 26,400

Monthly rent expense per financial statements:

$26,400 � 60 months $ 440

The excess of expense over payments during the rent�free period ($440 � 12) should be credited to an accruedliability. The liability should be reduced in each subsequent month by the excess of the monthly payments over theexpense ($550 � $440).

In recent years, a number of public companies restated their financial statements to correct errors relating to leaseaccounting. As a result of those restatements, the chairman of the AICPA Center for Public Company Audit Firmsrequested the Office of the Chief Accountant of the Securities and Exchange Commission (SEC) to clarify the SECstaff's interpretation of certain accounting issues and their application relating to operating leases. One area ofclarification related to the proper recognition of rent expense when the term of an operating lease includes periodsof free or reduced rents, often referred to as rent holidays. In February 2005, the Chief Accountant of the SEC issueda letter in response to the request indicating that the positions expressed within the letter are based on existingaccounting literature. The letter indicates, according to FASB ASC 840�20�25�2 (formerly FASB Technical Bulletin85�3, Accounting for Operating Leases with Scheduled Rent Increases), a lessee in a operating lease with rentholidays should recognize the rent holidays on a straight�line basis over the term of the lease, including any rentholiday period, unless another allocation method is more representative of the time pattern in which the property isused. Although the letter was intended for SEC registrants, the issues discussed are relevant to nonpublic entitiesas well. The positions expressed in the letter are consistent with the accounting treatment discussed in the previousparagraph. The SEC letter is discussed further later in this lesson.

Accounting for leases with scheduled annual increases is similar to accounting for leases with rent�free periods orreduced rents. To illustrate, assume a three�year lease provides for an annual base rent of $10,000 with increasesduring the second two years of at least 5% (that is, to at least $10,500 in the second year and $11,025 in the thirdyear). Since minimum payments of $31,525 are scheduled over the lease term, GAAP requires recognizing rent of$10,508 (or $31,525 � 3) on a straight�line basis during each of the three years. (Since the lessor and lessee wouldreport different amounts of rent each year for tax purposes, deferred taxes should be provided for the temporarydifferences between rent recognized for financial statement and income tax reporting.)

GAAP emphasizes that to use a method other than straight�line, it must be more representative of the time patternin which the property is used. Using factors such as the time value of money, anticipated inflation, or expected


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future revenues to allocate scheduled rent increases to expense is not appropriate because those factors do notrelate to the time pattern of actually using the leased property. FASB ASC 840�20�25 [formerly FASB TechnicalBulletin (TB) No. 88�1, Issues Relating to Accounting for Leases], provides additional guidance on using thestraight�line method to account for rental expense in the following circumstances:

a. The lessee has the right to control the use of the leased property.

b. Incentive payments are made by the lessor.

c. The lessor assumes the lessee's preexisting lease.

The FASB and the IASB are currently conducting a joint project related to accounting for leases. The objective of theproject is to issue a standard that would require the assets and liabilities arising from lease contracts to berecognized in the balance sheet. In March 2009, the Boards released a Discussion Paper, Leases: Preliminary

Views. The comment period for the Discussion Paper ended in July 2009. The Boards anticipate issuing anexposure draft in the second half of 2010 with a final document in 2011. Future editions of this course will update thestatus of this project.

Lessee Controls Use of Property. The right to control the use of the leased property should be considered as theequivalent of physical use. In other words, when the lessee controls the use of the leased property, recognition ofrental expense or rental revenue is not affected by the extent to which the lessee uses the leased property. AnAICPA Technical Practice Aid at TPA 5600.08 reinforces this concept and indicates a lease term for accountingpurposes may begin before the initial fixed noncancelable term stated in a lease agreement. The TPA referencesthe guidance in FASB ASC 840 that indicates for accounting purposes the lease term includes all periods in whichthe lessee has access to and control over the leased space even if those periods are prior to the fixed noncancel�able term included in the lease agreement.

Thus, for example, if a manufacturing building having excess capacity is leased, and the lessor provides forescalating rental payments in contemplation of the lessee's expected expansion and physical use of the excesscapacity, the aggregate lease payments should be recognized on a straight�line basis over the lease term asdiscussed previously. (Since rent is includable in taxable income by lessors and lessees when due, conformingwith GAAP causes a temporary difference between income for financial and income tax reporting.)

On the other hand, if rents escalate as the lessee gains control of the additional leased property, GAAP requiresrental expense and rental revenue to be recognized as due, provided rental amounts are based on the relative fairvalue of the additional leased property at the inception of the lease. If escalating rental payments are not based onfair value, however, they should be reallocated between the original leased space and the additional leased spacebased on the relative fair value of the property at the inception of the lease. After the reallocation, the amount ofrental expense or rental revenue attributable to the additional leased property should be proportionate to therelative fair value of the additional property, as determined at the inception of the lease, in the periods during whichthe lessee controls its use.

To illustrate a situation in which rental payments are not based on relative fair value, assume the owner of atwo�story office building has separate leases for each floor. The first floor lease expires, and the lessee decides notto renew. The lease on the second floor is scheduled to expire in five years. The lessor signs a 10�year master leaseagreement with a new tenant. During the first five years, the lessee only leases the first floor of the building, butduring the last five years, the lessee leases both the first and second floors. Rent for the first year is $50,000 withscheduled annual increases of 5% during the second through the fifth year. Rent for the sixth year is $90,000 withscheduled annual increases of 6%. At the inception of the lease, the market rental is $50,000 for the first floor and$80,000 for the entire building, resulting in a fair value for the first floor lease equal to 62.5% of the total fair value ofthe lease.


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The following summarizes approximate rental payments under the agreement reallocated based on the fair values.

FirstFloor

SecondFloor Total

Year 1 $ 50,000 $ � $ 50,000

Year 2 52,500 � 52,500

Year 3 55,100 � 55,100

Year 4 57,900 � 57,900

Year 5 60,800 � 60,800

276,300 � 276,300

Year 6 56,300 33,700 90,000

Year 7 59,600 35,800 95,400

Year 8 63,200 37,900 101,100

Year 9 67,000 40,200 107,200

Year 10 71,000 42,600 113,600

$ 593,400 $ 190,200 $ 783,600

Annual rent recognized on the first floor space would be $59,340 (that is, total rentals of $593,400 � the 10�yearlease term), and $38,040 would be recognized annually on the second floor space while it is leased (that is, totalrentals of $190,200 � the five�year lease term). As a result, the lessee would recognize annual rent expense of$59,340 during the first five years and $97,380 during the last five years (that is $59,340 for the first floor plus$38,040 for the second floor). The lessor would recognize the same amounts of rental income.

Operating leases sometimes provide the lessee with the right of first refusal on additional space as other leasesexpire. The straight�line method guidance does not apply to that type of arrangement.

In some situations, a lessee may enter into a leasing arrangement under which the lessee is given control of aleased asset for the purpose of constructing leasehold improvements and preparing the property for operations.According to FASB ASC 840�20�25�10 and 25�11 (formerly FSP No. FAS 13�1, �Accounting for Rental CostsIncurred during a Construction Period"), rental costs related to ground or building operating leases incurred duringa construction period should not be capitalized as a cost of construction but should be recognized as rentalexpense. Lessees should allocate the rental costs over the term of the lease.

Incentive Payments by Lessors. Incentive payments include items such as up�front cash payments to the lesseeto sign the lease and payments to reimburse the lessee for specific costs such as moving costs or abandonedleasehold improvements. The lessor and lessee are required to amortize incentive payments against rental incomeor expense over the term of the lease. The lessee should record receipt of the payment through a debit to cash anda credit to a deferred lease incentive account. The deferred lease incentive account should be amortized througha credit to rent expense over the lease term using the straight�line method. The lessor should record the paymentas a debit to a deferred lease incentive account and a credit to cash. The deferred lease incentive account shouldbe amortized by the lessor against rent income over the lease term using the straight�line method. (The requiredaccounting will create a temporary difference between income for financial and income tax reporting, since thelessor would deduct the incentive payment when paid and the lessor and lessee would recognize rent for taxpurposes when it is due.)

To illustrate, assume that the lessor reimburses the lessee for $10,000 of its moving costs as an incentive to enterinto a five�year noncancelable lease requiring annual rentals of $50,000. The lessee would record receipt of thepayment as a debit to cash and a credit to deferred lease incentive for $10,000. (Receipt of the payment has noeffect on the lessee's accounting for the moving costs. Expenses or losses such as moving expenses, losses onsubleases, or the write�off of abandoned leasehold improvements are charged to expense as incurred.) The$10,000 deferred lease incentive should be amortized over the five�year lease term through annual credits to rentexpense of $2,000 calculated using the straight�line method. As a result, the lessee would make the following entryeach year to record payment of the annual rentals:


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Rent expense 48,000

Deferred lease incentive 2,000

Cash 50,000

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

Cash 50,000


Rent income 48,000

Over the lease term, both the lessor and lessee would recognize rent of $240,000 (that is, annual rent of $48,000 �five years), which represents total minimum lease payments of $250,000 (that is, annual payments of $50,000 �five years) less the $10,000 incentive payment.

The guidance also applies when an incentive arises from payments by the lessor to third parties on behalf of thelessee, such as payments for leasehold improvements or moving costs. A common example relating to leaseholdimprovements is an agreement under which the lessor makes all leasehold improvements requested by the lesseeand bills the lessee for its cost less an allowance. In that situation, it is believed that the lessee should record the fullcost as leasehold improvements. (Since the tax basis of the leasehold improvements is the amount paid, atemporary difference will result because the basis of leasehold improvements for financial reporting will exceedtheir tax basis.)

To illustrate, assume that, as an incentive for a lessee to enter into a five�year lease for annual rentals of $50,000, thelessor agrees to make leasehold improvements for a total cost of $35,000 and to bill the lessee for $25,000. The$10,000 leasehold improvements allowance would be considered a rent incentive. The lessee would record theincentive through the following entry:

Leasehold improvements 35,000


Cash 25,000

The lessee would amortize the leasehold improvements over the shorter of their estimated useful life or the leaseterm, and the $10,000 deferred lease incentive would be amortized against rent expense over the five�year leaseterm using the straight�line method. As a result, $48,000 of the annual rent payments would be charged to rentexpense, and the remaining $2,000 would be charged to the deferred lease incentive.

If the lessor initially charged the $35,000 payment to leasehold improvements, it would record the $25,000 receiptfrom the lessee as follows:

Cash 25,000


Leasehold improvements 35,000

The lessor would amortize the deferred lease incentive over a five�year period using the straight�line method.

In February 2005, the Chief Accountant of the SEC issued a letter to the chairman of the AICPA Center for PublicCompany Audit Firms regarding the SEC staff's interpretation of certain accounting issues and their applicationrelating to operating leases. One issue addressed in the letter relates to landlord and tenant incentives. The SECletter indicates if a lessee makes leasehold improvements that are funded by landlord incentives or allowancesunder an operating lease, the lessee should capitalize the leasehold improvement assets and amortize them overan appropriate term. The SEC letter also indicates landlord incentives should be recorded as deferred rent andamortized as reductions of rent expense over the term of the lease. The SEC staff believes it is not appropriate to net


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deferred rent against leasehold improvements. Although the letter was intended for SEC registrants, the issuesdiscussed are relevant to nonpublic entities as well. The positions expressed in the letter are consistent with theaccounting treatment discussed in this lesson.

Lessor Assumes Lessee's Lease. If a lessor assumes a lessee's preexisting lease with a third party, the relatedloss incurred by the lessor is considered a rent incentive. The lessor and the lessee should independently estimatethe loss incurred by the lessor. While the lessee may not have access to the same information as the lessor, it stillmust estimate the loss to decide whether to accept the offer. The lessor should estimate its loss based on the totalremaining costs reduced by the expected benefits from the sublease or use of the assumed leased property. Themethod the lessee should use is not prescribed, but it may be appropriate for the lessee to base its estimate on acomparison of the new lease with the market rental rate available for similar lease property or the market rental ratefrom the same lessor without the lease assumption. (This accounting will create a temporary difference betweenfinancial and taxable income, since, for tax reporting, the lessor would deduct the loss as incurred (that is, aspayments under the assumed lease and rentals under the sublease are due), and the lessor and lessee wouldinclude rent in taxable income when it is due.)

To illustrate, assume that the lessee presently pays annual rent of $32,000 on its office facilities and three yearsremain under that lease. The lessee enters into a lease for new facilities that requires annual rentals of $50,000 overa noncancelable term of five years and the assumption of its existing lease. The lessor believes it can sublease thespace under the lessee's old lease for annual rentals of $24,000 but, because of current market conditions, believesthat it will need to grant a rent�free period of six months. The lessor should compute its loss on assuming the leaseas follows:

Total rental commitment remaining under the lease assumedthreeyears at $32,000 per year $ 96,000

Total sublease income2.5 years at $24,000 per year 60,000

Loss on assumption of the lease $ 36,000

The lessee, on the other hand, believes the annual market rental for similar property is $45,000. Thus, the lesseecalculates the value of the incentive as the $5,000 ($50,000 � $45,000) excess annual rental over the five�year termfor a total of $25,000. The lessee would record a loss of $25,000 at inception. As lease payments are made, the$25,000 would be amortized as a reduction of rent expense. The entries would be as follows:

At inception

Loss on sublease assumed by lessor 25,000


Annually thereafter

Rent expense 45,000


Cash 50,000

The lessor would record the loss of $36,000 as a debit to deferred lease incentive and a credit to accrued loss onlease assumed. Both the asset and liability should be amortized using the straight�line method, but the assetshould be amortized over the five�year term of the new lease because it is considered to be a cost of obtaining thenew lease, and the liability should be amortized over the three�year term of the old lease because the accrued lossrelates to the old lease. Sublease income of $20,000 would be recognized annually over the three�year subleaseterm under the straight�line method (that is, total sublease rentals of $60,000 � three years). The difference in eachyear between sublease income and rent collected would be debited or credited to accrued rent receivable asdiscussed previously.


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The lessor would record the following entries in the first year:

a.


Accrued loss on assumed lease 36,000

To record deferred lease incentive resulting fromestimated loss on assumed sublease.

b.

Accrued loss on assumed lease ($36,000 � 3) 12,000

Lease expense 20,000

Cash 32,000

To record expense relating to assumed lease.

c.

Cash 12,000

Accrued rent receivable 8,000

Lease income ($60,000 � 3) 20,000

To record income relating to assumed lease.

d.

Cash 50,000

Deferred lease incentive ($36,000 � 5) 7,200

Rental income 42,800

To record entries relating to new lease.

Contingent Rentals. In contrast to the lease incentives discussed in the preceding paragraphs, contingent rentalsare dependent on future changes in the factors on which the lease payments are based, such as future salesvolume, future inflation, or future property taxes. If contingent rentals under operating leases are based on anexisting index or rate, they would be included in the minimum lease payments based on the index or rate existingat the inception of the lease. (They would, therefore, be subject to the accounting treatment described previously.)Subsequent changes in the index or rate and other contingent rentals under operating leases should be chargedto expense when they are incurred. If contingent rentals are based on factors that do not exist or are not measurableat the inception of the lease, for example future sales volume, no amount for those factors should be included in theminimum lease payments. The entire amount based on those factors should be expensed as it is incurred.(Contingent rentals under capital leases should be excluded from minimum lease payments and also should becharged to expense when incurred.

FASB ASC 840�10�25�35; 840�10�40�1 (formerly EITF Issue No. 98�9, �Accounting for Contingent Rent"), requireslessees to recognize contingent rental expense in annual and interim periods prior to achieving a specified targetthat triggers the contingent rent if it is probable that the target will be achieved. Previously recorded contingentrental expense should be reversed into income if it later appears probable that the specified target will not be met.The EITF also reached a consensus that lessors should not recognize contingent rental income in interim periodsbefore achieving the specified target that triggers the contingent rent. However, in subsequent discussions, theEITF withdrew that consensus. Lessors that changed their accounting for contingent rental income due to the initialconsensus (reached at the EITF's May 21, 1998 meeting) can continue to follow that consensus or account forcontingent rental income using the accounting policy they followed before that consensus. Lessors that did notchange their accounting policy for contingent rental income because their existing accounting policy was consis�tent with the initial consensus should continue to use that policy. Regardless of the policy used, lessors shoulddisclose their accounting policy for contingent rental income. In addition, a lessor that accrues contingent rentalincome before a lessee achieves a specified target (because achieving the target was considered probable) mustdisclose the impact on rental income as if the lessor had deferred recognizing contingent rental income until thespecified target had been met.


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Disclosures. Disclosures are required for all operating leases that have noncancelable lease terms in excess ofone year.

The AICPA has issued a series of Technical Practice Aids (TPAs) that address accounting for leases. The TPAs,which are nonauthoritative, can be found at TIS Section 5600.

Advertising Costs

FASB ASC 340�20; 720�35 (formerly Statement of Position 93�7, Reporting on Advertising Costs), requires advertis�ing costs to be capitalized in some situations and applies to commercial businesses as well as nonprofit organiza�tions. It covers most types of advertising, such as TV or radio commercials, business or consumer publications, anddirect�mail advertising. However, fund�raising activities for nonprofit organizations are not considered advertisingwithin the scope of the requirements. In addition, the costs of premiums, contest prizes, gifts and similar promo�tions, as well as discounts or rebates (including those resulting from the redemption of coupons) are specificallyexcluded from the requirements. Other costs of coupons and similar items (such as the costs of magazine ornewspaper advertising space) are considered advertising costs and are subject to the requirements.

When Should Advertising Costs Be Expensed? For many companies, there is no significant change in account�ing for advertising other than direct�response advertising. Production costs incurred in advertising (for example,writing advertising copy, artwork, printing) can either be expensed as incurred or expensed the first time theadvertising occurs. However, the company may need to disclose its policy for reporting advertising expenses in itsfinancial statements. Communication costs should not be expensed until the first time the advertising occurs (forexample, the first time a television commercial is shown). Even if the advertisement will run for an extended timeperiod (for example, Yellow Page ads or bill boards), the advertisement typically cannot be withdrawn once thepublication or other communication is released. Accordingly, it is believed that the company has incurred a liabilityto pay for the advertising once the communication is released; therefore, the related expense should be recognizedat that time. Even if a publication bills the company monthly for an advertisement that will run for a year (forexample, Yellow Page ads), the expense should still be recognized when the advertisement first appears. If acompany trades products or services for advertising, the advertising expense and the revenue from the �sale"should be recorded at the fair value of either the advertisement or the sale, whichever is more objectively determin�able. As a practical matter, such transactions would not have to be recorded if their effect is not material to thecompany's results of operations.

When Should Advertising Costs Be Capitalized? Special rules may apply to advertising considered �direct�response advertising" when:

a. it can be shown that customers responded to a specific advertisement, and

b. there is a probable future economic benefit.

Some ways that a company can show that customers responded to a specific advertisement are:

� using coded order forms, coupons, or response cards.

� linking telephone calls to a unique phone number only included in a specific advertisement.

� maintaining files that indicate a customer's name and the related direct�response advertisement.

To demonstrate that the direct�response advertising will result in a future benefit, the entity should consider itsresponse experience with similar direct�response advertising used in the past. Considerations of likely responseshould include (a) the audience demographics, (b) the advertising method, (c) the product, and (d) economicconditions. The evidence should include a verifiable historical pattern of results for that entity. General industrystatistics on advertising methods are not adequate to show that there will be a probable future benefit. Also,retroactive capitalization of advertising costs (based on results in subsequent periods supporting a probable futurebenefit) is not permitted.


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FASB ASC 340�20�25�17 and 25�18; 340�20�35�7 (formerly Practice Bulletin No. 13, Direct�response Advertising

and Probable Future Benefits), indicates that a company should only consider primary revenues associated withdirect�response advertising when determining whether probable future benefits exist. Primary revenues are thosederived from sales to customers receiving and responding to the direct�response ads. A company can also obtainsecondary benefits from direct�response advertising. For example, if a publisher's subscription base increases asa result of direct�response advertising, the publisher will likely receive higher advertising fees for space sold in thepublication. Those increased advertising fees are secondary revenues and should not be considered when deter�mining whether probable future benefits exist or when amortizing and assessing the realizability of any advertisingreported as assets.

Direct�response Advertising Costs to Capitalize and Amortize. Not all costs attributable to direct�responseadvertising can be capitalized. Generally, only the following two types of costs should be included in amountsreported as assets:

a. Direct, incremental costs incurred in transactions with third parties (such as artwork or written advertisingcopy)

b. The portion of employee payroll (and payroll�related costs) directly associated with direct�responseadvertising activities

Items such as administrative costs, rent, depreciation, etc. should not be included in the capitalized advertisingasset. Tangible assets used in advertising, such as billboards, should be capitalized and depreciated over theirexpected useful lives. Printed sales materials, such as catalogs or brochures, can be accounted for as prepaidsupplies until they are distributed or no longer expected to be used.

A company should amortize the capitalized costs over the period that it believes it will obtain sales (or a benefit) asa result of that specific advertisement. Often the period will be fairly short (e.g., less than six months). In addition,the amortization for a given period should be in proportion to the amount of benefits received during that period.That means that the amortization will usually decline over time, with more amortization in earlier periods followingdistribution and less in later periods.

A company should also periodically assess the realizability of the advertising costs that remain capitalized. That isdone by comparing the carrying amounts of the capitalized advertising (on a �cost�pool�by�cost�pool basis") to theestimated remaining future net revenues expected to result from that specific advertisement. If the carryingamounts exceed the remaining future net revenues, the excess should be reported as advertising expense in theperiod that the evaluation occurs.

Applying these requirements to advertising costs can be reduced to a few simple decisions as outlined in Exhibit2�2.

Required Disclosures. Certain disclosures are required, even if advertising costs are not capitalized. For manysmall to medium�sized companies, expenditures for direct�response advertising will not be capitalized. In thosecases, disclosure of advertising expense for each income statement period presented is required. In addition, thenotes to the financial statements should disclose whether advertising costs are expensed as incurred for the firsttime the advertising takes place. Depending on the facts and circumstances, the financial results under the twoalternatives may or may not differ materially. For example, the results may differ materially when significantproduction costs are incurred over a long period or when communication costs are incurred significantly inadvance of when the advertising takes place. An example of when the results may not differ materially is adistributor that incurs material amounts of costs in communicating advertising through programs produced by themanufacturer, and the manufacturer

a. Arranges with local advertising agencies to bill the distributor for advertising communicated using printmedia when it appears and for advertising communicated using radio and television spots when they air.Since the costs of those forms of advertising are incurred when the advertising takes place, the resultsunder the SOP's two alternatives are the same.


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b. Bills the distributor for point�of�sale advertising in connection with a national campaign, and thepoint�of�sale material is received shortly before the campaign is to begin and therefore is quickly movedto the retail outlets.

While FASB ASC 340�20�50�1; 720�35�50�1 (formerly SOP 93�7) clearly requires disclosure of the company'sadvertising policy when the results of the two methods differ materially, some accountants have questionedwhether disclosure is required when the results do not differ materially. Disclosure of the alternative selected isconsistent with FASB ASC 235�10�50�1 through 50�6; 235�10�05�3 and 05�4 (formerly APB Opinion�No.�22) require�ment to disclose a selection of an accounting policy from existing acceptable alternatives. However, the guidanceindicates the accounting policies disclosed are those that materially affect financial position, cash flows, or resultsof operations. Under that presumption, a selection from existing acceptable alternatives that does not materiallyaffect the financial statements need not be disclosed. To illustrate applying that presumption to accounting foradvertising costs, a reader would not be able to better understand the financial statements knowing that the cost ofcommunicating advertising through various media is expensed when incurred if those costs are not incurred untilthe communication occurs. Accordingly, best practices indicate that the financial statements are not required todisclose the alternative selected when the financial results under the two alternatives do not differ materially.

Advertising Barter Transactions. Advertising barter transactions involve an exchange of advertising services forother services or products. Such transactions are not new; for example, small radio stations historically haveprovided airtime for advertisements in exchange for other services. However, the transactions are gaining newprominence with the increasing number of Internet companies that enter into transactions in which they exchangerights to place advertisements on each other's websites. In some transactions, no cash is exchanged, while inothers similar amounts of cash are exchanged (frequently referred to as �swapping checks").

Many Internet companies have tended to report net losses and net operating cash outflows, and their marketcapitalization often is based on revenues. Since no net cash is exchanged, two Internet companies conceptuallycould agree on a grossly inflated amount at which to report advertising, with each one reporting that same amountof advertising revenue and expense. To avoid the artificial inflation of market capitalization from such a practice,FASB ASC 605�20�25�14 through 25�18; 605�20�50�1 (formerly Issue No. 99�17, �Accounting for Advertising BarterTransactions"). While the guidance was issued specifically in response to concern about exchanges of Internetadvertising, it applies to all transactions in which advertising services are exchanged.


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Exhibit 2�2

Applying FASB ASC 340�20; 720�35 (formerly SOP 93�7) to Advertising costs

Yes

Yes

CostSpecificallyExcluded byFASB ASC340�20�15;

720�35�15 (for�merly SOP

93�7)?

Do Not Capitalize Cost. Expense asIncurred (Production Costs) or theFirst Time Advertising Occurs (Pro�duction or Communication Costs).

DirectIncremental Cost

Paid to Outside Party orEmployee Payroll (or Pay�roll�related) Cost Associ�ated with Direct�response

Advertising?

Direct�ResponseAdvertising

Cost?

Can ItBe Shown

That ResponseWas to Specific

Advertise�ment?

ProbableFuture

EconomicBenefit?

Capitalize Cost. Amortize overBenefit Period. Periodically

Assess Realizability ofUnamortized Portion.

Expense As Incurred (ProductionCosts) or the First Time the

Advertising Occurs (Productionor Communication Costs).

FASB ASC 340�20; 720�35(formerly SOP 93�7) Does Not Apply.

No

No

No

No

Yes

Yes

Yes

No

* * *


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The guidance was that revenue and expense should be recognized at the carrying amount of the advertisingsurrendered, which likely will be zero, unless the strict guidelines prescribed for determining fair value are met.Essentially, revenue and expense should be recognized at fair value only if the fair value of the advertisingsurrendered can be determined based on historical, cash�based similar experience with entities unrelated to thecounterparty of the barter transaction. In determining whether an advertising barter transaction should be recog�nized at fair value, the following criteria must be met:

a. The Experience Must Be Prior to the Transaction. The historical experience considered must be for a periodnot more than six months before the date of the barter transaction.

� If economic circumstances have changed such that transactions within that six�month period do notrepresent current fair value, then a shorter, more representative period should be used.

� Look backs are not permissible. In other words, the historical cash�based experience must occurbefore the barter transaction. If the cash�based experience occurs after the barter transaction butbefore issuance of the entity's financial statements, the cash�based experience cannot be used torecognize the barter transaction in the entity's financial statements.

b. The Experience Must Be Cash�based. The entity may consider only historical transactions in which itreceived cash, marketable securities, or other consideration that is readily convertible to a known amountof cash.

c. The Experience Must Be Similar. For advertising to be considered similar

� It must have been in the same media and within the same website or other advertising vehicle as theadvertising in the barter transaction.

� Its characteristics must be reasonably similar with respect to circulation, exposure, or saturation withinan intended market; timing (such as daily or weekly); prominence (such as a page on a website);demographics of readers, viewers, or customers; and length of time the advertising is displayed.

d. The Volume or Quantity of Advertising Surrendered in a Prior Cash�based Transaction Only Can Evidencethe Fair Value of an Equivalent Volume or Quantity of Advertising Surrendered in Subsequent Barter

Transactions. The amount of revenue recognized in an advertising barter transaction cannot exceed theamount of the prior cash�based transaction used to provide evidence of fair value. After a prior transactionis used to support recognition of an equal amount of barter revenue, that transaction cannot provideevidence of fair value for another barter transaction.

Required disclosures include

a. the amount of revenue and expense recognized from advertising barter transactions for each incomestatement period presented.

b. information about the volume and type of advertising surrendered and received for each income statementperiod presented if the fair value of advertising barter transactions is not determinable within the Issue'sguidelines.

Retroactive Adjustment of Workers' Compensation and Other Expenses

Workers' compensation carriers often charge annual premiums based on what they think the experience rate willbe for the year and adjust the premium later based on the actual rate. Sometimes the adjustment is settled in cash,but it may also be settled prospectively through an adjustment of the next year's premium. The expense recognizedfor the year should equal the adjusted premium for that period. That requires estimating the retroactive adjustment,regardless of whether it is a refund, an additional payment, or a prospective adjustment. Considering the need foran adjustment requires some practical considerations:

a. If workers' compensation expense is not material to the financial statements, a retroactive adjustment isnot likely to be material.


255

b. If the expense is material, often the most efficient approach is to talk with the agent about the likelihood ofa significant premium adjustment. Agents for the carriers often can estimate the amount of the adjustmentwithin an acceptable range.

c. If there is a reasonable possibility that the estimate will change with a material effect on next year's financialstatements, the requirements of FASB ASC 275�10 (formerly SOP 94�6, Disclosure of Certain Significant

Risks and Uncertainties), apply.

This guidance also applies to other expenses incurred under similar arrangements.


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257

SELF�STUDY QUIZ


17. PIP Company signed an operating lease agreement with Leases R Us. The lessor offered PIP a rent free periodof one year. For the remaining three years of the lease, PIP's monthly rent will be $1,000. How much rentexpense will PIP recognize in month twelve?

a. $0.

b. $750.

c. $1,000.

18. Assume the same facts as in the previous example. What will be the accrued liability on PIP's books at the endof the thirteenth month of the operating lease?

a. $0.

b. $250.

c. $8,750.

d. $9,000.

19. Up & Up signed a ten�year operating lease agreement with Ascending Company with an annual base rent of$10,000. Each succeeding year, the rent will increase by $1,000 over the previous year. How much rent expensewill Up & Up recognize in year five?

a. $10,000.

b. $14,000.

c. $14,500.

d. $15,000.

20. Bows & Bells was offered a $4,000 up�front cash lease incentive to sign a four�year noncancelable leaserequiring annual rentals of $40,000. How will Bows & Bells account for the incentive payment by the lessor?

a. Record the $4,000 receipt as income when received.

b. Record the $4,000 as a reduction in rent expense when received.

c. Record the $4,000 as a deferred lease incentive when received.

d. Record the $4,000 receipt as a reduction in moving costs when received.

21. When a lessor assumes a lessee's preexisting lease with a third party:

a. The lessor and lessee should independently estimate the loss incurred by the lessor.

b. The lessor and lessee should agree on the calculation of the loss incurred by the lessor.

c. The lessee must use the lessor's calculation of the loss.

d. The lessor must use the lessee's calculation of the loss.


258

22. Which advertising cost below is subject to the requirements in FASB ASC 340�20; 720�35 (formerly SOP 93�7,Reporting on Advertising Costs)?

a. Contest prizes.

b. Coupons printed in the newspaper.

c. Gifts and promotions.

d. Discounts or rebates.


259



17. PIP Company signed an operating lease agreement with Leases R Us. The lessor offered PIP a rent free periodof one year. For the remaining three years of the lease, PIP's monthly rent will be $1,000. How much rentexpense will PIP recognize in month twelve? (Page 244)

a. $0. [This answer is incorrect. A rent�free period does not mean that no rent expense is recorded on thefinancial statements. FASB ASC 840�20 (formerly SFAS No. 13, Accounting for Leases), provides guidanceon expense recognition.]

b. $750. [This answer is correct. A total of $36,000 will be paid during the contract period. The contractterm is for four years, which is forty�eight months. Therefore, $36,000 � 48 months = $750.]

c. $1,000. [This answer is incorrect. PIP's lease expense is not $1,000 per month during the twelfth monthbecause rent expense is recognized on a straight�line basis.]

18. Assume the same facts as in the previous example. What will be the accrued liability on PIP's books at the endof the thirteenth month of the operating lease? (Page 244)

a. $0. [This answer is incorrect. The excess of expense over payments during the rent�free period should becredited to an accrued liability.]

b. $250. [This answer is incorrect. This is the excess of the monthly payment over the expense in monthsthirteen through forty�eight.]

c. $8,750. [This answer is correct. The excess expense over payments during the rent�free period was$9,000 ($750 � 12). The liability should be reduced in each subsequent month (months thirteenthrough forty�eight) by the excess of the monthly payments over the expense ($1,000 � $750 =$250). Therefore, $9,000 � $250 = $8,750.]

d. $9,000. [This answer is incorrect. This is the amount of the accrued liability at the end of month twelve. Theexcess expense over payments during the rent�free period was $9,000 ($750 � 12).]

19. Up & Up signed a ten�year operating lease agreement with Ascending Company with an annual base rent of$10,000. Each succeeding year, the rent will increase by $1,000 over the previous year. How much rent expensewill Up & Up recognize in year five? (Page 244)

a. $10,000. [This answer is incorrect. $10,000 is the annual base rent. The rent increases each year by$1,000.]

b. $14,000. [This answer is incorrect. This is the amount of rent paid in year five. This is not the correct amountof rent expense for the year when applying FASB ASC 840�20 (formerly SFAS No. 13, Accounting forLeases).]

c. $14,500. [This answer is correct. The rent paid for the first year is $10,000. The rent paymentsincrease by $1,000 each year. The total rent paid over the ten year lease is $145,000. $145,000recognized on a straight�line basis over the term of the lease is $14,500 per year.]

d. $15,000. [This answer is incorrect. $15,000 is the amount of rent paid in year six. This calculation does notfollow the guidance in FASB ASC 840�20 (formerly SFAS No. 13).]


260

20. Bows & Bells was offered a $4,000 up�front cash lease incentive to sign a four�year noncancelable leaserequiring annual rentals of $40,000. How will Bows & Bells account for the incentive payment by the lessor?(Page 246)

a. Record the $4,000 receipt as income when received. [This answer is incorrect. The lease incentive shouldnot be recorded as revenue to Bows & Bells because the payments are amortized over the term of thelease.]

b. Record the $4,000 as a reduction in rent expense when received. [This answer is incorrect. Rent expenseis reduced when the incentive is amortized.]

c. Record the $4,000 as a deferred lease incentive when received. [This answer is correct. The lesseeshould record receipt of the payment through a debit to cash and a credit to a deferred leaseincentive account. The deferred lease incentive account should be amortized through a credit to rentexpense over the lease term using the straight�line method.]

d. Record the $4,000 receipt as a reduction in moving costs when received. [This answer is incorrect. Receiptof the payment has no effect on the lessee's accounting for specific costs such as moving costs orabandoned leasehold improvements. Expenses such as moving expenses, losses on subleases, or thewrite�off of abandoned leasehold improvements are charged to expense as incurred.]

21. When a lessor assumes a lessee's preexisting lease with a third party: (Page 248)

a. The lessor and lessee should independently estimate the loss incurred by the lessor. [This answeris correct. If a lessor assumes a lessee's preexisting lease with a third party, the related loss incurredby the lessor is considered a rent incentive. The lessor and the lessee should independentlyestimate the loss incurred by the lessor.]

b. The lessor and lessee should agree on the calculation of the loss incurred by the lessor. [This answer isincorrect. The lessee may not have access to the same information as the lessor. They are not requiredto agree on the calculation.]

c. The lessee must use the lessor's calculation of the loss. [This answer is incorrect. The lessee is not requiredto use the lessor's calculation of the loss. It may be appropriate for the lessee to base its estimate on acomparison of the new lease using market rental rates.]

d. The lessor must use the lessee's calculation of the loss. [This answer is incorrect. The lessee may not haveaccess to the same information as the lessor. The lessor is not required to use the lessee's calculation.]

22. Which advertising cost below is subject to the requirements in FASB ASC 340�20; 720�15 (formerly SOP 93�7,Reporting on Advertising Costs)? (Page 250)

a. Contest prizes. [This answer is incorrect. Contest prizes are specifically excluded from the requirementsof FASB ASC 340�20; 720�35 (formerly SOP 93�7).]

b. Coupons printed in the newspaper. [This answer is correct. Costs of coupons such as the costs ofmagazine or newspaper advertising space are considered advertising costs and are subject to therequirements of FASB ASC 340�20; 720�35. However, costs resulting from the redemption ofcoupons are excluded.]

c. Gifts and promotions. [This answer is incorrect. FASB ASC 340�20; 720�35 does not apply to gifts andpromotions or to the costs of premiums.]

d. Discounts or rebates. [This answer is incorrect. FASB ASC 340�20; 720�35 does not apply to discounts orrebates (including those resulting from the redemption of coupons.)]


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Lesson 2 (PFSTG093)


13. Which of the following costs associated with start�up activities is expensed as incurred as required by FASBASC 720�15�25�1 (formerly SOP 98�5, Reporting on the Costs of Start�Up Activities)?

a. Costs related to opening a new facility.

b. Costs of raising capital.

c. Costs of advertising.

d. Costs of acquiring long�lived assets.

14. ABC Manufacturing Company spent $100,000 in the current period for research and development. How willABC present these costs in the financial statements?

a. The costs will be reported on the balance sheet as inventory.

b. The costs will be reported as overhead on the statement of income.

c. The costs will be expensed as incurred on the statement of income.

d. The costs will be deferred to future periods.

15. Which of the following statements correctly describes the amortization of internal�use software?

a. The software should be amortized over a three year period.

b. The determination of the amortization period should consider obsolescence.

c. Amortization should begin when the software is placed into service.

d. The software should be amortized as a whole, not as individual modules.

16. For internal�use software, external costs for unspecified upgrades and enhancements incurred underagreements should be:

a. Expensed as incurred.

b. Expensed on a straight�line basis over the contract period.

c. Capitalized or expensed.

d. Capitalized and amortized.

17. Austin Company signed a three�year operating lease agreement with Houston Company. The lessor offeredAustin a rent free period of the first nine months. For the remaining months of the lease, Austin's monthly rentwill be $4,000. How much rent expense will Austin recognize in month sixteen?

a. $0.

b. $2,000.

c. $3,000.

d. $4,000.


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18. Assume the same facts as in the previous example. What will be the accrued liability on Austin's books at theend of the thirty�fifth month of the operating lease?

a. $0.

b. $1,000.

c. $4,000.

d. $27,000.

19. Fantasy Cakes signed a two�year operating lease agreement with Space Company. The rent for months onethrough nine is $450 each month. In month ten, the rent will increase to $550 and remain at that level throughthe remainder of the lease period. How much rent expense will Fantasy Cakes recognize in month nine?

a. $450.

b. $500.

c. $513.

d. $550.

20. According to FASB ASC 840�20�25�10 and 25�11 (formerly FSP No. FAS 13�1, �Accounting for Rental CostsIncurred during a Construction Period"), how should rental costs related to building operating leases beaccounted for during the construction period?

a. Expensed as incurred.

b. Capitalized.

c. Allocated over the term of the lease.

d. Deferred.

21. Noncancelable operating leases with lease terms in excess of what period require disclosures?

a. One year.

b. Two years.

c. Three years.

d. Five years.

22. Which of the following direct�response advertising costs is not capitalized?

a. Third�party artwork.

b. Third�party written advertising copy.

c. Directly associated payroll costs.

d. Rent.


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Lesson 3:�Income Tax Accounting

INTRODUCTION

FASB ASC 740 (formerly SFAS No. 109, Accounting for Income Taxes) provides requirements for accounting forincome taxes in annual financial statements. It is a comprehensive standard that provides the principal guidance onall aspects of accounting for income taxes including the following:

a. Calculating deferred tax assets and liabilities

b. Classifying deferred tax assets and liabilities in the balance sheet

c. Presenting income tax expense in the income statement

d. Disclosing information about income taxes

e. Recognizing the effects of operating loss carrybacks and carryforwards

f. Accounting for changes in tax rates

g. Accounting for changes in a company's tax status

FASB ASC 740�10 (formerly FIN 48, �Accounting for Uncertainty in Income Taxes"), was issued in June 2006 as aninterpretation of FASB ASC 740 (formerly SFAS No. 109). The Interpretation provides guidance on accounting foruncertainty in incomes taxes recognized in accordance with the standard.



� Identity issues related to accounting for income taxes.

� Calculate various income tax amounts, including deferred taxes, loss carryforwards, and others.

Overview of the Rules

The standards on accounting for and reporting on income taxes on the balance sheet and on calculating deferredtax assets and liabilities. Under the asset and liability approach, the tax effects of transactions are reported in theyear that the underlying transactions are recorded in the financial statements, but the tax effects are based on taxrates expected to be in effect in the period that the differences reverse. Changes in tax rates are recognized in theperiod that they are enacted (i.e., signed into law by the President). Deferred income tax provisions are thedifferences between deferred tax balance sheet accounts from period to period. The basic calculation of incometaxes consists of the following elements:

a. Calculate the current tax provision for the period. (The current tax provision is the amount expected to bereported on the tax return. The current income tax expense or benefit represents the income taxes payableor refundable for the year determined by applying the provisions of enacted tax law to taxable income.)

b. Calculate the deferred tax effects at the end of the period of (1) differences between transactions recordedin the financial statements and those recorded in the tax return and (2) operating loss and tax creditcarryforwards.

c. Provide a valuation allowance for the portion of deferred tax assets for which there is not more than a 50%chance of realization.

d. Subtract the deferred tax asset and liability at the beginning of the year from the amounts at the end of theyear in steps b. and c.

e. Total the amounts calculated in steps a. and d. to obtain the total tax provision or benefit for the year.


264

Differences between Financial and Income Tax Reporting

Permanent Differences. Not all differences between financial and income tax reporting are included in calculatingincome taxes as outlined in the preceding paragraph. Some differences have no tax consequences and accoun�tants sometimes use the term permanent differences to describe income and expenses that are reported in thefinancial statements but never will be reported in the tax returns. Some common examples are tax�exempt intereston municipal bonds, the dividends received deduction, penalties, and certain premiums on life insurance. AlthoughFASB ASC 740 (formerly SFAS No. 109) retains the concept of permanent differences from earlier authoritativestandards, it does not use that specific term. This course, however, continues to use the term permanent differ�ences to describe differences that have no tax consequences.

Temporary Differences. Temporary differences are differences between financial and income tax reporting thathave future tax consequences. Temporary differences are defined as differences between the financial and taxbasis of assets and liabilities that will result in future taxable or deductible amounts.

The term deductible temporary differences (or deductible differences) is used to refer to temporary differences thatwill result in deferred tax assets. Deductible differences generally represent expenses that have been recognized inthe financial statements but will be deducted in future tax returns, such as a provision for warranty costs. They alsomay represent income recognized in the tax returns but deferred for financial statement reporting, such assubscriptions received in advance. The term deductible reversals refers to reversals of deductible differences.

Term taxable temporary differences (or taxable differences) is used to refer to temporary differences that will resultin deferred tax liabilities. Taxable differences generally represent expenses that have been deducted in the taxreturns but will be expensed in future financial statements, such as depreciation deducted over shorter lives for taxpurposes than permitted by GAAP. They also may represent income recognized in the financial statements that willbe taxable in future tax returns, such as use of the�percentage�of�completion method of accounting by a smallcontractor for financial reporting and the completed�contract method for tax reporting. The term taxable reversals

refers to reversals of taxable differences.

Which Rates to Use

Deferred taxes are calculated using tax rates that are expected to be in effect when temporary differences reverse.Companies are required to consider sources of future taxable income other than reversals of temporary differenceswhen calculating deferred taxes. Thus, the rate used to measure deferred taxes is the rate that is expected to applyto estimated taxable income (which includes reversing temporary differences) in the period that the temporarydifferences are expected to reverse. Under current federal tax law, corporations with taxable income between$335,000 and $10,000,000 are taxed at a flat rate of 34%. Personal service corporations and corporations withtaxable income over $18,333,333 are taxed at a flat rate of 35%. Other corporations are subject to a graduated ratestructure that imposes rates ranging from 15% to 39% on various levels of taxable income. Companies are requiredto measure deferred federal taxes using the flat tax rate (currently 34% or 35%) unless: (a) the effect of thegraduated rate structure is significant or (b) special rates apply to the temporary difference. Since the 34% tax rateapplies to taxable income between $335,000 and $10,000,000, the highest flat tax rate that many corporations willbe subject to is 34%. In that instance, it is recommended that corporations base deferred tax calculations on the34% flat tax rate (unless a significantly lower average graduated tax rate applies or special rates apply to thetemporary difference).

Companies need only consider tax rates under the regular tax system. It is not necessary to consider temporarydifferences under the alternative minimum tax system or to calculate the effects of the alternative minimum taxsystem on the annual reversals.

Selecting a Tax Rate When Graduated Rates Are a Significant Factor. In some situations, using a flat rate tomeasure deferred taxes may produce significantly different results than if graduated tax rates had been used. Inthose situations, deferred taxes should be computed using the average tax rate applicable to taxable income of theyear in which the temporary difference is expected to reverse. The average graduated tax rate is calculated bydividing the tax on taxable income by taxable income. To illustrate, assume that a company expects taxable incomein year 2 to be $100,000. Under currently enacted tax laws, the first $50,000 of that income will be taxed at 15%, thenext $25,000 will be taxed at 25%, and the next $25,000 will be taxed at 34%. Thus, the company expects to pay


265

taxes of $22,250 in year 2. The expected average graduated tax rate is 22.25% ($22,250 � $100,000). Thefollowing are the average graduated tax rates for various levels of income based on current federal tax laws:

TaxableIncome Tax

AverageGraduatedTax Rate

$ 50,000 $ 7,500 15 %

75,000 13,750 18

100,000 22,250 22

125,000 32,000 26

150,000 41,750 28

200,000 61,250 31

250,000 80,750 32

335,000 113,900 34

Different average graduated tax rates may apply in different years. Should a different average graduated tax rate becomputed for each year in which temporary differences are expected to reverse? In most cases, no. Because thecalculation is based on expected taxable income, which is no more than an estimate, FASB ASC 740�10�55�138(formerly SFAS No. 109, Paragraph 236), states that determining a different average graduated tax rate for eachfuture year in the reversal period is usually not necessary. In most cases, using a single average graduated tax ratebased on average estimated annual taxable income during the reversal period will provide sufficient precision.

For companies with expected future taxable income of $10 million or less, it is believed that the effect of the currentfederal graduated rate structure could potentially be significant if future taxable income is expected to be under$150,000 (depending on the magnitude of temporary differences and carryforwards). The maximum effect of usinga flat tax rate of 34% instead of an average graduated tax rate would be to overstate the deferred tax asset or liabilityby 19% of the related temporary difference or carryforward (the flat tax rate of 34% less the lowest graduated taxrate of 15%). In other words, if a deferred tax asset were measured using a 34% rate instead of a 15% rate, thedeferred tax asset would be overstated by 56% (19% divided by 34%). The following table illustrates the effect of thepotential overstatement on pretax financial income of $50,000 for various changes in temporary differences:

Change inTemporaryDifference

19%Overstate�

mentPercentageof Income

$ 5,000 $ 950 1.9 %

10,000 1,900 3.8

20,000 3,800 7.6

30,000 5,700 11.4

40,000 7,600 15.2

50,000 9,500 19.0

The effect of using a 34% tax rate instead of an average graduated tax rate based on the current federal graduatedrate structure is believed to generally not be significant if future taxable income is expected to be between $150,000and $10 million. In that situation, the maximum effect of using the flat 34% tax rate instead of an average graduatedtax rate would be to overstate the deferred tax asset or liability by 6% of the related temporary difference orcarryforward (the flat tax rate of 34% less the average graduated tax rate of 28% for taxable income of $150,000).Such an overstatement is normally acceptable for the following reasons:

� Overstating the deferred tax asset or liability by 6% of the related temporary difference or carryforward isnot likely to be significant to the balance sheet, particularly considering the subjective nature of theestimate.

� Consistent use of the flat tax rate instead of an average graduated tax rate is not likely to have a significanteffect on the statements of income or cash flows.


266

If future taxable income is expected to exceed $10 million, the effect of using a flat tax rate of 35% instead of anaverage graduated tax rate generally will be insignificant.

Selecting a Tax Rate When Special Rates Apply. Certain types of taxable income may be taxed at different rates.For example, prior to the Tax Reform Act of 1986, federal tax law imposed a maximum tax rate of 28% on excess netlong�term capital gains. Currently, the federal regular tax system for domestic corporations does not impose anyspecial tax rates. Some tax jurisdictions may, however, and federal tax law may be changed to impose such ratesin the future. If special tax rates apply and they differ significantly from the regular tax rate, companies shouldmeasure the deferred tax effect of temporary differences that will not be taxed as ordinary income using the specialrates.

In addition, enacted rate changes are used in the calculation, but other rate changes are not, regardless of theirprobability. Tax rate changes are considered to be enacted when the President signs the underlying law. Forexample, the Job Creation and Worker Assistance Act of 2002 was signed by the President on March 9, 2002.Although the Act changed tax rates effective January 1, 2002, only deferred tax calculations in balance sheets as ofMarch 9, 2002, or later should have been based on the new tax rates. Balance sheets prior to March 9, 2002, shouldhave reflected deferred tax calculations based on the tax rates that were in effect at the balance sheet date.

Calculating the Deferred Tax Provision

The deferred tax provision is the change between the deferred tax asset or liability during the period. The deferredtax asset or liability is calculated by determining the deductible and taxable temporary differences at the balancesheet date and calculating the deferred tax effect. A tax liability always should be recognized for taxable temporarydifferences. A tax asset for deductible reversals should be reduced by a valuation allowance if it is more likely thannot that all or a portion of the asset will not be realized.

The steps in calculating the deferred tax provision are as follows:

a. Identify the taxable and deductible temporary differences and loss carryforwards available for tax reportingat the end of the year.

b. Calculate the deferred tax liability by multiplying total taxable differences by the applicable tax rate.

c. Calculate the deferred tax asset by multiplying total deductible differences and loss carryforwards by theapplicable tax rate.

d. Identify tax credit carryforwards available for tax reporting at the end of the year and record a deferred taxasset for the total carryforwards.

e. Provide a valuation allowance for the portion of the deferred tax asset for which there is not more than a50% chance that the benefit of the deductible differences and carryforwards of losses and tax credits willbe realized.

f. Subtract the net deferred tax asset or liability at the end of the year from the net amount at the beginningof the year to determine the deferred tax benefit or expense for the year. The net deferred tax asset or liabilityis the difference between the deferred tax liability and the deferred tax asset net of the related valuationallowance.

Each of the preceding steps is discussed in the remainder of this section.

Illustrations of the Basic Calculation

The four illustrations presented below show how to calculate deferred taxes under the following scenarios:

a. Illustration 1 uses a flat tax rate of 34% to calculate deferred taxes when there are taxable or deductibletemporary differences.


267

b. Illustration 2 uses a flat tax rate of 34% to calculate deferred taxes when there are both deductible andtaxable temporary differences.

c. Illustration 3 uses a flat tax rate of 34% to calculate deferred taxes when there is an enacted tax rate increase.

d. Illustration 4 uses an average graduated tax rate to calculate deferred taxes.

All of the illustrations assume that there are no operating loss or tax credit carryforwards.

Illustration 1Using a Flat Tax Rate of 34% to Calculate Deferred Taxes When There Are Taxable TemporaryDifferences or Deductible Temporary Differences. To illustrate, assume the following facts:

a. At the end of 20X0, a company had taxable temporary differences of $40,000 and recorded a deferred taxliability of $13,600 based on a flat tax rate of 34% ($40,000 � 34% = $13,600).

b. During 20X1, the taxable temporary differences increased by $50,000 to $90,000.

c. Based on taxable income expected in future years, the effect of the graduated tax rates is not consideredsignificant. There are no enacted changes to the 34% tax rate.

The deferred tax liability at the end of 20X1 would be $30,600 ($90,000 � 34%). The deferred tax expense for 20X1would be calculated as follows:

Ending deferred tax liability $ 30,600

Beginning deferred tax liability 13,600

Deferred tax expense $ 17,000

If the assumptions in this illustration were the same except that the temporary differences were deductible ratherthan taxable temporary differences, the calculation would be the same except that the deferred tax liabilities wouldbe deferred tax assets and the deferred tax expense would be a deferred tax benefit. The deferred tax assets wouldbe reduced, if necessary, by a valuation allowance as explained later in this lesson.

Illustration 2Using a Flat Tax Rate of 34% to Calculate Deferred Taxes When There Are Both Deductible andTaxable Temporary Differences. To illustrate, assume the following facts:

a. At the end of 20X0 and 20X1, a company has deductible and taxable temporary differences as follows:

20X0 20X1

Deductible $ 40,000 $ 60,000

Taxable 55,000 70,000

b. At the end of 20X0, deferred tax liabilities amount to $18,700 (taxable temporary differences of $55,000 �34%) and deferred tax assets total $13,600 (deductible temporary differences of $40,000 � 34%). Avaluation allowance was not considered necessary for the deferred tax assets. The company recorded anet deferred tax liability of $5,100 (deferred tax liabilities of $18,700 � deferred tax assets of $13,600).

c. Based on pretax income in previous years and the amount expected in future years, the effect of thegraduated tax rates is not considered significant. There are no enacted changes to the 34% tax rate.

Deferred tax liabilities and assets at the end of 20X1 would be calculated as follows (assuming that a valuationallowance is not considered necessary for the deferred tax assets):

Deferred tax liability ($70,000 � 34%) $ 23,800

Deferred tax asset ($60,000 � 34%) 20,400

Net deferred tax liability $ 3,400


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The deferred tax benefit for 20X1 would be as follows:



Deferred tax expense $ (1,700 )

Illustration 3Using a Flat Tax Rate of 34% to Calculate Deferred Taxes When There Is an Enacted Tax RateIncrease. If currently enacted tax law requires changes in future tax rates, companies will need a knowledge ofwhen temporary differences will reverse. Thus, companies will need to estimate the reversals of temporary differ�ences to some extent. The amount of scheduling can be reduced by using estimates or aggregate calculations.Companies may group several years together and, thus, schedule reversals based on only a few periods (forexample, the period before the rate change and the period after the rate change).

To illustrate, assume the same facts as in Illustration 1 except that during 20X1, tax rate changes were enacted thatincreased tax rates to 37% for 20X2 and to 40% for 20X3 and thereafter. Assume the taxable temporary differencestotaling $90,000 are expected to reverse $50,000 in 20X2 and $40,000 in 20X3.

As discussed previously, enacted future tax rates are used to calculate deferred taxes. Based on the assumed facts,the deferred tax liability at the end of 20X1 would be calculated as follows:

Temporary Differences

Expected ToReverse in Amount Tax Rate

DeferredTax Liability

20X2 $ 50,000 37% $ 18,500

20X3 $ 40,000 40% $ 16,000

$ 34,500

The deferred tax expense for 20X1 would be determined as follows:



Deferred tax expense $ 20,900

Illustration 4Using an Average Graduated Tax Rate to Calculate Deferred Taxes. The preceding illustrationshave each assumed the use of a flat tax rate. That not only simplified the illustrations but also reflects the belief thatflat tax rates will often be used. However, an average graduated rate may be used in some situations, and thefollowing illustrates how deferred taxes would be calculated assuming the following facts:

a. At the end of 20X0, a company recorded a deferred tax liability of $3,300.

b. At the end of 20X1, the company has deductible and taxable temporary differences as follows:

20X1

Deductible $ 60,000

Taxable 70,000


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c. Enacted tax rates at the end of 20X1 are as follows:

Taxable Income Tax

First $50,000 15% of taxable income

$50,001 to $75,000 $7,500 plus 25% of the amount over $50,000



Over $335,000 34% of taxable income

d. Taxable income for 20X0 and 20X1 is $100,000 and $110,000, respectively. It is expected that income willremain at approximately that level throughout the reversal period of the temporary differences. Nosignificant income at special tax rates (such as the capital gain rate in effect prior to the Tax Reform Act of1986) is expected.

The average graduated tax rate would be calculated as follows:

Tax on $110,000 [($110,000�$100,000) � 39% + $22,250] $ 26,150

Average graduated tax rate ($26,150 � $110,000) 24 %

The deferred tax liability at the end of 20X1 would be calculated as follows (assuming that a valuation allowance isnot considered necessary for the deferred tax assets):

Deferred tax liability ($70,000 � 24%) $ 16,800

Deferred tax asset ($60,000 � 24%) 14,400

Net deferred tax liability $ 2,400

The deferred tax benefit for 20X1 would be determined as follows:



Deferred tax benefit $ (900 )

Accounting for Loss Carryforwards

GAAP requires a deferred tax asset to always be recognized for the tax benefits of loss carryforwards, but it alsorequires a valuation allowance to be provided if it is more likely than not that all or a portion of the deferred tax assetwill not be realized. Furthermore, only loss carryforwards available for income tax purposes are considered. Thus,the necessary information can be easily obtained from the income tax returns or from tax files. There is no need fora separate calculation to convert that information to carryforwards for financial reporting.

To illustrate accounting for operating loss carryforwards assume the following:

a. A company has a net operating loss carryforward for tax purposes of $25,000.

b. The company has determined that a flat tax rate of 34% will be used to compute deferred taxes.

A deferred tax asset for the operating loss carryforward in the amount of $8,500 ($25,000 � 34%) would berecorded. Evaluating the need for a valuation allowance is discussed later in this lesson.

The Alternative Minimum Tax System

Perhaps the most significant provision of the Tax Reform Act of 1986 is the corporate alternative minimum tax rules,which were conceived to ensure that all companies pay at least a minimum amount of tax. Under the rules, a


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company's tax liability is the greater of taxes calculated using either the regular tax system or the alternativeminimum tax system. In reality, the AMT rules are structured so that many companies calculate two tax amounts:one based on the regular tax rules and a tentative minimum tax (TMT) based on the AMT rules. If the TMT exceedsthe regular tax, an additional tax equal to the excess, referred to as the alternative minimum tax (AMT), also must bepaid.

For tax years beginning after 1997, certain �small corporations" are exempt from AMT if their three�year averageannual gross receipts do not exceed $5 million for the first tax year beginning after 1996 and do not exceed $7.5million for later tax years. Corporations that qualify for the AMT exemption for tax years beginning in 1998 remainexempt from AMT as long as their average gross receipts for the preceding three years do not exceed $7.5 million.Corporations that initially qualify for the small corporation exemption from AMT but subsequently fail the $7.5million average gross receipts test become subject to AMT on a prospective basis (for certain AMT preferences andadjustments relating to transactions occurring in and after the year the corporation fails the test). A new corporationreceives an automatic AMT exemption, regardless of its receipts, in its first year of existence. The corporationremains exempt in its second year if gross receipts for the first year do not exceed $5 million (on an annualizedbasis, if the first year was less than 12 months). The corporation remains exempt in its third year if average grossreceipts for the first two years do not exceed $7.5 million (after annualizing the first year's receipts, if necessary).The corporation remains exempt from AMT in subsequent years as long as its average gross receipts for the threeprior years do not exceed $7.5 million (after any necessary annualizing). Once a corporation ceases to qualify forthe exemption, the exemption cannot be regained in a future year.

Income taxable under the AMT system is referred to as AMT income (or AMTI). It consists of taxable incomeadjusted as follows:

a. Items designated as preference items are added to taxable income in determining AMTI. The items that arecurrently designated as preference items include percentage depletion, intangible drilling costs,tax�exempt interest on certain private activity bonds, charitable contributions of certain appreciated capitalgain property, and accelerated depreciation on certain property placed in service before 1987.

b. Items designated as adjustments are either added to or subtracted from taxable income in determiningAMTI. The items that are currently designated as adjustments include methods used to account forlong�term contracts other than the percentage�of�completion method, adjusted gain or loss ondispositions, alternative tax net operating loss deductions, mining exploration and development costs,amortization of certified pollution control facilities, merchant marine capital construction funds, specialdeductions for Blue Cross/Blue Shield organizations, and alcohol fuel credits. In addition, the AMT systemimposes a depreciation method that adjusts depreciation for purposes of calculating AMTI.

For property placed in service after December 31, 1998, the Taxpayer Relief Act of 1997 repealed the AMTdepreciation adjustment resulting from the use of ADS recovery periods. In addition, the Internal Revenue ServiceRestructuring and Reform Act of 1998 allows taxpayers the option of completely eliminating the AMT depreciationadjustment by electing the 150% declining balance method (using regular tax depreciation lives) on propertyotherwise eligible for the 200% declining balance method. The AMT depreciation adjustment must continue to bemade for property placed in service on or before December 31, 1998, for as long as the property is owned.

ACE Adjustment. For tax years beginning in 1990, taxable income also is increased or decreased by an adjust�ment for adjusted current earnings (ACE adjustment). The ACE adjustment increases or decreases AMTI by 75% ofthe difference between ACE and AMTI (computed without regard to NOL deductions and the ACE adjustmentitself). The ACE adjustment may not decrease AMTI by more than the net cumulative amount by which it hasincreased AMTI in prior years, however.

The AMT rate (currently 20%) is applied to the excess of the AMTI over a prescribed exemption to determine theAMT. The exemption is $40,000, but it is phased out so that there is no exemption when AMTI is $310,000 or more.The phaseout is accomplished by reducing the exemption by 25% of the excess of AMTI over $150,000. Toillustrate, assume that AMTI is $200,000, which exceeds the $150,000 starting point for the phaseout by $50,000.Accordingly, the exemption is reduced by $12,500 (or 25% of the $50,000 excess) and would equal $27,500($40,000 less $12,500). The AMT rate would be applied to the $172,500 excess of AMTI over the availableexemption (or $200,000 less $27,500), and the AMT would be $34,500 (or $172,500 � 20%).


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With certain limitations, an excess of AMT over regular tax may be carried forward indefinitely to offset the excessof the regular tax over the AMT in future years. It may never reduce the tax for a year below the AMT, however. Thecarryforward is referred to as the AMT credit. There are no limits on the amount of excess AMT that can be carriedforward as a credit for tax years beginning after 1989. However, the Taxpayer Relief Act of 1997 requires �smallcorporations" that are exempt from AMT for tax years beginning after December 31, 1997, to reduce the regular taxby 25% of the amount over $25,000 when calculating how much of the AMT credit carryforward related to prioryears may be used.

Determining Deferred Taxes under the AMT System. The current income tax provision should be the higher ofincome taxes determined under the regular and AMT systems. Deferred taxes, however, should only be computedusing tax rates and temporary differences determined under the regular tax system; tax rates and temporarydifferences under the AMT system should not be considered. However, similar to other types of tax credit carryfor�wards, deferred tax assets should be recorded for the tax benefits attributable to the AMT credit carryforwards. Thedeferred tax asset should be reduced by a valuation allowance if it is more likely than not that some portion or all ofthe asset will not be realized.


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SELF�STUDY QUIZ


23. Frilly Girlz Boutique is depreciating select assets over a shorter time frame for tax purposes than permitted byGAAP. What type of a difference will the boutique have between financial and income tax reporting?

a. A permanent difference.

b. A deductible temporary difference.

c. A taxable temporary difference.

d. A deductible reversal.

24. What should companies consider when calculating deferred taxes under SFAS No. 109, Accounting for Income

Taxes?

a. Tax rates under the regular tax system.

b. Tax rates under the regular tax system and temporary differences under the alternative minimum taxsystem.

c. Tax rates under the regular tax system and the effects of the alternative minimum tax system on the annualreversals.

25. Pet Couture is subject to a flat tax rate of 34%, has taxable temporary differences of $120,000, and deductibletemporary differences of $50,000. A valuation allowance is not considered necessary. How much is the netdeferred tax liability?

a. $17,000.

b. $23,800.

c. $40,800.

d. $50,000.

26. Busy Bees Service Company is subject to a flat tax rate of 34%, has miscellaneous taxable temporarydifferences of $20,000, and deductible temporary differences of $5,000. In addition, Busy Bees has a netoperating loss carryforward for tax purposes of $7,000. The company believes that all of the deferred tax assetwill be realized. Therefore, a valuation allowance is not considered necessary. How much is the net deferredtax liability?

a. $1,700.

b. $2,380.

c. $2,720.

d. $6,800.


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23. Frilly Girlz Boutique is depreciating select assets over a shorter time frame for tax purposes than permitted byGAAP. What type of a difference will the boutique have between financial and income tax reporting? (Page 264)

a. A permanent difference. [This answer is incorrect. Permanent differences refer to income and expensesthat are reported in the financial statements but will never be reported in the tax return. An example of apermanent difference is federal income tax. FIT is reported as an expense in the financial statements butis never recorded as an expense on the federal tax return.]

b. A deductible temporary difference. [This answer is incorrect. Deductible temporary differences areexpenses that have been recognized in the financial statements but will be deducted in future tax returnsor income recognized in the tax returns but deferred for financial statement reporting.]

c. A taxable temporary difference. [This answer is correct. Taxable temporary differences generallyrepresent expenses that have been deducted in the tax returns but will be expensed in futurefinancial statements or income recognized in the financial statements that will be taxable in futuretax returns.]

d. A deductible reversal. [This answer is incorrect. Deductible reversals refer to reversals of deductibledifferences.]

24. What should companies consider when calculating deferred taxes? (Page 264)

a. Tax rates under the regular tax system. [This answer is correct. Companies need only consider taxrates under the regular tax system per FASB ASC 740 (formerly SFAS No. 109).]

b. Tax rates under the regular tax system and temporary differences under the alternative minimum taxsystem. [This answer is incorrect. Temporary differences under the alternative minimum tax system are notrequired to be considered when calculating temporary differences. However, deferred tax assets shouldbe recorded for the tax benefits attributable to any AMT credit carryforwards.]

c. Tax rates under the regular tax system and the effects of the alternative minimum tax system on the annualreversals. [This answer is incorrect. The effects of the alternative minimum tax system on the annualreversals are not required to be considered when calculating temporary differences. However, anydeferred tax asset that has been recorded with benefits attributable to AMT credit carryforwards should bereduced by a valuation allowance if it is more likely than not that some portion or all of the asset will notbe realized.]

25. Pet Couture is subject to a flat tax rate of 34%, has taxable temporary differences of $120,000, and deductibletemporary differences of $50,000. A valuation allowance is not considered necessary. How much is the netdeferred tax liability? (Page 267)

a. $17,000. [This answer is incorrect. This amount is the deferred tax asset ($50,000 � 34%).]

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

c. $40,800. [This answer is incorrect. This amount is the deferred tax liability ($120,000 � 34%).]

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


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26. Busy Bees Service Company is subject to a flat tax rate of 34%, has miscellaneous taxable temporarydifferences of $20,000, and deductible temporary differences of $5,000. In addition, Busy Bees has a netoperating loss carryforward for tax purposes of $7,000. The company believes that all of the deferred tax assetwill be realized. Therefore, a valuation allowance is not considered necessary. How much is the net deferredtax liability? (Page 269)

a. $1,700. [This answer is incorrect. This amount is the deferred tax asset ($5,000 � 34%).]

b. $2,380. [This answer is incorrect. This amount is the deferred tax asset for the operating loss carryforward($7,000 � 34%).]

c. $2,720. [This answer is correct. The deferred tax liability from the miscellaneous taxable temporarydifferences is $6,800 ($20,000 � 34%). The deferred tax asset is $1,700 ($5,000 � 34%). Thedeferred tax asset for the operating loss carryforward is $2,380 ($7,000 � 34%). The net of thesenumbers is the net deferred tax liability.]

d. $6,800. [This answer is incorrect. This amount is the deferred tax liability ($20,000 � 34%).]


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Considering the Need for a Deferred Tax Asset Valuation Allowance

The deferred tax asset should be reduced by a valuation allowance if it is more likely than not that all or a portion ofit will not be realized. In other words, a deferred tax asset should only be recognized if there is more than a 50%chance that it will be realized. Whether a deferred tax asset will be realized requires considerable judgment.Companies should weigh the potential effects of both positive and negative evidence. If negative evidence exists,it may be difficult to conclude that a valuation allowance is not needed for at least a portion of the deferred tax asset.The existence of negative evidence does not always indicate that a valuation allowance is needed, however. Insome cases, positive evidence may exist that outweighs the negative evidence, and a conclusion can be reachedthat a valuation allowance is not necessary. FASB ASC 740�10�30�21 and 30�22 (formerly SFAS No. 109, Para�graphs 23�24), lists the following examples of negative and positive evidence that should be considered (the list isnot all�inclusive):

Negative evidence

� Cumulative losses in recent years

� A history of operating loss or tax credit carryforwards expiring unused

� Losses expected in early future years by a presently profitable entity

� Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profitlevels on a continuing basis in future years

� A carryback, carryforward period that is so brief that it would limit realization of tax benefits if (a) a significantdeductible temporary difference is expected to reverse in a single year or (b) the enterprise operates in atraditionally cyclical business

Positive evidence

� Existing contracts or firm sales backlog that will produce more than enough taxable income to realize thedeferred tax asset based on existing sales prices and cost structures

� An excess of appreciated asset value over the tax basis of the entity's net assets in an amount sufficientto realize the deferred tax asset

� A strong earnings history exclusive of the loss that created the future deductible amount (tax losscarryforward or deductible temporary difference) coupled with evidence indicating that the loss (forexample, an unusual, infrequent, or extraordinary item) is an aberration rather than a continuing condition

Whether a deferred tax asset will be realized ultimately depends on whether there will be sufficient taxable incomeavailable during the carryback, carryforward period available under the tax law. FASB ASC 740�10�30�18 (formerlySFAS No.�109) lists the following sources of taxable income that should be considered when determining the needfor a valuation allowance:

a. Future reversals of existing taxable temporary differences

b. Future taxable income exclusive of reversing temporary differences and carryforwards

c. Taxable income in prior carryback years if carryback is permitted under the tax law

d. Tax�planning strategies

The following paragraphs provide guidance for estimating future taxable income from each of the four sources.

Estimating Future Reversals of Existing Taxable Temporary Differences. Companies may conclude that all ora portion of their deferred tax assets will be realized if future reversals of existing deductible differences can be


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offset by future reversals of existing taxable differences. In some cases, considering future reversals of taxabledifferences may be the easiest way to determine that no valuation allowance is needed. For example, assume thata company has a $20,000 taxable temporary difference at the end of 20X1 that is expected to reverse in evenamounts over the next four years. The company also has a $15,000 deductible temporary difference that isexpected to reverse in 20X3. A valuation allowance would not be necessary since the reversal of the deductibletemporary difference will be offset by reversals of existing taxable temporary differences through carryback andcarryforward provisions under the tax law.

When considering future reversals of taxable differences, it may be necessary to schedule the reversals (that is,identify the future years in which each temporary difference is expected to reverse) to some extent. The amount ofscheduling, however, will depend on the facts and circumstances of each case. It is believed that scheduling oftenwill not be necessary, or the amount of scheduling can often be reduced by using estimates or approximatecalculations. For example, in the preceding paragraph, it is apparent, without scheduling, that the reversal of thedeductible temporary differences will be offset by reversal of existing taxable temporary differences within thecarryback, carryforward period available under the tax law.

Deductible differences can only be offset by taxable differences of the appropriate character. For example, undercurrent federal tax laws, capital losses may only be deducted if they offset capital gains. Thus, the tax effects of anexisting deductible difference related to unrealized capital losses will not be realized if the only source of futuretaxable income is reversals of existing taxable differences that will produce ordinary income.

Considering Future Taxable Income. Companies may conclude that no deferred tax valuation allowance isneeded if there is more than a 50% probability that future taxable income will be sufficient to realize the deferred taxasset. For example, assume (a) a company has recorded a $10,000 deferred tax asset for a tax credit carryforwardthat will expire in 10 years, (b) the company expects its taxable income next year to be approximately $50,000, and(c) the currently enacted tax rate that is expected to be in effect next year is 34%. Based on those assumptions, thecompany's expected income tax before using the tax credit carryforward is $17,000 ($50,000 � 34%). Thus, thecompany expects sufficient taxable income next year to realize its $10,000 tax credit carryforward and a deferredtax valuation allowance is not necessary.

One source of future taxable income that should be considered when determining whether a valuation allowanceis necessary is future taxable income exclusive of reversals of existing temporary differences. Reversals of existingtemporary differences are implicit in estimates of future taxable income, however. Taxable income consists of GAAPincome adjusted for permanent differences and originating temporary differences and reversing temporary differ�ences. Thus, to conclude that no valuation allowance is needed for deductible temporary differences, companiesneed only determine that there is more than a 50% chance that taxable income will exist in the year that thedeductible differences are expected to reverse. The fact that taxable income is expected to exist in that yearindicates that the deductible reversals will be offset by other sources of taxable income.

Future taxable income does not include the effects of operating loss or tax credit carryforwards, however. Therefore,when considering the need for a valuation allowance for those items, the mere existence of taxable income duringthe carryforward period does not indicate that a valuation allowance is not needed. In those cases, companies mustdetermine that there is more than a 50% chance that future taxable income will be sufficient to absorb the losscarryforward or that taxes on future taxable income will be sufficient to offset the tax credit carryforward.

When determining whether a valuation allowance is needed, companies should consider not only whether suffi�cient future taxable income will exist but whether the appropriate character of taxable income will exist. Forexample, assume the following:

a. Current federal income tax law allows corporations to deduct capital losses only if they offset capital gains.Unused capital losses may be carried back three years and carried forward five years.

b. At the end of 20X4, a company has a $15,000 deductible difference related to an unrealized loss onmarketable securities.


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c. The company expects to realize the loss in 20X5; however, no capital gains are expected in that year. Thus,the company will be able to carry back the capital loss three years (20X2�20X4) and carry forward anyremaining capital loss five years (20X6�20Y0).

d. The company's taxable income during 20X3�20X4 totaled $85,000. None of that taxable income resultedfrom capital gains.

e. The company expects approximately $35,000 of taxable income each year during the next six years. Thecompany expects that $5,000 of the 20X6 taxable income will result from capital gains.

f. The currently enacted tax rate is 34%.

In this example, taxable income during the carryback, carryforward period is expected to total $295,000. Only$5,000 of that taxable income will result from capital gains, however. Therefore, only $5,000 of the $15,000deductible difference will be deducted on the company's tax returns. A valuation allowance of $3,400 [($15,000 �$5,000) � 34%] is needed at the end of 20X4.

Taxable Income in Prior Carryback Years. Many tax jurisdictions allow unused losses and deductions to becarried back to offset taxable income of prior tax years. For example, current federal tax law allows most companiesto carry back operating losses two years. To the extent that carrybacks are allowed by tax law, taxable income inprior carryback years may be considered when determining the need for a valuation allowance.

The carryback period is measured from the year that the deductible difference reverses, not originates. Forexample, in the illustration in item c. listed previously, the deductible difference originated in 20X4 but was expectedto reverse in 20X5. Thus, the deduction was carried back beginning with the third year preceding 20X5, not 20X4.

Tax�planning Strategies. Tax�planning strategies are required to be considered only when determining the amountof the deferred tax asset valuation allowance, not when otherwise calculating deferred tax assets or liabilities.Tax�planning strategies must meet the following three criteria to be considered qualifying strategies:

� The Strategy Must Be Prudent and Feasible. A strategy is prudent and feasible if management has the abilityto implement the strategy and expects to do so if necessary in future years. For example, the sale of an assetthat is essential to operations would not be prudent because the asset would need to be replaced; but astrategy to sell the asset and lease it back may be considered prudent. The strategy would only be feasible,however, if the company is likely to find a party that would enter into the sale�leaseback transaction. Theoverriding consideration is that management is able to apply and intends to apply the strategy unlessconditions change.

� The Strategy Is One That Management Ordinarily Might Not Take, But Would Take to Prevent an Operating

Loss or Tax Credit Carryforward from Expiring Unused. Thus, management must actually intend toimplement the strategy if necessary to realize the tax benefits of operating loss or tax credit carryforwards.For example, a company that uses accelerated depreciation methods for tax reporting may decide to usethe straight�line method for future acquisitions if the additional income from reduced depreciation wouldenable the company to use a loss carryforward.

� The Strategy Would Result in the Realization of Deferred Tax Assets. Tax�planning strategies are onlyconsidered when determining the need for a deferred tax asset valuation allowance.

Since tax�planning strategies are designed to enable realization of deferred tax benefits, they can be viewed asmethods of increasing future taxable income by (a) changing the tax treatment of recurring transactions or (b)initiating future transactions that will generate taxable income of the appropriate character.

Strategies may involve elections to treat recurring transactions differently, either retroactively or prospectively. Thefollowing are examples of such strategies:

� A strategy to retroactively change from accelerated depreciation methods to straight�line methods wouldaccelerate the reversal of the underlying taxable difference. The additional taxable income would beavailable for the offset of deductible differences or loss carryforwards.


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� Companies may change the tax treatment of recurring future transactions to shift estimated future taxableincome between future years. For example, a company that uses accelerated depreciation methods for taxreporting purposes may elect to begin using straight�line methods for future acquisitions. Such an electionwould reduce future depreciation expense and, as a result, increase future taxable income. Similarly, acompany may elect to terminate its LIFO election so that the cumulative effect of the reserve will generatefuture taxable income. (That strategy would be prudent if the company expects prices to remain stable sothat LIFO will not provide the advantages it provided in earlier years.)

Initiating future transactions to generate taxable income involves selling or reducing an existing asset or liquidatingor reducing an existing liability. Examples include the following:

� Selling investments in securities to generate capital gains so that capital loss carryforwards may be used

� Selling a building that is essential to continuing operations through a sale�leaseback agreement so that thegain on the sale generates taxable income of the appropriate character (i.e., capital gains or ordinaryincome through recapture provisions)

� Retiring long�term debt at a discounted amount to generate ordinary taxable income that will allow a losscarryforward to be used (If long�term interest rates are currently higher than the stated rate of long�termdebt, the lender may be willing to accept early pay�off at a discounted amount. If so, the excess of theoutstanding principal over the settlement amount would be taxed as ordinary income. The strategy wouldonly be feasible if the lender agrees to the early pay�off. It would only be prudent if the company could raisethe required cash to retire the debt without hurting its operations.)

� If trade accounts receivable are sold, the receivable balance may exceed the sales price because ofpotential collection problems. The loss on sale is deductible in the year of the sale. Such a strategyeffectively accelerates the reversal of deductible differences related to bad debts, perhaps to a year withsufficient taxable income to offset the deductible differences.

Several tax�planning strategies may be available to a company that would reduce or eliminate the need for avaluation allowance. For example, assume that using one strategy would reduce a company's valuation allowanceby $4,000, using another would reduce the company's valuation allowance by $9,000, and using both strategieswould reduce the company's valuation allowance by $13,000. In that situation, the company should recognize theeffect of both strategies and reduce the valuation allowance by $13,000. The company may not recognize the effectof one strategy and postpone the effect of the other until a later year.

Since all known tax�planning strategies should be considered, how extensive an effort should management maketo identify all tax�planning strategies? The FASB indicates that companies should make a reasonable effort toidentify all significant tax�planning strategies. The company's obligation to consider tax�planning strategies toreduce the valuation allowance required is the same as its obligation to apply the requirements of other accountingpronouncements. (A�search for tax�planning strategies is not necessary, however, if it can be concluded thattaxable income from other sources will be adequate to eliminate the need for a valuation allowance.)

Considering the Costs of Implementing the Strategies. The valuation allowance should reflect the costs ofimplementing tax�planning strategies. Those costs not only include the direct costs of implementing the strategies,such as legal costs and commissions, but their related tax effects as well (i.e., the tax benefit of the additionalexpenses incurred to implement the strategy). Only costs that would not otherwise be incurred should be consid�ered, and they should be considered net of the tax benefit of their deduction.

To illustrate, assume that a strategy is available to accelerate the reversal of a taxable difference of $12,000,enabling a net operating loss carryforward of $9,000 to be used before it expires. If there are no other sources oftaxable income, a 30% tax rate applies, and costs of $1,500 would be incurred to implement the strategy, deferredtax balance sheet accounts would be as follows: (a) deferred tax liability of $3,600 ($12,000 taxable difference �30%), (b) a deferred tax asset of $2,700 ($9,000 carryforward � 30%), and (c)�a valuation allowance of $1,050(costs of $1,500 less tax benefit of $450 from deducting those costs). In the year the loss carryforward arises, a taxbenefit of $1,650 should be recognized for the excess of the $2,700 asset over the $1,050 allowance. When thestrategy is implemented and the costs are incurred, the�remaining benefit of $1,050 is recognized. In that year, there


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would be a pretax loss of $1,500 equal to the implementation costs incurred and a tax benefit of $1,500 equal to the$450 tax benefit of deducting those costs plus the $1,050 benefit from eliminating the valuation allowance. Thedeferral of a part of the benefit is required although realization of all of it is more likely than not because of thestrategy that accelerates the reversal of existing taxable differences.

Deciding Which Sources of Taxable Income to Consider. FASB ASC 740�10�30�18 (formerly SFAS No. 109,Paragraph 21), states, �To the extent evidence about one or more sources of taxable income is sufficient to supporta conclusion that a valuation allowance is not necessary, other sources need not be considered." Thus, companiesdo not always have to consider each source of future taxable income to determine whether a valuation allowanceis needed. If a valuation allowance is needed, however, all four sources of future taxable income must be consid�ered to determine the amount of the valuation allowance.

The Standard does not establish an order of preference for the four sources of future taxable income. Thus, thesources should be considered in the order that is most efficient. It is believed that taxable income will often be themost efficient source to consider for the following reasons:

a. Taxable income of many small to medium�sized companies remains relatively constant. Thus, estimatingtaxable income in those cases may not be difficult. (When there are significant loss carryforwards that expirein the near future or significant carryforwards that require a certain character of income, however, othersources of future taxable income may also need to be considered.)

b. When determining the need for a valuation allowance, precise estimates of taxable income are not alwaysneeded. For example, assume that a company has a net operating loss carryforward of $100,000 thatexpires in 10�years. To conclude that no valuation allowance is necessary, the company need onlydetermine that there is more than a 50% probability that it will generate taxable income of $100,000 duringthe next 10 years. Precise estimates of the amount of taxable income during each of the next 10 years arenot needed.

c. Future taxable income includes future reversals of existing taxable and deductible differences. Thus, avaluation allowance will not be needed for the tax benefits of deductible differences so long as a taxableloss is not estimated for a year during the reversal period. To illustrate, if a deductible difference of $10,000is expected to reverse next year and break�even operations are expected, a valuation allowance would notbe needed. The deductible reversal would be offset by $10,000 of other sources of taxable income. (Thatdoes not apply when considering the need for a valuation allowance for loss carryforwards, however.)

Because the most efficient approach varies depending on the company and its circumstances, however, there willbe instances in which each of the four sources will be most efficient. In some cases, considering taxable reversalsmay be the easiest and least subjective method of determining whether a valuation allowance is necessary.Reversals of existing temporary differences are implicit in estimates of future taxable income. As a result, consider�ing future taxable income views two of the four sources of future taxable income (i.e., reversals of existing taxabledifferences and future taxable income exclusive of reversals of existing temporary differences) as a single source.Thus, companies should not consider reversals of existing taxable temporary differences in addition to futuretaxable income unless future taxable income specifically excludes those reversals.

Companies may conclude that a valuation allowance is not needed if future reversals of existing deductibledifferences can be offset by future reversals of existing taxable differences. Although some scheduling may berequired to reach that conclusion, detailed scheduling of the reversals of taxable and deductible differences foreach year may not be necessary. Question 2 of the FASB Special Report on FASB ASC 740�10�55�17 (formerlySFAS No. 109) states, �. . . if existing taxable temporary differences that will reverse over a long number of futureyears greatly exceed deductible differences that are expected to reverse over a short number of future years, it maybe appropriate to conclude, in view of a long (for example, 15 years) carryforward period for net operating losses,that realization of future tax benefits for the deductible differences is thereby more likely than not without the needfor scheduling." If deductible reversals exceed taxable reversals, the likelihood of taxable income from othersources should be assessed.

In other cases, considering taxable income in prior carryback years may be the most efficient method of determin�ing whether a valuation allowance is necessary. If the carryback period includes the current year and one or more


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years prior to the current year, the taxable income in carryback years will be based, at least in part, on actual taxableincome. Therefore, considering taxable income in carryback years is less subjective than estimating taxableincome from other sources.

In still other cases, considering tax�planning strategies may be the most efficient method of concluding that novaluation allowance is needed. For example, a company may have tax exempt investment securities. A tax�planningstrategy to sell the assets could result in additional future taxable income that would allow deferred tax assets to berealized.

Considering More Than One Source of Future Taxable Income. In some situations, it may be necessary toconsider more than one source of future taxable income to determine whether a valuation allowance is necessary.To illustrate, assume that a company has a net operating loss carryforward of $200,000 that expires in three years.The loss carryforward arose primarily due to significant losses during the first few years after the company wasformed. Since that time, taxable income has ranged from $25,000 to $50,000. The company expects future taxableincome from the following sources:

� Future Taxable Income (i.e., Reversals of Existing Taxable Differences and Taxable Income Exclusive of

Reversals of Existing Taxable Differences). Based on past trends, the company believes that $100,000 oftaxable income will be generated during the next three years.

� Taxable Income in Prior Carryback Years. The existence of operating loss carryforwards indicate that thereis no available taxable income in prior carryback years. Either (a) the taxable income in prior carrybackyears has already been used to offset the operating loss carryforwards or (b) an election was made toforego carryback and carry the losses forward.

� Tax�planning Strategies. The company has a note receivable from the sale of real estate in a prior year. Thesale is accounted for under the installment method, and gross profit of $50,000 has been deferred.Management would pledge the note for collateral for new debt in an arrangement that would triggerrecognition of all of the deferred taxable income. Costs of implementing the strategy are expected to beinsignificant.

Considering those sources of future taxable income, the loss carryforward would be realized as follows:

Loss carryforward $ 200,000

Sources of future taxable income:

Taxable income during the next three years (100,000 )

Tax�planning strategies:

Gross profit recognized upon sale of note receivable (50,000 )

Unused loss carryforward 50,000

Assumed average tax rate 15 %

Valuation allowance needed $ 7,500

To record the deferred tax benefits of the loss carryforward, the company would record a deferred tax asset of$30,000 ($200,000 � 15%) and a valuation allowance of $7,500.

Income Statement Presentation

Captions. Income tax expense generally is presented as a separate line item in the income statement immediatelypreceding net income (or income before extraordinary items and cumulative accounting adjustments, if applica�ble). Many companies use the caption �Income Taxes," although �Federal Income Taxes" frequently is used if acompany is not subject to taxes of other jurisdictions. Other captions that may be used include the following:

a. Provision for Income Taxes (or Provision for Taxes on Income)


282

b. Taxes on Income (or Taxes on Earnings)

c. Income Tax Expense

d. Federal and State Income Taxes

Captions for income tax benefits are illustrated later in this lesson.

Disclosing Components of Income Tax Expense. FASB ASC 740�10�50�9 (formerly Paragraph 45 of SFAS No.109) requires the following components of income tax expense attributable to continuing operations to be dis�closed either on the face of the financial statements or in the related notes for each period presented:

a. Current tax expense or benefit

b. Deferred income tax expense or benefit, exclusive of any adjustments for the components listed in c.through h.

c. Investment tax credits

d. Government grants (to the extent recognized as a reduction of income tax expense)

e. The benefits of operating loss carryforwards

f. Tax expense that results from allocating certain tax benefits directly to contributed capital.

g. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or for a change ina company's tax status

h. Adjustments of the beginning�of�the�year balance of a valuation allowance because of a change incircumstances that causes a change in judgment about the realizability of the related deferred tax assetin future years. For example, any acquisition�date income tax benefits or expenses recognized fromchanges in the acquirer's valuation allowance for its previously existing deferred tax assets as a result ofa business combination.

Note that the standard only requires the components of income tax expense related to continuing operations to bedisclosed. Thus, total tax expense allocated to items other than continuing operations (for example, extraordinaryitems and discontinued operations) should be disclosed, but the financial statements need not disclose thecomponents of income tax expense allocated to other elements of net income. FASB ASC 220�10�45�12 (formerlySFAS No. 130, Reporting Comprehensive Income), requires disclosure of the income tax expense or benefitallocated to each component of other comprehensive income.


283

If the components of tax expense include only current and deferred taxes or current taxes, deferred taxes, and ITC,some companies disclose the components on the face of the income statement. For example:


INCOME TAXES

Current 98,000

Deferred 30,000

128,000


or


INCOME TAXES

Current, net of investment tax credit of $10,000 34,300

Deferred 12,100

46,400


Note that although the current and deferred components of income tax expense include taxes from all applicabletax jurisdictions (for example, federal, foreign, state, and local), taxes from each jurisdiction typically are not shownseparately on the income statement.

Even though the components of income tax expense are permitted to be disclosed on the face of the incomestatement, many companies show income tax expense as a net amount, as illustrated below, and disclose thecomponents in the notes to the financial statements.


INCOME TAXES 48,500


Net Operating Losses. FASB ASC 740�20�45�3 (formerly Paragraph 37 of SFAS No.109) states that, in mostcircumstances, the tax benefits of loss carryforwards or carrybacks �. . . shall be reported in the same manner as thesource of the income or loss in the current year and not in the same manner as the source of the operating losscarryforward or taxes paid in a prior year or the source of expected future income that will result in realization of adeferred tax asset for an operating loss carryforward from the current year." Thus, tax benefits of operating lossesmay be classified as either (a) a reduction of the current�period income tax expense (or a tax benefit), (b) anextraordinary item, or (c)�an�element of discontinued operations. As a general rule, the tax benefits of a current�yearloss are characterized in the same manner as the loss, regardless of whether the loss is carried back or forward. Forexample, the tax benefits of a loss from continuing operations would be allocated to continuing operations, and thetax benefits of an extraordinary loss would be allocated to the extraordinary item. However, if no tax benefits wererecognized in the current year for a current�year loss because the related deferred tax asset was offset by avaluation allowance, the tax benefits of the loss generally are characterized in the same manner as the income inthe subsequent year that enables the tax benefits of the loss carryforward to be realized. For example, assume thatno tax benefit was recognized in the current year for an extraordinary loss because the related deferred tax assetwas offset by a valuation allowance. If the loss carryforward was realized next year because the company hadincome from continuing operations, the tax benefits would be allocated to continuing operations. (However,adjustments of the beginning�of�the�year balance of a valuation allowance because of a change in circumstancesthat causes a change in judgment about the realizability of the related deferred tax asset ordinarily should beallocated to continuing operations.)


284

For most small businesses, it is believed that realization of tax benefits of both loss carrybacks and loss carryfor�wards generally will be attributable to income from continuing operations, since the criteria for reporting a transac�tion as an extraordinary item are rarely met and discontinued operations are not encountered frequently.Accordingly, the tax benefits of operating losses generally will be shown as a reduction of income tax expense (oras a tax benefit).

Special rules apply to the tax effects of deductible differences and carryforwards related to (a) contributed capital,(b) expenses for employee stock options, (c)�dividends paid on unallocated shares held by an ESOP that arecharged to retained earnings, and (d) deductible differences and carryforwards as of the date of a quasi�reorgani�zation. The tax effects of deductible differences and carryforwards related to items (a) through (d) should becharged or credited directly to other comprehensive income or to the related components of stockholders' equity.

Loss Carrybacks. If operating losses are carried back to earlier periods under provisions of the tax law, theStandard requires an asset to be recognized for the amount of refundable taxes. If there are no temporarydifferences, either in the period of loss or the carryback periods, the claim for refund of income taxes also should bereported as a tax benefit in the statement of income. The following income statement presentation would beappropriate assuming that the tax benefit is attributable to continuing operations:

LOSS BEFORE INCOME TAX BENEFIT (41,500 )

INCOME TAX BENEFIT (8,300 )

NET LOSS $ (33,200 )

If the income statement shows a tax benefit, appropriate captions would include �Income Tax Benefit," �FederalIncome Tax Benefit," and �Federal and State Income Tax Benefit."

If there are temporary differences, either in the period of the loss or the carryback periods, the claim for refund ofincome taxes still should be recognized as the current tax benefit. However, because deferred taxes reported in theincome statement are based on the change in deferred tax assets and liabilities at the beginning and end of theperiod, the income statement might report either a deferred tax benefit or a deferred tax expense. If the total ofcurrent and deferred taxes results in a net tax benefit, reporting the benefit as a single amount is recommended.Similarly, if a net tax expense results, it is believed that the expense should be reported as a single amount using acaption such as �Income Taxes," as illustrated previously. (In either case, the components of income tax expenseshould be disclosed in the notes to the financial statements.) The following presentation, however, also would beacceptable:


INCOME TAXES

Current tax benefit (2,000 )

Deferred tax expense 12,000

10,000

NET INCOME $ 15,000

If the tax loss for the year is carried back and there is an extraordinary loss, the extraordinary item is reported net ofthe related tax benefits as illustrated below.

INCOME BEFORE EXTRAORDINARY ITEM 8,000

EXTRAORDINARY ITEMsettlement of class action customer suit, net ofinsurance proceeds (less applicable income taxes of $9,400) (36,600 )

NET LOSS $ (28,600 )


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Loss Carryforwards. The tax benefit of operating losses that are carried forward should be recognized in theincome statement in the year the losses occur but should be reduced by a valuation allowance when it is more likelythan not that all or a portion of the assets will not be realized. If no valuation allowance is considered necessary, thetax benefits of the loss are characterized the same as the current�year loss. If no tax benefits were recognized in thecurrent year for a current�year loss because the related deferred tax asset was offset by a valuation allowance, thetax benefits of the loss generally are characterized in the same manner as the income in the subsequent year inwhich the tax benefits of the loss carryforward are realized. Thus, for example, FASB ASC 740�10�55�38 (formerlySFAS No. 109, Paragraph 245), indicates that the tax benefit of an operating loss carryforward that (a) is firstrecognized in a company's financial statements during the current year and (b) resulted from an extraordinary lossin a prior year would be allocated to

a. continuing operations if it offsets the current or deferred tax consequences of income from continuingoperations, or

b. an extraordinary gain if it offsets the current or deferred tax consequences of the extraordinary gain.

An exception to the preceding rule exists when tax benefits are recognized in a subsequent year as a result ofchanges in judgment about the future realization of the tax benefits. In those circumstances, the tax benefits arerequired to be allocated to continuing operations. Thus, the effects of the change in the valuation allowance shouldbe allocated to continuing operations if the adjustment relates to the tax benefits of items that arose in a prior yearand are expected to be realized in a future year. The effects of other changes in the balance of a valuationallowanceincreases in the allowance for deductible differences and carryforwards arising in the current year anddecreases in the allowance for realization in the current year of the benefits of items that arose in prior yearsareallocated among continuing operations and items other than continuing operations following the method illustrateditems a. and item b. above.

To illustrate allocating the tax benefits of loss carryforwards, assume that a company has a loss carryforward at theend of last year in the amount of $30,000. A deferred tax asset of $12,000 ($30,000 � 40% assumed tax rate) wasrecorded at that time. The asset was reduced by a $6,000 valuation allowance, however, because the companydetermined that there was less than a 50% probability that $15,000 of the loss carryforward would be realized infuture years. During the current year, the company incurs a loss from continuing operations of $20,000 and a gainfrom restructuring debt of $60,000. The company carries the $30,000 loss forward to the current year, resulting ina current tax liability of $4,000 on taxable income of $10,000 (taxable income before the loss carryforward of$40,000 � $30,000 loss carryforward � 40% tax rate). Although the entire loss carryforward is realized for taxpurposes in the current year as a result of the extraordinary gain, $6,000 of it is recognized for financial statementpurposes last year and $6,000 of it is recognized this year. The tax benefits of the loss carryforward recognized inthe current year financial statements should be allocated to extraordinary items since it offsets the current taxconsequences of the extraordinary gain. Income taxes would be allocated between pretax income from continuingoperations and the extraordinary gain as follows:

Current tax expense $ 4,000

Deferred tax expense

Deferred tax assetbeginning of the year($12,000 � $6,000) $ 6,000

Deferred tax assetend of the year � 6,000

Total income tax expense $ 10,000

Allocation

Continuing operations:

Income tax benefit of loss from continuingoperations ($20,000 � 40%) (8,000 )

Extraordinary gain $ 18,000


286

Consisting of:

Tax benefit of change in prior�year valuationallowance

$ (6,000 )

Tax on gain ($60,000 � 40%) 24,000

$ 18,000

The company's income statement would be presented as follows:

LOSS BEFORE INCOME TAX BENEFIT ANDEXTRAORDINARY ITEM (20,000 )

INCOME TAX BENEFIT (8,000 )

LOSS BEFORE EXTRAORDINARY ITEM (12,000 )

EXTRAORDINARY ITEMgain from restructuring debt, net of relatedincome taxes of $18,000 42,000

NET INCOME $ 30,000

In the preceding illustration, the tax benefits of the prior�year loss carryforward are allocated to the extraordinarygain. They are not allocated to continuing operations because there is no income from continuing operations in thesubsequent year; thus, they do not meet the criteria in item a. of the �Loss Carryforwards" paragraph. Furthermore,they do not relate to the tax benefits of items that arose in a prior year and are expected to be realized in a futureyear, and, thus, they do not meet the exception in the previous paragraph. Rather, they relate to the tax benefits ofitems that arose in a prior year and are realized in the current year. Those adjustments of the balance of a valuationallowance are allocated following the method illustrated in items a. and b. of the �Loss Carryforwards" paragraph.

Tax Credit Carrybacks and Carryforwards. Certain tax credits that arise but cannot be used in the current yearmay be carried back for a refund of taxes paid in prior years or carried forward to reduce taxes due in subsequentyears. The tax benefits of tax credit carrybacks and carryforwards should be recognized in the income statement inthe year they arise, unless they are offset by a valuation allowance. GAAP does not address presenting the taxbenefit of tax credit carrybacks or carryforwards. However, it is believed that the guidance provided in the precedingparagraphs for carrybacks and carryforwards of operating losses should be followed. Accordingly, the tax benefitof a tax credit may be classified as either (a)�a reduction of the current�period income tax expense, (b) anextraordinary item, or (c) an element of discontinued operations, depending on the source of the tax credit in thecurrent year, or, if a valuation allowance is provided, the income in a subsequent year that allows the tax credit to berealized.

For most small businesses, it is believed that realization of tax benefits of both carrybacks and carryforwards of taxcredits generally will be attributable to income taxes related to continuing operations, since the criteria for reportinga transaction as an extraordinary item are strict, and discontinued operations are not encountered frequently. Inaddition, it is believed that as a result of the Tax Reform Act of 1986, the benefit of tax credits usually will not bematerial to small businesses, so that all of the benefits generally could be allocated to income taxes related tocontinuing operations, even if there are components other than continuing operations.

Intraperiod Tax Allocation

Definition. GAAP requires intraperiod tax allocation, which refers to the mechanics of allocating income taxeswithin a period to income from continuing operations and to various other components of net income and equity.GAAP requires income taxes to be allocated to the following components:

a. Continuing operations

b. Discontinued operations:


287

c. Extraordinary items

d. Other comprehensive income, for example, unrealized holding gains and losses on available�for�salemarketable securities

e. Items charged or credited directly to stockholders' equity, such as:

(1) Prior�period adjustments

(2) An increase or decrease in contributed capital (for example, stock issue costs that are reported as areduction of the related proceeds on the financial statements and are deducted for tax purposes)

(3) Expenses for employee stock options recognized differently for financial reporting and for taxpurposes

(4) Dividends that are paid on unallocated shares held by an ESOP and that are charged to retainedearnings

(5) Deductible temporary differences and carryforwards that existed at the date of a quasi�reorganizationaccounted for as a direct addition to contributed capital and recognized for tax purposes in a laterperiod

Allocation Method. GAAP prescribes an allocation method that focuses on continuing operations. The differencebetween income tax expense on income from continuing operations and the total income tax expense or benefit isthe tax to be allocated to income from sources other than continuing operations. The basic allocation proceduresare as follows:

a. Calculate income tax expense or benefit for the year (including current and deferred taxes)

b. Determine income taxes on continuing operations, which include the tax effect of:

(1) Pretax income or loss from continuing operations

(2) Change in tax laws or rates

(3) Change in tax status

(4) Changes in circumstances that cause a change in judgment about the realization of deferred taxassets in future years

(5) Tax deductible dividends paid to shareholders (except those paid on unallocated shares held by anESOP and charged to retained earnings)

c. The difference between a. and b. is the amount allocated to sources other than continuing operations

d. When there is only one source other than continuing operations, the difference in c. is allocated to thatsource

e. When there are two or more sources other than continuing operations, the difference in c. is allocated toeach of the sources in proportion to the tax effect of each source

Allocation Involving a Single Gain Element. To illustrate allocating tax expense to the components of net incomewhen there is income from continuing operations and an extraordinary gain, assume that a company had notemporary differences and its pretax income included the following components:

Income from continuing operations $ 60,000

Extraordinary gain 30,000

GAAP pretax income and taxable income $ 90,000


288

Assuming that ordinary income and capital gains are taxed at 40%, income taxes would be allocated as follows:

Tax on GAAP pretax income ($90,000 � 40%) $ 36,000

Tax on continuing operations ($60,000 � 40%) 24,000

Tax to be allocated to extraordinary gain $ 12,000

Allocation Involving Item Charged to Other Comprehensive Income. Under current GAAP, certain items arecharged or credited to other comprehensive income rather than net income. Generally, the tax effects of those itemsare also charged or credited directly to other comprehensive income. There are a number of situations when thattreatment is appropriate. Although many of the situations are uncommon, some, such as changes in unrealizedgains and losses on marketable securities classified as available�for�sale securities, can be quite common.

To illustrate allocating tax expense when there are items charged to other comprehensive income, assume that acompany has the following temporary differences:

Beginningof Year

Endof Year

Unrealized losses on marketable equity securities that areavailable for sale $ 23,000 $ 37,000


Total deductible temporary differences $ 76,000 $ 101,000

Its results of operations for the year (all of which relate to continuing operations) are summarized below:

GAAP pretax income $ 360,000

Temporary difference related to accrued expenses 11,000

Taxable income $ 371,000

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

Current taxes ($371,000 � 40%) $ 148,400

Deferred taxes:

Ending deferred tax asset ($101,000 � 40%) $ 40,400

Beginning deferred tax asset ($76,000 � 40%) 30,400 (10,000 )

Total tax provision $ 138,400

The company would allocate its income tax provision to continuing operations and other comprehensive income asfollows:

Current taxes on income from continuing operations($371,000 � 40%) $ 148,400

Ending deferred tax asset related to accrued expenses($64,000 � 40%) $ 25,600

Beginning deferred tax asset related to accruedexpenses ($53,000 � 40%) 21,200 (4,400 )

Taxes attributable to income from continuing operations 144,000

Total tax provision 138,400

Tax benefit allocated to other comprehensive income $ (5,600 )


289

The tax provision allocated to income would be presented in the company's income statement as follows:


INCOME TAXES 144,000


The tax benefit allocated to other comprehensive income would be added to the deferred tax amounts allocated toother comprehensive income in previous years (assumed to be $9,200) and the accumulated other comprehensiveincome would be presented in the company's balance sheet as follows:


Common stock 1,000


Unrealized loss on marketable equity securities (net of deferredincome taxes of $14,800) (22,200 )

532,600

FASB ASC 220�10�45�12 (formerly SFAS No. 130) also requires disclosure of the income tax benefit or expenseallocated to each component of other comprehensive income. Consequently, the notes to the financial statements(or the face of the financial statement that displays the components of other comprehensive income) must disclosethe current year tax benefit of $5,600 allocated to other comprehensive income resulting from the $14,000 ofunrealized losses on marketable equity securities in the current year.

The preceding illustration assumes that a deferred tax asset valuation allowance is not needed. But, what if avaluation allowance were needed because the company did not expect sufficient future capital gains to allow it todeduct the unrealized losses on marketable equity securities? How would the effects of the valuation allowance beallocated between income from continuing operations and other comprehensive income? The tax provision isrequired to be allocated based on the effects of each category on the total tax provision for the year. Consequently,if the company recorded a valuation allowance at the beginning and end of the year for the full amount of thedeferred tax asset related to the unrealized losses, the tax provision would be computed and allocated to incomefrom continuing operations and other comprehensive income as follows:

Total tax provision

Current taxes ($371,000 � 40%) $ 148,400

Deferred taxes:

Ending deferred tax asset [($101,000 � 40%) �$14,800 valuation allowance] $ 25,600

Beginning deferred tax asset [($76,000 � 40%) �$9,200 valuation allowance] 21,200 (4,400 )

Total tax provision $ 144,000

Allocation to income from continuing operations andother comprehensive income

Current taxes on income from continuing operations($371,000 � 40%) $ 148,400

Ending deferred tax asset related to accruedexpenses ($64,000 � 40%) $ 25,600

Beginning deferred tax asset related to accruedexpenses ($53,000 � 40%) 21,200 (4,400 )

Taxes attributable to income from continuing operations 144,000

Total tax provision (calculated above) 144,000

Tax benefit allocated to other comprehensive income $ �0�


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291

SELF�STUDY QUIZ


27. Which of the following items is positive evidence in considering the need for a deferred tax asset valuationallowance?

a. A brief carryback or carryforward period.

b. A history of expired tax credit carryforwards.

c. An unsettled circumstance that could adversely affect future operations.

d. A sufficient amount of appreciated asset value over the tax basis of the entity's net assets.

28. Which of the following is not one of the three criteria to be considered qualifying tax�planning strategies?

a. Management must be willing to implement the strategy.

b. The realization of deferred tax assets would be a result of the strategy.

c. The strategy must be retroactive.

d. The strategy must be prudent and feasible.

29. Which of the following is not a source of future taxable income to consider when determining whether avaluation allowance is necessary?

a. A capital contribution.

b. Taxable income exclusive of reversals of existing taxable differences.

c. Taxable income in prior carryback years.

d. Tax�planning strategies.

30. Devine Winery has income from continuing operations of $520,000 and an extraordinary gain of $30,000. Theentity did not have any temporary differences. Assume that ordinary income and capital gains are taxed at 30%.What amount of income taxes would be allocated to extraordinary gain?

a. $0.

b. $9,000.

c. $156,000.

d. $165,000.


292



27. Which of the following items is positive evidence in considering the need for a deferred tax asset valuationallowance? (Page 276)

a. A brief carryback or carryforward period. [This answer is incorrect. A carryback, carryforward period thatis so brief that it would limit realization of tax benefits if a significant deductible temporary difference isexpected to reverse in a single year or the enterprise operates in a traditionally cyclical business is negativeevidence that a deferred tax asset will be realized.]

b. A history of expired tax credit carryforwards. [This answer is incorrect. A history of tax credit carryforwardsexpiring unused is negative evidence that a deferred tax asset will be realized.]

c. An unsettled circumstance that could adversely affect future operations. [This answer is incorrect.Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profitlevels on a continuing basis in future years is negative evidence that a deferred tax asset will be realized.]

d. A sufficient amount of appreciated asset value over the tax basis of the entity's net assets. [Thisanswer is correct. An excess of appreciated asset value over the tax basis of the entity's net assetsin an amount sufficient to realize the deferred tax asset is positive evidence that a deferred tax assetwill be realized per guidance in FASB ASC 740�10�30�21 and 30�22 (formerly SFAS No. 109,Paragraphs 23�24).]

28. Which of the following is not one of the three criteria to be considered qualifying tax�planning strategies?(Page 278)

a. Management must be willing to implement the strategy. [This answer is incorrect. Management must bewilling to implement the strategy if necessary to realize the tax benefits of operating loss or tax creditcarryforwards to be considered a qualifying strategy.]

b. The realization of deferred tax assets would be a result of the strategy. [This answer is incorrect.Tax�planning strategies are only considered when determining the need for a deferred tax asset valuationallowance. Therefore, this is one of the three criteria.]

c. The strategy must be retroactive. [This answer is correct. The strategy does not have to beretroactive to qualify. However, some strategies may involve elections to treat recurring transactionsdifferently, either retroactively or prospectively.]

d. The strategy must be prudent and feasible. [This answer is incorrect. This answer is a requirement for thetax strategy to be considered qualifying. Management must have the ability to implement the strategy andexpect to do so if necessary in future years.]

29. Which of the following is not a source of future taxable income to consider when determining whether avaluation allowance is necessary? (Page 281)

a. A capital contribution. [This answer is correct. A capital contribution is not income; it is an increasein equity.]

b. Taxable income exclusive of reversals of existing taxable differences. [This answer is incorrect. Futuretaxable income (i.e., reversals of existing taxable differences and taxable income exclusive of reversals ofexisting taxable differences) should be considered.]


293

c. Taxable income in prior carryback years. [This answer is incorrect. Taxable income in prior carryback yearscould be considered. The existence of operating loss carryforwards indicate that there is no availabletaxable income in prior carryback years.]

d. Tax�planning strategies. [This answer is incorrect. Tax�planning strategies could be considered as a sourceof future taxable income, and are required to be considered only when determining whether a valuationallowance is necessary.]

30. Devine Winery has income from continuing operations of $520,000 and an extraordinary gain of $30,000. Theentity did not have any temporary differences. Assume that ordinary income and capital gains are taxed at 30%.What amount of income taxes would be allocated to extraordinary gain? (Page 287)

a. $0. [This answer is incorrect. The tax allocated to extraordinary gain is not $0. Devine Winery has anextraordinary gain of $30,000. Tax must be allocated to this gain.]

b. $9,000. [This answer is correct. The tax on GAAP pretax income is $165,000 ($550,000 � 30%). Taxon continuing operations is $156,000 ($520,000 � 30%). The tax to be allocated to extraordinarygain is $9,000 ($165,000 � $156,000).]

c. $156,000. [This answer is incorrect. $156,000 is the tax on continuing operations.]

d. $165,000. [This answer is incorrect. $165,000 is the tax on GAAP pretax income.]


294


Lesson 3 (PFSTG093)


23. Travel Around Company's meal expenses for the year per the statement of income were $6,564. Since only fiftypercent of that amount is deductible for income tax purposes, what type of a difference is this classified as?

a. A permanent difference.

b. A deductible temporary difference.

c. A taxable temporary difference.

d. A temporary difference.

24. If using a flat rate to measure deferred taxes may produce significantly different results than if graduated taxrates had been used, deferred taxes should be calculated using the average tax rate applicable to taxableincome of the year in which the temporary difference is expected to reverse. What would be the averagegraduated tax rate for an expected taxable income of $150,000 under currently enacted tax laws?

a. 22%.

b. 26%.

c. 28%.

d. 31%.

25. A valuation allowance should reduce a tax asset for deductible reversals if it is � � � � � � that all or a portionof the asset will not be realized.

a. Likely.

b. Probable.

c. Possible.

d. More likely than not.

26. The Grain Bin is subject to a flat tax rate of 34%, has taxable temporary differences of $100,000, and deductibletemporary differences of $20,000. A valuation allowance is not considered necessary. How much is the netdeferred tax liability?

a. $6,800.

b. $21,200.

c. $27,200.

d. $34,000.


295

27. Carry On Corporation has a $4,000 deductible difference related to an unrealized loss on marketable securities.Federal income tax law allows corporations to deduct capital losses only if they offset capital gains. Unusedcapital losses may be carried back three years and carried forward five years. Total income during thecarryback, carryforward period is expected to total $289,000, but only $3,000 of that taxable income will resultfrom capital gains. Based on the tax rate of 34%, how much valuation allowance is needed?

a. $0.

b. $340.

c. $1,020.

d. $1,360.

28. When must tax�planning strategies be considered?

a. When calculating deferred tax assets.

b. When calculating deferred tax liabilities.

c. When determining the amount of the deferred tax asset valuation allowance.

d. When the strategy is prudent.

29. Which of the following is not a permitted classification of tax benefits of operating losses when disclosingcomponents of income tax expense under FASB ASC 740�20�45�3 (formerly Paragraph 37 of SFAS No. 109)?

a. An unusual or infrequent item.

b. An extraordinary item.

c. An element of discontinued operations.

d. A reduction of the current period income tax expense.

30. Lifeline Company's tax rate is 40%. Current taxes were calculated as $85,000. The total deductible temporarydifferences at the beginning of the year were $2,600 and at the end of the year were $5,500. How much is thetotal tax provision?

a. $82,800.

b. $83,840.

c. $86,040.

d. $85,000.


296


297

GLOSSARY

Agent. An agent has general or specific authority, as determined by the principal, to bind the principal as regardsthird parties (i.e., an agent works for and under the control of another (the principal) and has the power to imposeliability to third parties on the principal). A �general agent," however, is not an independent contractor, trustee, oremployee (servant). Duties of an agent include acting with loyalty and good faith (�fiduciary" relationship);obedience; necessary skill, care, and diligence; and duty to account. An agent's duties do not include makingdelegation or substitution. An agent is generally not personally liable to third parties unless the agent does any ofthe following: acts for a nonexistent, incompetent, or undisclosed principal, signs a negotiable instrument in his ownname, misrepresents his authority, or personally guarantees certain acts. Agents are liable for their own torts.

Capital lease. A capital lease is a lease that meets one or more of the following criteria for capitalization. For boththe lessee and the lessor: the lease transfers ownership of the property to the lessee by the end of the lease term,the lease contains a bargain purchase option, the lease term is equal to 75% or more of the estimated economic lifeof the lease property, and the present value at the beginning of the lease term of the minimum lease payments equalsor exceeds 90% of the excess of the fair market value of the leased property at that time.

Component. A component may be a reportable segment or an operating segment [per FASB ASC 280 (formerlySFAS 131)], a reporting unit [per FASB ASC 350 (formerly SFAS 142)], a subsidiary, or a qualifying asset group [perFASB ASC 205 (formerly SFAS 144)].

Deductible temporary differences. Temporary differences that will result in deferred tax assets. Deductibledifferences generally represent expenses that have been recognized in the financial statements but will be deductedin future tax returns, such as a provision for warranty costs. They also may represent income recognized in the taxreturns but deferred for financial statement reporting, such as subscriptions received in advance. The termdeductible reversals refers to reversals of deductible differences.

Deferred tax provision. The deferred tax provision is the change between the deferred tax asset or liability duringthe period. The deferred tax asset or liability is calculated by determining the deductible and taxable temporarydifferences at the balance sheet date and calculating the deferred tax effect. A tax liability always should berecognized for taxable temporary differences. A tax asset for deductible reversals should be reduced by a valuationallowance if it is more likely than not that all or a portion of the asset will not be realized.

Depreciation. Depreciation is the process of systematic, rational allocation of the cost of operational assets to theaccounting periods benefited. Depreciation is not a process of valuation, does not represent a reserve to replace theasset, and does not mean that cash will be available to replace the asset. Depreciation allowed for tax purposes oftendiffers from depreciation allowed for accounting. Accounting depreciation attempts to match the cost of the assetto the revenues generated over the life of the asset. It represents accrual accounting and has no effect on cash flows(a noncash expense). Depreciation expense must be added back to accounting income when reconciling to cashfrom operations.

Expenses. Outflows or other using up of assets or incurrences of liabilities (or a combination of both) from deliveringor producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major orcentral operations.

Extraordinary item. Extraordinary items are events or transactions that meet both of the following criteria: unusualnature and infrequency of occurrence. (see unusual item and infrequent item)

Gains. Increases in equity (net assets) from peripheral or incidental transaction of an entity and from all othertransactions and other events and circumstances affecting the entity except those that result from revenues orinvestments by owners.

Infrequent item. The underlying event or transaction should be of a type that would not reasonably be expected torecur in the foreseeable future, taking into account the environment in which the entity operates.


298

Losses. Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all othertransactions and other events and circumstances affecting the entity except those that result from expenses ordistributions to owners.

Minority interest. A minority interest is ownership of less than 50% of outstanding voting stock (i.e., the net assets)of another corporation. It may be accounted for by the equity or cost method. It is a subset of stockholders' equity,disclosed as a separate item of equity on the consolidated financial statements of the parent of the subsidiary thatis less than wholly (100%) owned by the parent.

Net income. Each item presented in the statement of income may be categorized according to one of the fourcomponents of net income. According to Statement of Financial Accounting Concepts (SFAC) No. 6, thecomponents of net income are revenues, expenses, gains, and losses.

Operating lease. An operating lease is a lease that does not meet one of the criteria for capitalization, specifically,a lease that does not transfer a material ownership interest in the leased asset from the lessor to the lessee. Rentalon an operating lease is charged to expense over the lease term as it becomes payable; a nonrefundable downpayment is capitalized and recognized on a straight�line basis over the lease term.

Permanent differences. Income and expenses that are reported in the financial statements but never will bereported in the tax returns. Some common examples are tax�exempt interest on municipal bonds, the dividendsreceived deduction, penalties, and certain premiums on life insurance.

Principal. A principal is one with the legal capacity to contract, who agrees with another (the agent) that the agentshould act on the principal's behalf. A principal is the person with control over an agent in an agency relationship.

Revenues. Actual or expected cash inflows (or the equivalent) that have occurred or will eventuate as a result of anentity's ongoing major or central operations.

Temporary differences. Temporary differences are differences between financial and income tax reporting that havefuture tax consequences.

Taxable temporary differences. Temporary differences that will result in deferred tax liabilities. Taxable differencesgenerally represent expenses that have been deducted in the tax returns but will be expensed in future financialstatements, such as depreciation deducted over shorter lives for tax purposes than permitted by GAAP. They alsomay represent income recognized in the financial statements that will be taxable in future tax returns, such as useof the percentage�of�completion method of accounting by a small contractor for financial reporting and thecompleted�contract method for tax reporting. The term taxable reversals refers to reversals of taxable differences.

Unusual item. The underlying event or transaction should possess a high degree of abnormality and be of a typeclearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into accountthe environment in which the entity operates.


299

INDEX

B

BUSINESS COMBINATIONS�

� Sale of assets following pooling of interests 215. . . . . . . . . . . . . .

C

CAPTIONS� Equity in earnings of investee 223. . . . . . . . . . . . . . . . . . . . . . . . . . � Extraordinary items 216. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income statement 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes 281. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unusual or infrequent items 217. . . . . . . . . . . . . . . . . . . . . . . . . . . .

CODE OF PROFESSIONAL CONDUCT, AICPA� Rule 203 203. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COMPREHENSIVE INCOME� Equity method investees 223. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income tax allocation 286, 288. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COMPUTER SOFTWARE COSTS� Computer software to be sold, leased, or marketed 234, 237. . . � Internal�use computer software 235. . . . . . . . . . . . . . . . . . . . . . . . . � Software developed as part of a reengineering project 239. . . . .

CONSTRUCTION CONTRACTORS� Income recognition 206. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

D

DEFERRED CHARGES� Lease incentives 246. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DEPRECIATION� ACRS 231. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Departures from GAAP 231. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 231. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DISCLOSURES� Advertising 251, 254. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Depreciation 231. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income taxes

�� Allocation of income tax to other comprehensiveincome 282, 286. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Change in tax status 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Composition of tax provision 282. . . . . . . . . . . . . . . . . . . . . . . . �� Discontinued operations 282. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Extraordinary items 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Loss carryforwards 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Tax credits 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Tax rates 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Leases 250. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Research and development costs 233. . . . . . . . . . . . . . . . . . . . . .

DISCONTINUED OPERATIONS� Adjustment of previously reported amounts 218. . . . . . . . . . . . . . � Examples 218. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Gain or loss on disposal 218. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Identifying a component 217. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income statement presentation 217, 218. . . . . . . . . . . . . . . . . . . . . � Income taxes 218. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Presentation considerations 218. . . . . . . . . . . . . . . . . . . . . . . . . . .

E

EXIT OR DISPOSAL ACTIVITIES� Consolidate or close facilities 221. . . . . . . . . . . . . . . . . . . . . . . . . . � Contract termination costs 221. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 219. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Presentation and disclosure 222. . . . . . . . . . . . . . . . . . . . . . . . . . .

EXPENSES� Advertising 250. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Classification in income statement 204. . . . . . . . . . . . . . . . . . . . . . � Computer software costs 234. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 203. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exit or disposal activities 221. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Recognition 208. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Research and development costs 233, 237. . . . . . . . . . . . . . . . . . � Retroactive adjustment of workers' compensation 254. . . . . . . .

EXTRAORDINARY ITEMS� Adjustment of previously reported amounts 217. . . . . . . . . . . . . . � Captions 216. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 214, 215. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Examples 215. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income statement presentation 214, 216. . . . . . . . . . . . . . . . . . . . . � Income taxes 216, 282, 283, 284, 287. . . . . . . . . . . . . . . . . . . . . . . � Intraperiod tax allocation 216. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Materiality 215. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Receipt of Federal Home Loan Mortgage Corporation

stock 215. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Recognized by equity investee 223. . . . . . . . . . . . . . . . . . . . . . . . . � Sale of assets following pooling of interests 215. . . . . . . . . . . . . . � Tax benefits of loss carryforward 285. . . . . . . . . . . . . . . . . . . . . . . .

I

INCOME STATEMENT� Authoritative basis 203. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Basic financial statement 203. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Classifying items 203, 204. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components of net income 203. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosure requirements 214. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Expense recognition 208. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Form and style 204. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Gains 203, 208. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Losses 203, 208. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Multiple�step format 204. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Order of presentation 214. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Revenue recognition 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Single�step format 204. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Title 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INCOME TAXES� Alternative minimum tax 269. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Authoritative literature 263. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 281, 284. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Deferred, liability method

�� Alternative minimum tax 269. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Calculating 263, 266. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Deferred vs. liability method 263. . . . . . . . . . . . . . . . . . . . . . . . �� Loss carryforwards 269. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Permanent differences 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Tax�planning strategies 278. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Tax rates 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Temporary differences 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Deferred tax assets 263, 266, 267,. . . . . . . . . . . . . . . . . . . . . . . . . . 276, 283, 285

� Deferred tax asset valuation allowance 263, 276. . . . . . . . . . . . . . � Disclosures

�� Allocation of income tax to other comprehensiveincome 286. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Composition of tax provision 282. . . . . . . . . . . . . . . . . . . . . . . . �� Discontinued operations 282. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Extraordinary items 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Loss carryforwards 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Tax credits 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Tax rates 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Income statement presentation 281. . . . . . . . . . . . . . . . . . . . . . . . . � Intraperiod tax allocation

�� Authoritative requirement 286. . . . . . . . . . . . . . . . . . . . . . . . . . .


300

�� Comprehensive income 286. . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Cumulative accounting adjustments 286. . . . . . . . . . . . . . . . . �� Discontinued operations 283, 286. . . . . . . . . . . . . . . . . . . . . . . �� Extraordinary items 216, 283, 284, 286. . . . . . . . . . . . . . . . . . . �� Item charged directly to stockholders' equity 288. . . . . . . . . . �� Operating losses 283. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Prior�period adjustments 286. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Unusual or infrequent items 217. . . . . . . . . . . . . . . . . . . . . . . .

� Investment tax credits 282, 286. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Loss carrybacks 284. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Loss carryforwards 269, 277, 282,. . . . . . . . . . . . . . . . . . . . . . . . .

283, 285� Permanent differences 264. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Recognized by equity investee 223. . . . . . . . . . . . . . . . . . . . . . . . . � Tax credits 282, 286. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Tax law changes 266, 282. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Temporary differences, examples of

�� Leases 245, 246, 247, 248. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INVESTMENTS� Captions 223. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Common stockequity method

�� Accounting treatment 222. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Different fiscal years 224. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Dividends on investee's cumulative preferred stock 222. . . . �� Extraordinary items recognized by investee 223. . . . . . . . . . . �� Income statement presentation 223. . . . . . . . . . . . . . . . . . . . . �� Income taxes of investee 223. . . . . . . . . . . . . . . . . . . . . . . . . . . �� Intercompany profits 222. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Negative balances 222. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Other comprehensive income reported by investee 223. . . . �� Prior�period adjustments recognized by investee 223. . . . . .

L

LEASES� Bargain rentals 244. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Contingent rentals 249. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Leasehold improvements 246. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Operating leases 244. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Assumption of lease 248. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Contingent rentals 249. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Disclosures 250. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Incentive payments 246. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Income taxes 245, 246, 247, 248. . . . . . . . . . . . . . . . . . . . . . . . �� Les controls use of property 245. . . . . . . . . . . . . . . . . . . . . . . . �� Recognition of rentals 244. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

M

MATERIALITY� Extraordinary items 215. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P

PRIOR�PERIOD ADJUSTMENTS� Discontinued operations 218. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Equity method 223. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Extraordinary items 217. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Tax allocation 286. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

R

RECEIVABLES� Rent 248. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RESEARCH AND DEVELOPMENT COSTS� Accounting 233, 237. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 233. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 233. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RETAINED EARNINGS� Dividends

�� Cumulative preferred stock of investee 222. . . . . . . . . . . . . . .

REVENUE� Captions 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Classifications in income statement 204. . . . . . . . . . . . . . . . . . . . . � Deferred 246. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 203. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Equity in earnings of investee 222. . . . . . . . . . . . . . . . . . . . . . . . . . � Recognition 205. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Recognition as principal or agent 206. . . . . . . . . . . . . . . . . . . . . . . � Sales and other similar taxes 207. . . . . . . . . . . . . . . . . . . . . . . . . . . � Sales incentives 207. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Shipping and handling 207. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

S

START�UP COSTS 232. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

U

UNUSUAL OR INFREQUENT ITEMS� Captions 217. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 217. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosure requirements 217. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Examples 215. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Income statement presentation 214, 217. . . . . . . . . . . . . . . . . . . . . � Intraperiod tax allocation 217. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


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COURSE 4

PREPARING FINANCIAL STATEMENTS: ASSETS (PFSTG094)

OVERVIEW

COURSE DESCRIPTION: This interactive self�study course provides an introduction to the preparation of theasset portion of financial statements. Topics in the first lesson include the propercaptions, classification and valuation of current assets including inventory,receivables and marketable securities. The second lesson covers long�terminvestments and using the equity method to account for nonmarketable equitysecurities. Lesson three discusses the balance sheet presentation andclassification of property and equipment, including capital leases and thecalculation of depreciation. The last lesson is on intangible assets, the impairment ofgoodwill and application of FASB ASC 360�10 (formerly SFAS No. 144).

PUBLICATION/REVISION

DATE:

November 2009


PREREQUISITE/ADVANCE

PREPARATION:

Basic knowledge of accounting.





KNOWLEDGE LEVEL: Intermediate

LEARNING OBJECTIVES:

Lesson 1Current Assets


� Identify correct balance sheet captions for current assets such as cash, receivables, and inventory.

� Calculate and account for the value of marketable securities and treasury securities at the balance sheet date.� Determine the correct reporting for receivables and inventory.

Lesson 2Long�term Investments


� Determine the appropriate captions and valuation for long�term investments such as nonmarketable securities,cash value of life insurance policies, and property held for investment.

� Determine the accounting treatment for nonmarketable equity securities.

� Determine the correct reporting for cash value life insurance policies.


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Lesson 3Property and Equipment


� Identify the balance sheet presentation options for property and equipment.

� Determine the classification of and properly record assets acquired by capital lease, contribution or exchange.� Calculate depreciation.

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


� Identify the appropriate accounting for goodwill and other intangibles.� Determine when an asset is impaired.

� Determine when to apply FASB ASC 360�10 (formerly SFAS No. 144) to long�lived assets.



Thomson Reuters

Tax & AccountingR&GPFSTG094 Self�study CPE

36786 Treasury CenterChicago, IL 60694�6700



For information regarding refunds and complaint resolutions, dial (800) 323�8724 for Customer Service and your

questions or concerns will be promptly addressed.


303

Lesson 1: Current Assets

INTRODUCTION

Current assets normally include the following items:

a. Cash available for current operations and items that are the equivalent of cash

b. Marketable securities representing the investment of cash available for current operations

c. Inventories of raw materials, goods in process, finished goods, operating supplies, and ordinarymaintenance materials and parts

d. Receivables:

(1) Trade accounts and notes

(2) Receivables from officers, employees, affiliates, and others if collectible in the ordinary course ofbusiness within one year

e. Prepaid expenses such as insurance, interest, rents, taxes, unused royalties, current paid advertisingservice not yet received, and operating supplies


In this lesson the proper captions, classification and valuation of current assets including inventory, receivables andmarketable securities are discussed.

Completion of this lesson will enable you to:� Identify correct balance sheet captions for current assets such as cash, receivables, and inventory.� Calculate and account for the value of marketable securities and treasury securities at the balance sheet date.� Determine the correct reporting for receivables and inventory.

Cash and Cash Equivalents

Cash as a balance sheet caption should ordinarily include cash on deposit with banks and other institutions andcash on hand (for example, change funds and undeposited receipts). It is generally presented as a single item, butmay be combined with short�term investments considered to be cash equivalents. When the two are combined, thecaptions should be descriptive, such as �Cash and cash equivalents." When cash and cash equivalents arepresented as a single amount, the notes to financial statements frequently disclose the components. For example:

NOTE XCASH AND CASH EQUIVALENTS

Cash and cash equivalents consist of the following:

20X2 20X1

Cash $ 50,000 $ 45,000

Certificates of deposit 100,000 �

Short�term securities 45,000 95,000

$ 195,000 $ 140,000

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


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should be combined to agree with the statement of cash flows, the balance sheet should subtotal those amounts.Similarly, cash and short�term investments that are not cash equivalents should not be combined in the balancesheet.

Operating Accounts. Even though banks offer a variety of deposit instruments, small and midsize nonpublicentities ordinarily have at least one operating account. Operating accounts that bear interest typically have a lowinterest rate and do not generate significant amounts of interest income. Depending on the facts and circum�stances, however, entities may want to disclose the balances of interest�bearing operating accounts. Relevantinformation may be disclosed in a note to the financial statements or through an expansion of the asset caption,such as:

Cash, including interest�bearing accounts of$275,000, with interest averaging 3% $ 390,000

Certificates of Deposit. Certificates of deposit generally are not subject to withdrawal limitations although with�drawal before maturity usually results in a loss of a portion of the interest earned. Accordingly, best practicesindicate that certificates of deposit may be included with cash and need not be separately disclosed. Someaccountants, however, disclose the amount of certificates of deposit that have been included with cash or presentcertificates of deposit as a separate balance sheet caption as follows:

20X2 20X1

Cash, including certificates of deposit(20X2$150,000; 20X1$125,000) $ 500,000 $ 430,000

Marketable securities 100,000 200,000

or

Cash $ 55,000

Certificates of deposit 200,000

Short�term investments 250,000

As previously discussed, best practices indicate that subtotals of cash and cash equivalents that agree with theamounts in the statements of cash flows should be presented.

Money Market Accounts. Money market accounts offered by banks, savings and loan associations, and broker�age houses are typically subject to only minimal withdrawal restrictions. Therefore, they are more in the nature ofinterest�bearing checking accounts and should be included in the cash caption.

Repurchase Agreements. Repurchase agreements are short�term investments typically sold by banks as alterna�tives to certificates of deposit. Transfers to and from the fund are made daily to cover checks clearing in operatingaccounts. Accordingly, repurchase agreements should be presented in the financial statements in a manner similarto money market accounts.

Held Checks. Checks written but not released as of the balance sheet date should be reinstated on the company'sbooks, thus increasing cash as of the date of the financial statements. The offsetting entry generally increasesaccounts payable.

Overdrafts. Overdrafts are a result of either of the following situations:

a. The bank statement at the balance sheet date reports an overdraft (a real overdraft).

b. The bank statement at the balance sheet date reports a positive balance, and the overdraft, in essence,arises from �playing the float" (a book overdraft).

However, there is no reason for captions to distinguish between a real overdraft and a book overdraft, and the singlecaption �cash overdraft" or �bank overdraft" should be used. If the company has a positive cash balance in one


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year and a negative balance in the other, the following captions would be appropriate in comparative balancesheets:

20X2 20X1

CURRENT ASSETS

Cash $ � $ 10,000

CURRENT LIABILITIES

Cash overdraft 5,000 ��

Entities frequently have cash accounts with more than one financial institution. Generally, for each financialinstitution, all cash account balances should be totaled to determine whether the entity has a net positive ornegative balance. If a net negative balance with a financial institution is immaterial, generally it may be offset againstpositive balances in other financial institutions. However, if it is material, generally it should be included with currentliabilities and either presented separately or included with accounts payable.

Restricted Cash. Cash restricted for special purposes should be segregated from cash available for generaloperations and, normally, should be excluded from current assets. However, as noted in FASB ASC 210�10�45�4(formerly Chapter�3 of ARB No. 43), it may be included in current assets when it is considered to offset maturingdebt that has been properly set up as a current liability. Examples of the presentation of restricted cash are asfollows:

a. Cash deposited with a trustee for mortgage loan payments:

CURRENT ASSETS

Cash $ 100,000

Restricted cash for mortgage loan repayment 25,000

Accounts receivable 400,000

Inventory 600,000

TOTAL CURRENT ASSETS 1,125,000

PROPERTY AND EQUIPMENT 575,000

OTHER ASSETS

Deposits 50,000

Restricted cash for mortgage loan repayment 150,000

$ 1,900,000

b. Total cash of $150,000 of which $100,000 is restricted proceeds from industrial revenue bonds:

CURRENT ASSETS

Cash $ 50,000

OTHER ASSETS

Deposits 10,000

Restricted cash from industrial revenue bonds 100,000

Note that, as in example (a), restricted cash may have both a current and noncurrent portion.

Compensating Balances. There is no GAAP requirement to disclose compensating balance agreements unlessthe agreement legally restricts the use of the funds.


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Escrow Accounts. In practice, two types of escrow accounts are often encountered:

a. Amounts on deposit that will be used to pay expenses

b. Agency accounts

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


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SELF�STUDY QUIZ


1. Company A has the following account balances with Bank of the U.S. on 12/31/X1:

Operating account: $100,000; Money market account $50,000; Payroll account ($10,000)

Also, on 12/31/X1, Company A wrote $15,000 worth of checks from its operating account, but held on to themuntil 1/10/X2.

How much does Company A report as �Cash" on its 12/31/X1 balance sheet?

a. $105,000.

b. $140,000.

c. $155,000.

d. $165,000.

2. Which of the following is segregated from cash available for general operations?

a. Restricted cash.

b. Certificates of deposit.

c. Repurchase agreements.

d. Short�term investments.


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1. Company A has the following account balances with Bank of the U.S. on 12/31/X8:

Operating account: $100,000; Money market account $50,000; Payroll account ($10,000)

Also, on 12/31/X8, Company A wrote $15,000 worth of checks from its operating account, but held on to themuntil 1/10/X9.

How much does Company A report as �Cash" on its 12/31/X8 balance sheet? (Page 303)

a. $105,000. [This answer is incorrect. Money market accounts are in the nature of interest�bearing checkingaccounts and should be included in the cash caption.]

b. $140,000. [This answer is incorrect. Checks written but not released as of the balance sheet date shouldbe reinstated on the company's books, thus increasing cash as of the date of the financial statements.]

c. $155,000. [This answer is correct. Cash as a balance sheet caption should ordinarily include cashon deposit with banks and other institutions and cash on hand. An overdraft in an account of afinancial institution can be offset with a positive balance in another account in the same institution.Checks written but not released as of the balance sheet date should be reinstated on the company'sbooks.]

d. $165,000. [This answer is incorrect. An overdraft in an account of a financial institution can be offset witha positive balance in another account in the same institution, and be reported as cash if it is a net positivebalance.]

2. Which of the following is segregated from cash available for general operations? (Page 305)

a. Restricted cash. [This answer is correct. Cash restricted for special purposes should be segregatedfrom cash available for general operations and, normally, should be excluded from current assets.]

b. Certificates of deposit. [This answer is incorrect. CDs are generally not subject to withdrawal limitationsalthough withdrawal before maturity usually results in a loss of a portion of the interest earned. Usually, CDsare included with cash and need not be separately disclosed.]

c. Repurchase agreements. [This answer is incorrect. Repurchase agreements are alternatives to CDs soldby banks. Transfers to and from the fund are made daily to cover checks clearing in operating accounts.Repurchase agreements should be presented in the financial statements in a manner similar to moneymarket accounts.]

d. Short�term investments. [This answer is incorrect. Short�term investments that are considered cashequivalents can be combined in the balance sheet under the �Cash and cash equivalents" caption.]


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Marketable Securities

The balance sheet caption �marketable securities" includes equity securities and debt securities. Examples ofthose types of securities are:

Equity Securities Debt Securities

Common Stock Bonds

Preferred Stock Bankers Acceptances

Warrants U.S. Treasury Notes

Calls Convertible Debt

Puts Preferred Stock (that must be redeemed)

This lesson discusses both current and noncurrent marketable securities because decisions about classificationmay influence captions and, in some cases, measurement. Money market accounts, repurchase agreements, andcertificates of deposit (except for some �jumbo CD's") are not marketable securities.

FASB ASC 320�10 (formerly SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities)establishes accounting standards for both marketable equity and debt securities. This guidance requires businessentities to account for marketable equity securities and most marketable debt securities at fair value. It applies tobusiness entities other than those that use specialized accounting principles for investments, such as securitiesbrokers and dealers, defined benefit pension plans, and investment companies. (It does not apply to nonprofitorganizations, however.) Certain debt securities that entities intend to hold to maturity are accounted for atamortized cost; most marketable debt and equity securities, however, are accounted for at fair value.

Definitions. FASB ASC 320�10�20 (formerly SFAS No. 115) defines debt and equity securities as follows:

DEBT SECURITY

Any security representing a creditor relationship with an entity.

ExamplesU.S. Treasury securities, U.S. government agency securities, municipal securities,corporate bonds, convertible debt, redeemable preferred stock, commercial paper, all securi�tized debt instruments (such as collateralized mortgage obligations and real estate mortgageinvestment conduits)

EQUITY SECURITY

Any security representing an ownership interest in an entity or the right to acquire or dispose of anownership interest in an entity at fixed or determinable prices. Equity securities do not includeconvertible debt or redeemable preferred stock.

ExamplesCommon, preferred, and other capital stock; stock rights and warrants; put and calloptions

This guidance applies to equity securities whose fair value is readily determinable and all debt securities. It alsoapplies to restricted stock if the restrictions terminate within one year. It does not apply to investments in equitysecurities that would be required to be accounted for using the equity method, if not for the election of the fair valueoption under FASB ASC 825�10 (formerly SFAS No. 159, The Fair Value Option for Financial Assets and FinancialLiabilities), or to investments in consolidated subsidiaries. The fair value of an equity security is readily determin�able if:

a. sales prices or bid�and�asked quotations are currently available in:

(1) a securities exchange registered with the Securities and Exchange Commission.

(2) an over�the�counter market publicly reported by the National Association of Securities DealersAutomated Quotations systems or by Pink Sheets LLC.


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b. the security trades only in a foreign market, but that market is of a breadth and scope comparable to oneof the U.S. markets previously discussed.

c. the fair value per share or unit of a mutual fund is determined and published and is the basis for currenttransactions.

Summary of Accounting Principles. Accounting for investments depends on (a) the type of securityeither debtor equityand (b) the entity's intent and ability to hold it to maturity. At acquisition, investments should be classifiedinto one of the following categories:

� Held to Maturity. Debt securities for which the entity has both the positive intent and ability to hold to maturity.Securities for which an entity has an intent to hold for an indefinite time or a lack of an intent to sell shouldnot be classified in this category. If an entity's intent is uncertain, this category is not appropriate. In addition,a security cannot be classified as held to maturity if it can be contractually prepaid or otherwise settled suchthat the security holder would not recover substantially all of its recorded investment. A debt security withthose characteristics should be evaluated to determine whether it contains an embedded derivative thatmust be accounted for separately.

� Trading. Debt securities that do not meet the �intent�to�hold" criterion and equity securities that have readilydeterminable fair values, both of which are bought and held principally for the purpose of selling them inthe near term (e.g., the entity's normal operating cycle), and thus generally are held for only a short periodof time.

� Available for Sale. Securities that do not meet the criterion to be classified as held to maturity or trading.

Most entities classify their securities into one of two categorieseither held to maturity or available for sale. Tradingsecurities are held principally by financial institutions and similar entities, such as entities with mortgage bankingactivities. According to FASB ASC 320�10�20 (formerly Question 34 of the FASB Q & A on SFAS No. 115), suchsecurities generally have a holding period measured in hours and days rather than months or years. However,classifying securities as trading is not prohibited just because they will be held longer. Generally, as a practicalmatter, the securities activities of small and medium�sized entities normally are incidental and classifying them asavailable for sale better captures their substance. Accordingly, the provisions of FASB ASC 320�10 (formerly SFASNo. 115) as they apply to trading securities are not discussed in detail in this course.

Exhibit 1�1 summarizes the accounting for investments. For debt securities classified as held to maturity, thesecurities are carried at amortized cost (unless there is a decline in the value of individual securities that is not dueto temporary declines). Realized gains and losses are recorded in the income statement in the period that they areearned.

Debt and equity securities classified as available for sale are recorded at fair value. Generally, the fair value of thesecurities held is the product of the number of shares held and the per�share price or quotation. The fair value is notreduced for expected transaction costs or for any blockage discount. As a practical matter, if a quoted market priceis not available for an equity security, it probably is not subject to the requirements discussed in this lesson.Realized gains and losses are recorded in the income statement in the period that they are earned. Unrealizedgains and losses are reported in other comprehensive income. However, declines in value of individual securitiesbelow amortized cost that are other than temporary should be included in earnings. See further discussion ofimpairment of securities later in this lesson.


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Exhibit 1�1

Accounting for Marketable Securities

Category Type of Investment BasisReporting Unrealized

Gains and LossesBalance SheetClassification

Held tomaturity

Debtentity has posi�tive intent and ability tohold to maturity, andthe security cannot becontractually prepaid orotherwise settled suchthat the security holderwould not recover sub�stantially all of itsrecorded investment

Amortized cost,reduced fornontemporarydeclines

Charge nontemporarylosses to earnings; donot recognize otherunrealized gains andlosses

Current or noncurrentdepending on FASBASC 210�10�45 (for�merly ARB No. 43)(generally noncurrent;classify as currentwhen maturity iswithin 12 months)

Trading Debt and equityheldprincipally for sale inthe near term

Fair value Report in earnings Current or noncurrentdepending on FASBASC 210�10�45 (for�merly ARB No. 43)

Availablefor sale

Debt and equity otherthan above

Fair value Report in other com�prehensive income;charge nontemporarylosses to earnings

Current or noncurrentdepending on FASBASC 210�10�45 (for�merly ARB No. 43)

* * *

According to FASB ASC 320�10�35�33 (formerly Question 47 of the FASB Q & A on SFAS No. 115), if an entitydecides to sell an available�for�sale security that has declined in value below its amortized cost and the decline isnot considered to be temporary, the investment should be written down to its fair value in the period that thedecision to sell was made, rather than in the period in which the sale occurs. In that case, the write�down should becharged to earnings rather than recorded in other comprehensive income. The situation might be most obvious ifa company sells a security at a loss shortly after the balance sheet date. The value to which a security is writtendown becomes its new cost basis. Impairment of securities is discussed further later in this lesson.

Categorizing Securities. Categorizing securities under GAAP may be challenging. The most difficult decisions arelikely to surround whether a security meets the positive�intent and ability�to�hold criteria to classify it as held tomaturity. Unfortunately, GAAP provides no guidance on evaluating an entity's intent, so classification decisions maybe inconsistent in practice. Although many entities intend to hold securities for a long term or an indefinite period,GAAP precludes classifying debt securities as held to maturity if they would be available to be sold in response tofactors such as the following:

a. Changes in market interest rates and related changes in the securities' prepayment risk

b. Need for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrenderof insurance policies, or payment of insurance claims)

c. Changes in the availability of and the yield on alternative investments

d. Changes in funding sources and terms

e. Changes in foreign currency risk


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Transferring Securities between Categories. An entity should reconsider whether a marketable security isproperly categorized at each reporting date. Changes in circumstances, such as an entity no longer having theability to hold a debt security to maturity, may cause a security to be transferred to another category. Transferringa security to a different category requires adjusting the carrying amount of the security to its fair value at the date oftransfer so that all of the unrealized holding gain or loss is recognized as of that date. Accounting for the unrealizedholding gain or loss depends on the type of transfer, as follows:

a. Transfers from the Trading Category. For securities transferred from the trading category, the unrealizedholding gain or loss at the date of transfer is already recognized in earnings and should remain in retainedearnings after the transfer, regardless of the category to which the securities are transferred. For example,the unrealized holding gain or loss on a security transferred from the trading category to theavailable�for�sale category is included in retained earnings at the transfer date, while subsequent changesin the unrealized holding gain or loss should be included in accumulated other comprehensive income.

b. Transfers to the Trading Category. For securities transferred to the trading category, recognize in earningsthe portion of the unrealized holding gain or loss at the transfer date that has not been previouslyrecognized in earnings. For transfers of available�for�sale securities, that will entail reclassifying intoearnings amounts reported in accumulated other comprehensive income through the transfer date. Forexample, assume that an available�for�sale security has an unrealized gain of $20,000 at the beginning ofthe year and its fair value increases by an additional $5,000 to $80,000 by the transfer date. The securityfirst should be adjusted to its fair value at the transfer date by recognizing the additional $5,000 unrealizedholding gain in other comprehensive income, as follows:

Available�for�sale securities 5,000

Other comprehensive income 5,000

The carrying amount of the security is then its $80,000 fair value, and accumulated other comprehensiveincome related to the security is the $25,000 cumulative holding gain at the transfer date (of which $20,000was recognized in prior years and $5,000 was recognized in the current year). The transfer from theavailable�for�sale category to the trading category should be recorded by reclassifying the $25,000unrealized holding gain into earnings, as follows:

Trading securities 80,000



Unrealized gain on securities 25,000

Since $20,000 of the unrealized holding gain was recognized in comprehensive income in prior years (asother comprehensive income), recording the transfer only increased comprehensive income (and equity)for the current year by the $5,000 additional unrealized gain that arose during the current year through thetransfer date. The increase should be reported in two componentsa $20,000 net reduction in othercomprehensive income (the $5,000 additional unrealized holding gain less the $25,000 reclassification)and a $25,000 increase in earnings. However, if the security originally had been classified asheld�to�maturity instead of available�for�sale, none of the unrealized holding gain would have beenrecognized in comprehensive income previously, and in addition to increasing earnings by $25,000, thetransfer also would increase current year comprehensive income (and equity) by $25,000.

c. Transfers to Available�for�sale from Held�to�maturity. For debt securities transferred to the available�for�salecategory from the held�to�maturity category, recognize the unrealized holding gain or loss in othercomprehensive income at the transfer date. For example, if the fair value of a held�to�maturity security hasincreased by $20,000 to $70,000, the carrying amount of the security should be increased by $20,000 fromits $50,000 cost basis to its $70,000 fair value, with the $20,000 unrealized holding gain recognized in othercomprehensive income as follows:

Held�to�maturity securities 20,000



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The transfer then would result in reporting the security as an available�for�sale security with a carryingamount of $70,000 as follows:



Since the security previously was classified as held�to�maturity, none of the unrealized gain was recognizedin prior years, and the transfer therefore increased current year comprehensive income (and equity) by$20,000.

d. Transfers to Held�to�maturity from Available�for�sale. For debt securities transferred to the held�to�maturitycategory from the available�for�sale category, the security's fair value at the transfer date becomes its newcost basis. (Subsequent changes in the security's fair value only should be recognized when they arerealized, unless a decline in fair value is other than temporary. In that situation, the decline should berecognized immediately in earnings, and the fair value at that date becomes the security's new cost basis.)The unrealized holding gain or loss at the date of transfer should remain in accumulated othercomprehensive income but be amortized over future years as a premium or discount. (A premiumaccumulates when there is an unrealized gain at the date of transfer, and a discount accumulates whenthere is an unrealized loss.) The offset to the change in the discount or premium is an increase or decreasein other comprehensive income. Consequently, increasing a premium reduces accumulated othercomprehensive income and the carrying amount of the security, while increasing a discount increasesaccumulated other comprehensive income and the carrying amount of the security. When the securitymatures, its carrying amount will equal its face value. This accounting results in recognizing comprehensiveincome for the unrealized holding gains or losses that arise while a security is classified as available for sale.However, since those gains or losses will not be realized, comprehensive income is correspondinglyeliminated over the period from the transfer date to the security's maturity.

To illustrate, assume that an entity purchases a debt security for its $50,000 face value and classifies it asavailable�for�sale at the beginning of the year. The security bears interest at 8% and is due in three years.At the end of the year, when the security's fair value is $60,000, the entity reclassifies it as held�to�maturity.To record the realization of the amounts due under the security, the transfer to the held�to�maturity category,and the amortization of the unrealized holding gain at the transfer date, the entity should:

(1) Recognize $4,000 ($50,000 face value � 8%) interest income for the year.

Cash 4,000

Interest income 4,000

(2) Increase the carrying amount of the security by $10,000 from its $50,000 cost to its $60,000 fair valueand reclassify the security to held�to�maturity at the transfer date.





(3) Compute the level effective rate that will fully amortize the $60,000 fair value at the transfer datethrough receipt of the two remaining annual interest payments and the principal that is due in twoyears. That rate is 15.71%.

(4) At the end of the following year, multiply $60,000 (the security's carrying amount) by 15.71%, andsubtract the $4,000 interest income from the $9,426 result. Record the $5,426 difference as a premiumon the debt security, with an offsetting reduction in other comprehensive income as follows:


314

Cash 4,000


Premium on debt security 5,426


After that adjustment, $4,574 ($10,000 � $5,426) of the $10,000 unrealized holding gain at the transferdate remains in accumulated other comprehensive income. The carrying amount of the security is$54,574, consisting of the $60,000 fair value at the transfer date less the $5,426 accumulatedpremium.

(5) At the end of the following year, multiply the $54,574 carrying amount of the security by 15.71%, andsubtract the $4,000 interest income from the $8,574 result. Record the $4,574 difference as a premiumon the debt security, with an offsetting reduction in other comprehensive income as follows:

Cash 4,000




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

Cash 50,000



Transfers from the held�to�maturity category and into or out of the trading category should be rare, due to the highthreshold for classifying investments into those categories. In addition, FASB ASC 320�10�35�13 (formerly SFASNo. 115, Paragraph 81) notes that available�for�sale securities should not be automatically transferred to the tradingcategory merely because the company decides to sell the security or because the passage of time has caused thesecurity's maturity date to be within one year.

Subsequent Changes in Fair Value. The fair value measurements should be based on values at the end of thereporting period. Changes in fair value occurring after the end of the reporting period but before the financialstatements are issued or are available to be issued should not be recognized. For example, if the quoted marketprice of an equity security traded on a national exchange is $100,000 at the end of the reporting period but declinesto $50,000 prior to the financial statements being issued or being available to be issued, the security should bereported at $100,000. That conclusion is not affected by whether the decline in value began before the end of thereporting period.

Measurement of a security's fair value is not intended to estimate the value the reporting entity will realize; it ispurely a measure of the number of shares held multiplied by the per share price at the end of the reporting period.Fair value under FASB ASC 320�10 (formerly SFAS No. 115) does not consider factors that could affect the amountrealized (such as control premiums, blockage factors, and selling costs), nor does it consider changes in value thatwill occur before the security is sold. Accordingly, the disclosure requirements of FASB ASC 450 (formerly SFASNo. 5, Accounting for Contingencies), and FASB ASC 275�10�50 (formerly SOP 94�6, Disclosure of Certain Signifi�

cant Risks and Uncertainties), do not apply. However, FASB ASC 855�10 (formerly SFAS No. 165) presentssubsequent changes in the fair value of assets or liabilities as an example of a nonrecognized subsequent eventthat should be disclosed if failing to disclose the event would cause the financial statements to be misleading. Inthat case, the nature of the event and an estimate of its financial effect, or a statement that such an estimate cannotbe made, should be disclosed.


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Impairment of Securities. When the fair value of an available�for�sale or held�to�maturity security declines belowits amortized cost the security is considered impaired. The reporting entity must then determine whether thatimpairment is other than temporary to properly account for, report, and disclose the security

FASB ASC 320�10�35�17 through 35�35A (formerly FSP FAS 115�1 and FAS 124�1, �The Meaning of Other�Than�Temporary Impairment and Its Application to Certain Investments") provides guidance regarding the meaning ofother�than�temporary impairment and its application to debt and equity securities. GAAP provides guidance for (a)determining when an investment is impaired, (b) determining whether the impairment is other than temporary, and(c) measuring, recognizing, presenting and disclosing an impairment loss if the impairment is deemed other thantemporary.

Determining When an Investment Is Impaired. An investment is deemed impaired if its fair value is less than its cost.For this purpose, cost includes adjustments made to an investment's cost basis for accretion, amortization,collection of cash, previous other�than�temporary impairments recognized in earnings (less any cumulative�effectadjustments), foreign exchange, and hedging, and is sometimes referred to as the amortized cost basis. Generally,an investment should be assessed for impairment each reporting period, including interim periods if interimfinancial statements are issued. If an investment is deemed impaired, the impairment should be analyzed todetermine if the impairment is other than temporary.

Determining Whether the Impairment Is Other Than Temporary. When an investment is deemed impaired, thereporting entity should determine whether the impairment is temporary or other than temporary. FASB ASC320�10�35�30 (formerly FSP FAS 115�1 and FAS 124�1) states that other than temporary does not mean permanent.When determining whether an impairment is other than temporary, the reporting entity should consider theguidance in FASB ASC 320�10�35 (formerly FSP FAS 115�1 and FAS 124�1) as well as other relevant guidance suchas FASB ASC 325�40�35 (formerly EITF Issue No. 99�20, �Recognition of Interest Income and Impairment onPurchased and Retained Beneficial Interests in Securitized Financial Assets").

GAAP addresses the determination of whether an impairment is other than temporary separately for equity securi�ties and debt securities. However, it provides more detailed guidance for debt securities than for equity securities.For example, FASB ASC 320�10�35�32A indicates a reporting entity should apply pertinent guidance, such as FASBASC 325�40�35 (formerly EITF Issue No. 99�20) in making the determination for equity securities. On the otherhand, FASB ASC 320�10�35�33A through 33I (formerly FSP FAS 115�1 and FAS 124�1) provides detailed guidancefor determining whether an other�than�temporary impairment has occurred in relation to debt securities. Chapter 30of PPC's Guide to GAAP includes additional information regarding determining whether an impairment is other thantemporary.

Recognizing and Measuring an Other�than�Temporary Impairment Loss. When impairment is determined to beother�than�temporary, a loss should be recognized. The recognition and measurement of the loss varies dependingon whether the investment is an equity security or a debt security. For an equity security, an impairment loss shouldbe recognized in earnings for the entire difference between the cost and fair value of the security at the balancesheet date. The fair value becomes the new amortized cost basis of the security and should not be adjusted forsubsequent recoveries in fair value.

For debt securities, the amount of the other�than temporary impairment recognized in earnings depends onwhether the reporting entity intends to sell the security (or whether it is more likely than not the entity will be requiredto sell the security) before recovery of the amortized cost basis less any current�period credit loss. If the entity plansto sell the security (or more likely than not it will be required to sell the security) before recovery, the other�than�tem�porary impairment should be recognized in earnings for the entire difference between the amortized cost basis andfair value at the balance sheet date. If there is no intention to sell the security and it is not more likely than not thatthe entity will be required to sell before recovery, the other�than�temporary impairment should be separated intoamounts pertaining to (a) the credit loss and (b) all other factors. The amount related to the credit loss should berecognized in earnings while the remaining amount should be recognized in other comprehensive income (net oftaxes). The prior amortized cost basis less the other�than�temporary impairment loss recognized in earningsbecomes the new amortized cost basis of the security. That amount should not be adjusted for subsequentrecoveries in fair value, but should be adjusted for accretion and amortization.


316

Treasury Securities

Types of Treasury Securities. Many nonpublic companies invest in debt securities, and often in U.S. Treasurysecurities. The three types of Treasury securities are bills, notes, and bonds.

� Treasury bills, or T bills, are short�term obligations of the U.S. government with a term of one year or less.They require a minimum investment of $10,000 and, when initially issued, are scheduled to mature in threemonths (13 weeks or 91 days), six months (26 weeks or 181 days), or 12 months. (T bills with differentremaining maturities can also be purchased in secondary markets after they are initially issued.) T bills donot pay coupon interest; instead, they trade at a discount from their par value of $10,000 and mature at parvalue. The discount, however, is based on the quoted yield, which is similar to an interest rate (and is thebasis for determining interest rates in some agreements). The difference between purchase price and thepar value of the T bill is called �accreted interest," which is paid when the T�bill matures. Physical certificatesare not issued for T bill purchases; they are issued in book form only.

� Treasury notes are intermediate�term obligations of the U.S. government with terms of two to ten years.They are initially issued at par value and can be purchased in $1,000 denominations (although, dependingon how they are purchased, a five note minimum may be required). Treasury notes pay semiannual couponinterest, and they repay par value at maturity. Most Treasury notes are issued in book form only.

� Treasury bonds are similar to Treasury notes except that they have maturities over ten years. They areinitially issued at par value, pay semiannual coupon interest, and repay par value at maturity. Most Treasurybonds are issued in book form only.

Accounting for Treasury Bills. When purchased, T bills should be recorded at cost, which will be a discount fromtheir $10,000 par value. For example, a company would make the following entry to record the purchase of a91�day T bill on September 14, 20X1, at 97:

Short�term investments 9,700

Cash 9,700

To record the purchase of T bill.

As discussed previously, even though T bills do not pay coupon interest, the discount represents interest at theyield quoted at the date of acquisition. Accordingly, a question arises about whether the discount should beaccreted during the period the T bill is held.

Specific guidance is provided for the tax accounting of T bills. According to IRC Section 454(b)(2), the discount isnot accreted. If a T bill is held to maturity, all of the discount is reported as interest income. However, if it is sold priorto maturity, Section 1271(a)(3) requires the following:

� Recognizing interest income in the amount of the discount that would have been accreted through the saledate

� Treating the remainder of the difference between the sales proceeds and the acquisition cost as ashort�term capital gain or loss

Since tax rules view the discount as interest income and capital gain or loss is recognized only for value changesother than discount accretion, best practices indicates that IRC Section 454's approach of not accreting thediscount probably results from the view that accretion normally is not material.

For financial reporting, the only guidance that addresses accounting for T bills is found in accounting textbooks andsimilar publications, and they differ in their conclusions about whether to accrete the discount. If the effect would bematerial to the financial statements, best practices indicate accreting the discount because that is consistent withthe general accounting for other discounts. As a practical matter, however, since T bills normally have low yieldsand mature over short periods, best practices indicates that the effect of discount accretion normally is not materialto the financial statements.


317

To illustrate the accounting considerations, if the discount on the T bill in the immediately previous example, wereaccreted and the company's year ends in October, interest income of $155 would be recognized for the year, asfollows:

� Number of days since September 14 (date T bill was purchased) 47

� Number of days T bill is outstanding 91

� Discount ($10,000 par value less $9,700 acquisition cost) $ 300

� Discount accreted at the end of October ($300 � 47/91) $ 155

The following entry would record the accretion:

Short�term investments 155

Interest income 155

To accrete interest income on T bill.

After that entry, the balance of the T bill would be $9,855 ($9,700 + $155).

If the T bill were classified as a held�to�maturity security, it would be recorded in the company's financial statementsat $9,855 if the discount were accreted and at $9,700 if it were not. (Even though the financial statements wouldonly report a net amount, separate general ledger accounts may be maintained for the par value and the discount.)If the T bill were classified as available�for�sale, GAAP requires it to be recorded at fair value. Accordingly, thecompany would make an entry debiting or crediting the carrying amount of the T bill with a corresponding entry toother comprehensive income for the unrealized gain or loss.

Determining Fair Value. FASB ASC 820�10 (formerly SFAS No. 157 ) provides guidance on measuring fair value.In many cases, quoted market prices will be used to measure fair value. T bills are quoted in terms of bid and askedprices. Instead of specifying a price for T bills, however, they are quoted at a discount from par value. For example,financial publications, such as the Wall Street Journal, often show market prices of T bills as follows:

MaturityDays toMaturity Bid Asked Chg. Yield

Oct 10 'X6 97 5.18 5.16 +0.05 5.31

The first two columns indicate the date on which the T bills mature and the number of days remaining to maturity.As explained above, the bid and asked prices are quoted at discounts from par. In this example, the bid pricemeans an entity could sell a T bill from its portfolio maturing on October 10, 20X6, at a discount of 5.18% below par;it could purchase that T bill at a discount of 5.16% below par.

Best practices are to use the last bid price on the balance sheet date to estimate the fair value. Using the quotationsin the preceding paragraph, fair value of a $10,000 T bill would be determined as follows:

Fair�Value�� $10, 000��($10, 000� .0518� 97)

360�� $9, 860.43

Applying the yield to the fair value over the period until the T bill matures will accrete it to $10,000:

Quoted yield 5.31

Fair value $9,860.43

Interest income that would be earned if the investment wereheld for a year at the quoted yield = $9,860.43 � .0531 $523.59

Number of days until maturity 97

Number of days in the denominator (while 360 days are usedto calculate the price of a T bill, 365 days are used tocalculate its yield) 365


318

Interest that would be earned by holding the T bill untilmaturity = $523.59 � 97/365 $139.15

Accreted value at maturity = $9,860.43 + $139.15 (plus arounding difference of $.42) $10,000.00

Accounting for Treasury Notes and Bonds. Treasury notes and bonds may be purchased either at par ($1,000)or above or below par, depending on market conditions. Like investments in corporate or municipal bonds,Treasury notes and bonds should be recorded at cost, and any discount or premium amortized to income using theinterest method over the life of the securities. According to FASB ASC 835�30�20; 835�30�35�2; and 35�3 (formerlyAPB Opinion No. 12) the interest method arrives at periodic interest, including amortization, that represents a leveleffective rate on the sum of the face amount of the investment plus or minus the unamortized premium or discount.For convenience, an investment account is typically debited for the par value of the bond or note, and relateddiscount or premium is recorded in a separate account. For financial reporting, however, the investment accountshould be shown as a net amount.

To illustrate, a company would make the following entry to record the purchase of 10 five�year Treasury notesat�129:

Investment in Treasury notes 10,000

Premium on Treasury notes 2,900

Cash 12,900

To record the purchase of Treasury notes.

The yield implicit in the purchase price is 3.245% calculated on a semiannual basis (which is 6.49% interest). Thatis the rate that will discount 10 semiannual payments of $668.75 (see entries following Exhibit 1�2) and a singlepayment of $10,000 due 10 semiannual periods from the purchase date to $12,900. To find the premium amortiza�tion for the first six months, subtract interest calculated using the yield from the coupon interest. (A spreadsheet forcalculating amortization of premium and discount is illustrated in Exhibit 1�2.)

Coupon interest $ 668.75

Interest using the yield ($12,900 � 3.245%) 418.60

Premium amortization $ 250.15

Exhibit 1�2

Calculating Premium Amortization or Discount Accretion

Premium amortization or discount accretion is the difference between the interest at the coupon rate and interest atthe yield quoted when the Treasury obligation was bought. It can be calculated using a simple spreadsheet suchas the following, which assumes 10 five�year notes totaling $10,000 are purchased at 129 and bear coupon interestat 13.375% annually.

Par value $ 10,000.00

Purchase price $ 12,900.00

Period to maturity

Number of years 5

Number of semiannual periods 10

Coupon rate

Annual 13.3750 %

Semiannual 6.6875 %

Semiannual interest payments $ 668.75


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Quoted yield at the date of purchase

Annual 6.4900 %

Semiannual 3.2450 %

InvestmentBalance

InterestIncome

Using YieldPremium

AmortizationPrincipalReceived

Initial Payment $ 12,900.00

1 12,649.85 $ 418.60 $ 250.15

2 12,391.59 410.49 258.26

3 12,124.95 402.11 266.64

4 11,849.65 393.45 275.30

5 11,565.42 384.52 284.23

6 11,271.97 375.30 293.45

7 10,969.00 365.78 302.97

8 10,656.19 355.94 312.81

9 10,333.23 345.79 322.96

10 0.00 335.52 333.23 $ 10,000.00

$ 3,787.50 $ 2,900.00

Notes:

1. The premium amortization is computed by subtracting the interest income calculated using the yield from thecoupon interest.

2. The investment balance is calculated by subtracting the premium amortization and principal received.

3. The method used in this illustration normally will result in a small balance at maturity. This should be chargedor credited to interest income for the year of maturity. In this illustration, that adjustment increases interestincome of the final period by $.21.

4. As an alternative, the investment balance could be calculated using present values, with premiumamortization generally computed as the change in the investment balance. That requires present valuecalculations of the number of remaining interest payments and the single payment of par value at maturity.

5. The following illustrates the accounting entries:

Treasury notes at par value 10,000.00

Premium on Treasury notes 2,900.00

Cash 12,900.00

To record acquisition of the Treasury notes.

Cash 668.75

Premium on Treasury notes 250.15

Interest income 418.60

To record receipt of the first interest payments.

Cash 10,668.75

Treasury notes at par value 10,000.00



To record receipt of the final interest payments and the par value.


320

6. Over the period the notes are held, the following would be recorded:

Cash received from 10 interest payments of $668.75 $ 6,687.50

Excess of $12,900.00 cash paid for the notes over the $10,000.00received for their par value (2,900.00 )

Interest income recognized $ 3,787.50

* * *

Every six months, the company would record interest on the note and amortization of premium or discount. If thenote had a coupon rate of 133/8, semiannual interest and premium amortization for the first six months would berecorded as follows:

Cash 668.75



To record semiannual income on Treasury note($10,000 � 0.13375/2) and premium amortization.

The entry would result in the following amounts at the end of the first six months:

� Unamortized premium ($2,900.00 initial amount less $250.15) $ 2,649.85

� Investment ($10,000.00 initial balance plus $2,649.85 unamortized premium) $ 12,649.85

(The $12,649.85 investment balance is the present value of nine semiannual interestpayments of $668.75 and a single payment of $10,000 due nine semiannual periodsfrom now, calculated using a semiannual yield of 3.245%.)

� Interest income ($668.75 coupon less $250.15 using yield) $ 418.60

Because Treasury notes and bonds pay coupon interest, it should be accrued and any premium or discount shouldbe amortized as of the balance sheet date. In addition, if notes or bonds are purchased between interest dates, thepurchase of accrued interest also should be recorded. Similar to Treasury bills, when Treasury notes or bondsmature, an entry debiting cash and crediting investments should be made If notes or bonds are sold beforematurity, any related premium or discount would be eliminated, and accrued interest should be recorded if the saleoccurs between interest dates.

If Treasury notes or bonds are classified as held�to�maturity securities at the balance sheet date, they should berecorded at amortized cost (that is, cost less amortization of premium or discount). If, on the other hand, they areclassified as available for sale, GAAP requires them to be recorded at fair value. In that circumstance, the companywould record the fair value adjustment by debiting or crediting the carrying amount of the Treasury note or bondwith a corresponding entry to other comprehensive income for the unrealized gain or loss.

Determining Fair Value. The fair value of Treasury bonds or notes at the financial statement date may bedetermined by reference to the last quoted bid price at that date. Financial publications, such as the Wall Street

Journal, might report information such as the following:

RateMaturityMo/Yr Bid Asked Chg. Ask Yield

67/8 July X9n 101:05 101:07 �7 6.43

The first column indicates the coupon ratein this case, 67/8%. The second column indicates that maturity of theTreasury note is July 20X9. (The �n" annotation indicates that this is a Treasury note rather than a bond.) The bidand asked quotes are not stated in percentages, as they are in the case of Treasury bills. Instead, numbers to theright of the colon represent 32nds of one point. In this case, the bid quote (the price at which an entity could sell)


321

translates to 1015/32 or $1,011.56, and the asked quote (the price at which an entity could purchase) translates to1017/32 or $1,012.19. The �ask yield" represents the yield to maturity on the note. Accordingly, the fair value of fivenotes maturing July 20X9 would be $5,057.80 ($1,011.56 � 5). If the Treasury note were classified as available forsale, the fair value adjustment would be recorded by debiting or crediting the carrying amount of the investments(cost plus or minus any related premium or discount) with a corresponding entry to other comprehensive incomefor the unrealized gain or loss.

Presenting Unrealized Gains and Losses. As explained earlier in this lesson, companies should debit or creditthe carrying amount of investments in available�for�sale marketable securities, with a corresponding entry to othercomprehensive income, to record unrealized gains and losses on the securities and report them at fair value in thefinancial statements. GAAP (as amended) also requires the notes to the financial statements to disclose thefollowing, by major security type, for available�for�sale securities: (a) aggregate fair value, (b)�total gains forsecurities with net gains in accumulated other comprehensive income, and (c) total losses for securities with netlosses in accumulated other comprehensive income. For securities classified as held�to�maturity, the followingdisclosures, by major security type, are required: (a) the aggregate fair value, (b) gross unrecognized holdinggains, (c) gross unrecognized holding losses, (d) the net carrying amount, and (e) the gross gains and losses inaccumulated other comprehensive income for any derivatives that hedged the forecasted acquisition of theheld�to�maturity securities. To keep track of that information, some companies may prefer to use more than oneaccount for available�for�sale securities (for example, initially recording all securities at cost and recording unreal�ized gains and losses in a separate account). While that practice is acceptable, the financial statements shouldpresent available�for�sale securities at a net amountfair valuenot cost plus or minus a valuation allowance.

GAAP requires unrealized gains and losses on available�for�sale securities to be recorded in other comprehensiveincome. Accordingly, the equity section of a company's balance sheet might appear as follows:


Capital stock$1.00 par value; 16,000 shares issued; 15,832 sharesissued and outstanding

15,832

Additional paid�in capital 7,509,076

Net unrealized gain on marketable securities 4,675

Members' (deficit) (4,555,357 )

2,974,226


322


323

SELF�STUDY QUIZ


3. Company B purchased 20 $1,000 face value bonds on January 1, 20X1 at an amortized cost of $985 per bond.Company B will hold the bonds until maturity, 10 years later, unless there are changes in the yield on alternativeinvestments that make it advantageous to sell the bonds. On December 31, 20X8, the bonds have a marketvalue of $960 per bond. What does Company B report as the value of the bonds on the December 31, 20X8balance sheet, and how is the unrealized, temporary loss reported?

a. $19,200; report in earnings.

b. $19,200; report in other comprehensive income.

c. $19,700; no loss is reported.

d. $20,000; no loss is reported.

4. Company C held bonds with a carrying amount of $30,000 which were originally classified as held�to�maturity.On December 31, 20X2, the company transfers the bonds to the available�for�sale category. On that day, themarket value of the bonds was $35,000. How much does Company C report as other comprehensive incomedue to this transfer?

a. $0.

b. $5,000.

c. $30,000.

d. $35,000.

5. A company purchases a debt security at its $80,000 face value and classifies it as available�for�sale. Thesecurity bears interest at 10%, and is due in five years. On December 31, 20X1, the security's fair value is$85,000 and the company reclassifies the security as held�to�maturity. On January 31, 20X2, the security's fairvalue is $90,000. The 20X2 financial statements are issued on March 15, 20X2. What amount does the companyreclassify from available�for�sale to held�to�maturity?

a. $8,000.

b. $80,000.

c. $85,000.

d. $90,000.

6. A company purchases four 52�week $10,000 Treasury bills (T bills) at 98. The company classifies the T bills asavailable for sale. At the end of the year, the Wall Street Journal reports the following information regarding theT bills: Days to maturity: 85; Bid 6.2; Ask 6.3; Yield 6.55. What amount is reported as the value of the bondson its year�end financial statements?

a. $38,626.15.

b. $39,200.00.

c. $39,405.00.

d. $39,414.44.


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7. How should an entity present available�for�sale securities on its balance sheet?

a. The net fair value.

b. Amortized cost.

c. Cost plus or minus a valuation allowance.

d. Cost less any non�temporary declines in value.


325



3. Company B purchased 20 $1,000 face value bonds on January 1, 20X1 at an amortized cost of $985 per bond.Company B will hold the bonds until maturity, 10 years later, unless there are changes in the yield on alternativeinvestments that make it advantageous to sell the bonds. On December 31, 20X8, the bonds have a marketvalue of $960 per bond. What does Company B report as the value of the bonds on the December 31, 20X8balance sheet, and how is the unrealized, temporary loss reported? (Page 310, Exhibit 1�1)

a. $19,200; report in earnings. [This answer is incorrect. The loss would be reported in earnings if the bondsare held for trading.]

b. $19,200; report in other comprehensive income. [This answer is correct. The bonds should beclassified as available�for�sale since the company would consider selling the bonds in somecircumstances. Bonds that are available for sale with an unrealized loss should report the loss inother comprehensive income.]

c. $19,700; no loss is reported. [This answer is incorrect. Since the company would consider selling thebonds in certain circumstances, the bonds are not treated as held�to�maturity and should be reported atfair value.]

d. $20,000; no loss is reported. [This answer is incorrect. The bonds are originally recorded at their amortizedcost, the basis of the bonds either remains the same or is adjusted based on their market value, dependingon their classification.]

4. Company C held bonds with a carrying amount of $30,000 which were originally classified as held�to�maturity.On December 31, 20X2, the company transfers the bonds to the available�for�sale category. On that day, themarket value of the bonds was $35,000. How much does Company C report as other comprehensive incomedue to this transfer? (Page 312)

a. $0. [This answer is incorrect. The carrying amount of the bonds is increased to its current value on thetransfer date. The other side of the entry is other comprehensive income.]

b. $5,000. [This answer is correct. To transfer the bonds from held�to�maturity to available�for�sale, thebonds are first adjusted to their market value. The other side of the entry is to other comprehensiveincome. The bonds can then be reclassified to available�for�sale at their new carrying amount.]

c. $30,000. [This answer is incorrect. The original carrying amount of the bonds is already recorded at itscarrying amount of $30,000. This amount should be adjusted to its market value at the transfer date, witha corresponding entry to other comprehensive income.]

d. $35,000. [This answer is incorrect. This is the amount that is reclassified from the held�to�maturity toavailable�for�sale category.]

5. A company purchases a debt security at its $80,000 face value and classifies it as available�for�sale. Thesecurity bears interest at 10%, and is due in five years. On December 31, 20X1, the security's fair value is$85,000 and the company reclassifies the security as held�to�maturity. On January 31, 20X2, the security's fairvalue is $90,000. The 20X2 financial statements are issued on March 15, 20X2. What amount does the companyreclassify from available�for�sale to held�to�maturity? (Page 312)

a. $8,000. [This answer is incorrect. This is the amount of interest the company earns on the investment,which is recognized as interest income.]

b. $80,000. [This answer is incorrect. Debt securities transferred to the held�to�maturity category from theavailable�for�sale category are adjusted to a new cost basis; the original cost or amortized cost is not thebasis of the reclassified security.]


326

c. $85,000. [This answer is correct. The security's value at the transfer date becomes its new costbasis. Changes in value subsequent to the report date, but before the issuance of the financialstatements should not be recognized. Subsequent changes in value are recognized when realized.]

d. $90,000. [This answer is incorrect. Changes in value subsequent to the report date, but before the issuanceof the financial statements should not be recognized.]

6. A company purchases four 52�week $10,000 Treasury bills (T bills) at 98. The company classifies the T bills asavailable for sale. At the end of the year, the Wall Street Journal reports the following information regarding theT bills: Days to maturity: 85; Bid 6.2; Ask 6.3; Yield 6.55. What amount is reported as the value of the bondson its year�end financial statements? (Page 317)

a. $38,626.15. [This answer is incorrect. The fair value is not calculated using the discounted cost of the Tbills.]

b. $39,200.00. [This answer is incorrect. This is the amount that would be reported if the T bills were classifiedas held to maturity.]

c. $39,405.00. [This answer is incorrect. Although GAAP does not specify whether the bid price, the askedprice, or some combination of the two represents the fair value, the best method to determine the fair value,generally is not the asked price.]

d. $39,414.44. [This answer is correct. Best practices are to use the last bid price on the balance sheetdate to estimate the fair value. The calculation of fair value is determined as: $40,000 � (($40,000� .062 � 85)/360)].

7. How should an entity present available�for�sale securities on its balance sheet? (Page 321)

a. The net fair value. [This answer is correct. Some companies prefer to use more than one accountfor available�for�sale securities to keep track of the original cost and unrealized gains and losses.However, the financial statements should present available�for�sale securities at a net amountfairvaluenot cost plus or minus a valuation allowance.]

b. Amortized cost. [This answer is incorrect. Securities that are classified as held�to�maturity are reported attheir amortized cost.]

c. Cost plus or minus a valuation allowance. [This answer is incorrect. Some companies choose to keep trackof their available�for�sale securities in separate accounts, but these accounts should not be shownseparately on the financial statements.]

d. Cost less any non�temporary declines in value. [This answer is incorrect. Market value declines insecurities that are classified as available�for�sale are reported even if the change is temporary.]


327

Receivables

Receivables is a broad term that includes amounts due from others as a result of sales of merchandise, services,or other assets, or as a result of a loan. Receivables may be divided into three categories: trade, nontrade, andrelated party. This lesson considers the financial statement presentation of certain specific types of receivables andthe presentation and calculation of the allowance for doubtful accounts.

Balance Sheet Captions. The captions used in presenting receivables vary according to the types of receivablesand the level of detail to be presented on the face of the balance sheet. The captions should be accuratedescriptions of the accounts included. The most frequently used are:

� Accounts receivable

� Trade accounts receivable

� Receivables

The first two generally refer to trade accounts. The captions also are appropriate when nontrade receivables areinsignificant or are presented in a separate caption. �Receivables" is a more appropriate caption when significantnontrade receivables are combined with trade receivables. In such cases, disclosure of the types of receivablesthat have been combined should be considered.

Trade Receivables. Trade receivables include open accounts, notes, and installment contracts representingclaims for goods and services sold in the ordinary course of business. Frequently, open accounts and current notesare combined under the caption �Trade accounts and notes receivable." However, it is generally good practice todisclose the amounts and terms of trade notes or installment receivables, particularly when the notes or installmentcontracts significantly extend the normal collection period. When space allows, many accountants use separatecaptions on the balance sheet to set out the amounts of trade notes or installment receivables. For example:

Trade receivables


Short�term installment contracts 675,000

Less allowance for doubtful contracts 50,000

925,000

GAAP requires certain other disclosures that apply to receivables. Those disclosures are generally made in notesto the financial statements.

Nontrade Receivables. To make financial statements more informative and useful, nontrade receivables, if mate�rial, should be separately classified. Nontrade receivables are items such as:

a. tax refund claims,

b. receivables from sales not part of the operating cycle, such as sales of plant or equipment, and

c. dividends receivable.

If nontrade receivables are not individually material, they may be classified together, for example, �Accountsreceivableother" or �Other receivables." If immaterial in the aggregate, they may be included with trade accountsor notes. Best practices indicate that nontrade receivables also may include the current portion of deferred taxassets; the noncurrent portion, however, should be presented with other noncurrent assets.

Related Party Receivables. FASB ASC 850�10�50 (formerly SFAS No. 57) requires material amounts of notes andaccounts receivable from related parties including stockholders, officers, management, or affiliates to be disclosed.The disclosure normally may be provided using a balance sheet presentation such as the following:


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Cash 10,000

Accounts receivable

Trade 65,000

Related parties 25,000

or

Cash 10,000

Marketable securities 15,000


Due from related parties 35,000

Tax refund claim 20,000

The caption �Due from Related Parties" is useful when several types of related party receivables are present. Whenonly one type of receivable is present, a more descriptive caption is often used, e.g., �Officer notes receivable,"�Due from affiliates," or �Due from stockholders." GAAP also requires other disclosures about related partytransactions, which are usually provided in a note to the financial statements.

Transfers of Receivables Prior to Adoption of SFAS No. 166. FASB ASC 860 (formerly SFAS No. 140, Account�ing for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities) is the authoritative literature onreporting by transferors for transfers of receivables. Transfers of receivables in which the transferor surrenderscontrol over the receivables should be recorded as sales (to the extent that the consideration received for thetransferred receivables does not include beneficial interests in those receivables). The transferor is considered tohave surrendered control over the transferred receivables only if all of the following conditions are met:

a. The transferred receivables must be isolated from the transferor (i.e., the receivables must be beyond thereach of the transferor and its creditors, even in bankruptcy or other receivership).

b. The transferee obtains the right to pledge or exchange the transferred receivables without constrainingconditions that provide more than a trivial benefit to the transferor.

c. The transferor must not maintain effective control over the transferred receivables through (1) an agreementthat entitles and obligates the transferor to repurchase the receivables before their maturity or (2) the abilityto unilaterally cause the holder to return specific transferred receivables other than when the cost ofservicing the receivables becomes burdensome in relation to the benefits of servicing them, often referredto as a �cleanup call."

Transactions that do not meet the above criteria for a sale should be accounted for as a secured borrowing withpledge of collateral.

Upon completion of a transfer of receivables meeting the criteria listed above to be accounted for as a sale, thetransferor should:

a. Derecognize (i.e. remove from the balance sheet) all receivables sold.

b. Recognize all assets received and liabilities incurred in consideration for the transferred receivables asproceeds from the sale.

c. Measure the assets obtained and liabilities incurred at fair value.

d. Recognize any gain or loss on the sale in earnings.

For any transfer of receivables, including those accounted for as sales, GAAP requires the transferor to continue tocarry in its balance sheet any retained interest in the transferred receivables by allocating the previous carryingamount between the receivables sold (if any) and the retained interests (if any), based on their relative fair values atthe date of the transfer. Examples of retained interests include securities backed by the transferred receivables and


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undivided interests. If the transferor cannot determine whether an asset represents a retained interest or proceedsfrom the sale, the asset should be treated as proceeds from the sale.

When an entity transfers receivables to another entity (the transferee), it often does so with recourse. In that case,the transferee has the right to receive payment from the transferor or the transferor must�repurchase the receivablesif the debtor defaults. Transfers of receivables with recourse must meet the conditions previously listed to beaccounted for as a sale. The effect of�recourse provisions on the application of the conditions listed previously mayvary by jurisdiction. In some jurisdictions, the transfer of receivables with full recourse may not place the transferredreceivables beyond the reach of the transferor and its creditors. However, transfers with limited recourse may. Whenaccounting for a transfer of receivables with recourse as a sale, the proceeds of the sale should be reduced by thefair value of the recourse obligation. To illustrate how to record a transfer of receivables with recourse that isrecognized as a sale, assume that:

� A $100,000 note is sold for $95,000, with the transferor retaining recourse for $25,000.

� There is no fee for the transfer.

� The transferor estimates that losses under the recourse provision will total $5,000.

The transferor would record the following journal entry:

Cash 95,000

Loss on sale of receivable 10,000

Note receivable 100,000

Recourse obligation 5,000

If the transfer of receivables with recourse does not meet the conditions previously listed to be accounted for as asale, the transfer should be accounted for as a secured borrowing and pledge of collateral.

Transfers of Receivables after Adoption of SFAS No. 166. FASB ASC 860 (formerly SFAS No. 140) providesaccounting and reporting standards for transfers and servicing of financial assets. Those standards apply totransfers of receivables. In June 2009, the FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets,which will amend the guidance in FASB ASC 860 (formerly SFAS No. 140). The new standard will be effective as ofthe beginning of an entity's first annual reporting period beginning after November 15, 2009. Earlier application isprohibited. The recognition and measurement provisions of the new standard should be applied to transfers thatoccur on or after the effective date. At the date this course was completed, SFAS No. 166 had not been codified intothe FASB Accounting Standards Codification. Future editions of this course will incorporate the relevant ASCreferences.

GAAP discusses transfers of financial assets in terms of transfers of an entire financial asset, a group of entirefinancial assets, or a participating interest in an entire financial asset, which are collectively referred to as transferred

financial assets. One of the primary considerations in determining the proper accounting for transfers of financialassets is whether the transferor (and its consolidated affiliates) has surrendered control over the assets transferred.Generally, if the transferor surrenders control over the transferred financial assets, the transfer is accounted for asa sale and the related assets are removed from the transferor's balance sheet. A transferor is considered to havesurrendered control over transferred financial assets if all of the following conditions are met:

a. The transferred financial assets (i.e., the transferred receivables) have been isolated from the transferor(that is, put beyond the reach of the transferor and its creditors, even if the transferor is in bankruptcy orother receivership).

b. Each transferee (or third�party holder of beneficial interests if the transferee solely engages in securitizationor asset�backed financing activities and is constrained from pledging or exchanging the assets it receives)has the right to pledge or exchange the transferred assets (or beneficial interests) it received, and nocondition both (1) constrains the transferee (or third�party holder) from taking advantage of that right, and(2) provides more than a trivial benefit to the transferor.


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c. Effective control over the transferred financial assets (or related third�party beneficial interests) is notmaintained by the transferor, its consolidated affiliates, or its agents. A transferor's effective control may bemaintained through agreements such as the following: (1) one that entitles and obligates the transferor torepurchase or redeem the assets before their maturity, (2) one that gives the transferor the unilateral abilityto cause the holder to return specific financial assets and a more�than�trivial benefit related to that ability(other than through a clean�up call) and, (3) one that allows the transferee to require the repurchase oftransferred financial assets by the transferor at a price so favorable to the transferee that it is probable thatthe repurchase will occur.

Accounting for Transfers of Participating Interests. As noted earlier, transfers of financial assets may involvetransfers of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financialasset. GAAP provides different accounting guidelines for transfers of participating interests than for transfersinvolving entire financial assets or groups of entire financial assets. Accordingly, it is important to understand whatconstitutes a participating interest. A participating interest has all of the following characteristics:

a. It represents, from the date of the transfer, a proportionate (pro rata) ownership interest in an entire financialasset. The transferor's percentage of ownership interests may change over time if certain conditions aremet.

b. From the transfer date, all cash flows received from the entire financial asset are divided between theparticipating interest holders in proportion to their ownership share. Certain cash flows allocated ascompensation for services performed, if any, and some proceeds received by the transferor for thetransferred portion are excluded from this determination.

c. Each participating interest holder (including the transferor) has rights of equal priority and no interest issubordinated to another participating interest holder's interest.

d. The entire financial asset may not be pledged or exchanged without the agreement of all participatinginterest holders.

If a transferred interest in an entire financial asset has the characteristics of a participating interest, the transferorshould analyze the transfer to determine if it satisfies the conditions for surrendered control. If the transferor of theparticipating interest has surrendered control, the transfer should be accounted for as a sale. Upon completion ofthe transfer, the transferor should:

a. Allocate the entire financial asset's previous carrying amount between the participating interests sold andthe participating interest retained by the transferor based on their relative fair values at the transfer date.

b. Derecognize (that is, remove from the balance sheet) the participating interests sold.

c. Recognize and initially measure at fair value all assets received and liabilities incurred in the sale.

d. Recognize any gain or loss on the sale in earnings.

e. Report any participating interest or interests that the transferor retains as the difference between the priorcarrying amount of the entire financial asset and the amount derecognized.

The transferee should recognize and initially measure at fair value the participating interest and any other assetsreceived or liabilities incurred.

If a transferred interest in an entire financial asset does not have the characteristics of a participating interest, thetransferor and the transferee should account for the transfer as a secured borrowing and pledge of collateral. Thetransfer should also be accounted for as a secured borrowing and pledge of collateral if the transferred interest hasthe characteristics of a participating interest but the transfer does not satisfy the conditions to be accounted for asa sale.

If the transferor transfers an entire financial asset in multiple interests that do not individually qualify as participatinginterests, the transferor should evaluate whether the entire financial asset transferred should be accounted for as asale when all interests have been transferred.


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Accounting for Transfers of an Entire Financial Asset or Group of Entire Financial Assets. For transfers of an entirefinancial asset or a group of entire financial assets that meet the conditions for sale accounting, the transferorshould do the following upon completion of the transfer:

a. Derecognize (that is, remove from the balance sheet) the transferred financial assets.

b. Recognize and initially measure at fair value all assets received and liabilities incurred in the sale.

c. Recognize any gain or loss on the sale in earnings.

The transferee should record any assets obtained and liabilities incurred at fair value.

If a transfer of an entire financial asset or a group of entire financial assets does not meet the conditions to beaccounted for as a sale in its entirety, upon completion of the transfer the transferor should account for the transferas a secured borrowing and pledge of collateral.

GAAP provides detailed implementation guidance regarding accounting for transfers of financial assets. SeeChapter 48 of PPC's Guide to GAAP for additional analysis of accounting for transfers of financial assets accordingto FASB ASC 860 (formerly SFAS No. 140).

Accounting for Secured Borrowings. A transfer of an entire financial asset, a group of entire financial assets, or aparticipating interest in an entire financial asset may not meet the conditions for sale accounting. In those situations,the transferor and the transferee should account for the transfer as a secured borrowing with pledge of collateral.Likewise, if a transfer involves part of an entire financial asset and that partial transfer does not have the characteris�tics of a participating interest, the transfer also should be accounted for as a secured borrowing with pledge ofcollateral. That accounting requires the transferor to continue to report the transferred financial assets on itsbalance sheet without changing how it measures those assets.

Transfers of Receivables with Recourse. When an entity transfers receivables (including an entire receivable, agroup of entire receivables, or part of an entire receivable) to another entity (the transferee), it often does so withrecourse. When there is recourse, the transferee has the right to receive payments from the transferor or thetransferor must repurchase the receivables in certain cases, such as when the debtor defaults. Transfers of entirereceivables with recourse must meet the conditions to be accounted for as a sale. However, a transfer of a portionof a receivable with recourse is not considered a participating interest and must be accounted for as a securedborrowing.

The effect of recourse provisions on the application of the requirements may vary by jurisdiction. In some jurisdic�tions, the transfer of receivables with full recourse may not place the transferred assets beyond the reach of thetransferor, its consolidated affiliates, and its creditors; however, transfers with limited recourse may. If a transfer ofentire receivables with recourse meets the conditions, the transfer should be accounted for as a sale with theproceeds of the sale reduced by the fair value of the recourse obligation. If a transfer of entire receivables withrecourse does not meet those conditions, the transfer should be accounted for as a secured borrowing.

Inventories

Inventories, according to FASB ASC 330�10�20 (formerly ARB No. 43, Chapter 4), include the following items:

a. Items held for sale in the ordinary course of business

b. Items in the process of production for sale

c. Items to be consumed in the production of goods or services to be available for sale

Operating supplies not directly entering into the production of the product should be treated as prepaid expensesrather than inventories. Also, in some industries, most notably construction, items that might appear to be invento�ries receive special accounting treatment and are not presented in the financial statements as inventories, forexample, costs and estimated earnings in excess of billings on contracts in progress.


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Balance Sheet Captions. Inventories are normally presented in the balance sheet at the lower of cost or market.The retail inventory method used by department stores and some other retailers approximates lower of cost ormarket. Some specialized industries, such as agricultural products, state inventories above cost, but those excep�tions are rare. GAAP requires the following to be disclosed:

a. Basis upon which the inventory classifications are stated

b. Method of determining costs

It is common practice to disclose the inventory basis and method of determining cost within the balance sheetcaption. For example:

Inventories, at the lower of first�in, first�out cost or market.

However, the disclosures may be made in the notes rather than on the face of the balance sheet.

Components of Inventory. There is no requirement to disclose the components or types of inventory, but, inpractice, disclosure is almost universal in the following situations:

a. Manufacturing inventories in various stages of completion

b. Inventories of distinct product lines

Examples of disclosure of inventory components, which may be made on the face of the balance sheet or in thenotes, are as follows:

20X2 20X1

Inventories

Raw materials 75,000 60,000

Work in process 25,000 30,000

Finished goods 50,000 40,000

20X2 20X1

Inventories

New vehicles 200,000 225,000

Used vehicles 150,000 175,000

Parts and accessories 150,000 150,000

20X2 20X1

Inventories

Gasoline 15,000 17,000

Groceries 60,000 75,000

Other 10,000 5,000

Determining Inventory Cost. There are two aspects of determining inventory costs that must be considered:

a. What costs are properly charged to inventory?

b. In what sequence should those costs be charged to cost of sales as inventory is sold?

Companies that do not manufacture a product, such as retailers and wholesalers, generally incur only directmaterial costs in acquiring their inventories. Inventory costs of manufacturing companies include three compo�nents:

a. Direct materials, including invoice cost, freight�in, and tooling charges from vendors


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b. Direct laborpayroll costs of personnel whose efforts directly result in manufacture of the product

c. Indirect costs, including factory facility costs, utilities, indirect manufacturing labor and related costs, butexcluding general and administrative expenses

The proper allocation of indirect costs between inventory and cost of sales is a key factor in determining inventorycost.

Generally accepted accounting principles essentially permit four ways of determining the sequence of costs to becharged to cost of sales.

a. Specific Identification. The cost of each unit is tracked and charged to cost of sales when the unit is sold.

b. First�in, First�out (FIFO). Inventory sold is considered to be the oldest inventory available for sale;conversely, ending inventory is considered to be the latest inventory purchased.

c. Last�in, First�out (LIFO). Inventory sold is considered to be the latest inventory purchased; conversely,ending inventory is considered to be the oldest inventory available for sale.

d. Average Cost. The cost of items in inventory is determined on the basis of the average cost of all similaritems available during the period.

Most companies use either the FIFO or LIFO method. Inventory methods such as standard cost or the retail methodare generally accepted conventions used in applying one of the four methods allowed by GAAP. Disclosing thoseconventions is not required and, if disclosed, usually is included in the notes rather than on the face of the balancesheet.

Applying Lower of Cost or Market. The lower of cost or market rule basically requires recognizing an unrealizedloss when historical cost will not be recovered through the expected selling price. Generally, FASB ASC 330�10�20(formerly ARB No. 43) requires writing inventory down to current replacement cost (market value) except in thefollowing instances:

� Market value should not be less than net realizable value reduced by an allowance for an approximatelynormal profit margin. (Thus, cost should be used to value inventory if the net realizable value will providefor an approximately normal gross profit, even if current replacement cost is lower than historical cost.)

� Market value should not exceed the inventory's net realizable value. (In other words, net realizable valueshould be used to value the inventory if it is lower than current replacement cost.) Net realizable value isthe estimated selling price less costs of completion and disposal.

To illustrate, assume that an item costs $40, sells for $50 (which provides for normal profit margin of $10) and at theend of 20X2, its current replacement cost drops to $30.

� If the selling price is unaffected (perhaps because of firm sales commitments), the inventory would becarried at $40 since the selling price will recover cost plus the normal profit margin.

� If the selling price drops to $40, the inventory would be carried at $30. The income statement for 20X2 wouldshow a loss (through a charge to cost of sales) of $10 for the loss in value, and the income statement for20X3 would show a profit of $10 resulting from the sale.

� If the net realizable value (selling price less costs of completion and disposal) drops to $25, the inventorywould be stated at $25.

Obsolescence. Excess and obsolete inventory should be written down to its net realizable value, which may bescrap value, even if the inventory is not actually scrapped or even segregated. Many companies establish reservesfor obsolete and slow moving inventory by using a formula based on supply and past sales history. Inventory valuesare generally presented in the financial statement as a net amount, that is, the reserves are not presented on the


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face of the balance sheet. It may, however, be appropriate to disclose the methods used to determine the reservein the accounting policies note.

The Need for Physical Counts. Most accountants agree that inventories should be adjusted to physical count atleast annually. The one exception generally accepted in annual financial statements is the use of inventory amountsderived from well�maintained perpetual inventory records. (However, many accountants will not rely on perpetualrecords unless they are systematically tested by periodic physical counts.) The inability to obtain reliable counts ofinventory at year end either by physical count or perpetual records may cause significant problems for accountantsin practice, who may be required by professional standards to modify their report or, in compilation and reviewengagements, to withdraw from the engagement. As explained in the next section, inventory amounts may beestimated by appropriate methods such as the gross profit method in interim financial statements.

InventoriesInterim Financial Statements

In interim financial statements, several modifications of the accounting standards for inventory are permitted orrequired.

Gross Profit Method. The gross profit method is the most common method of estimating inventories at interimdates when physical inventories are not taken. The use of this method to determine inventory and cost of goodssold, although not an acceptable accounting method in annual statements, is an acceptable method for interimfinancial statements [FASB ASC 270�10�45�6 (formerly APB Opinion No. 28)]. However, the interim financialstatements should disclose the method used to value inventory and any significant adjustments that result fromreconciliation with the annual physical inventory.

Market Declines. Even when the gross profit method is used, it may be obvious that market is below cost.Temporary declines in the market value of inventory to values below cost need not be recognized in interim financialstatements if the market decline can reasonably be expected to be restored by the end of the fiscal year. If, however,the company cannot reasonably expect a decline at an interim date to reverse by year end, inventory should beadjusted to market value at the interim date. A subsequent recovery in value before year end should be recognizedin the interim period during which the recovery takes place. However, the inventory, once adjusted downward tomarket, should not be written up above original cost.

LIFO Approximations. Many companies compute LIFO inventory values only on an annual basis. At interim dates,a FIFO basis is used. In that case, the following considerations apply:

� If the difference between LIFO and FIFO values as of the interim date is immaterial, the inventory basis maybe identified as LIFO.

� If the difference is material and the financial statements are issued with inventories on a FIFO basis, thestatements are not in conformity with GAAP because they do not use the same method as used in theyear�end statements. The preparer also should be concerned about potential violation of various IRSregulations regarding LIFO, particularly Reg.�1.472�2(e)(6), holding that in certain cases a series of interimstatements presenting results of operations on a non�LIFO basis constitutes presentation of annual resultson a non�LIFO basis.

� If the difference between LIFO and FIFO values is material, the preparer may want to approximate anadjustment to LIFO and present the statements with inventory stated at the estimated LIFO value. Thatapproach parallels the use of gross profit percentages at interim dates. Best practices indicate such anapproach is proper and is not a departure from GAAP if the estimation method has a reasonable basis. Ofcourse, the estimation method used to value the inventories should be disclosed.

LIFO Inventory Liquidations. When there is a liquidation of a LIFO layer in an interim period, a determination mustbe made of whether the liquidation is temporary or permanent. If the liquidation is permanent, the interim periodfinancial statements should disclose the effect on net income resulting from the liquidation. If the liquidation istemporary, the inventory at the interim reporting date should not give effect to the LIFO liquidation, and cost of salesshould include the expected cost of replacement of the liquidated LIFO layer. The temporary nature of theliquidation should be disclosed in the financial statements.


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Standard Cost System. Planned variances expected to be absorbed by the end of the fiscal year should ordinarilybe deferred in interim financial statements. Unanticipated variances that are not expected to be absorbed should,however, be reported in interim financial statements.


336


337

SELF�STUDY QUIZ


8. A bakery has a note receivable of $150,000 due from a grocery store. The bakery sells the receivable to a bankfor $140,000, with the bakery retaining recourse for $20,000. The bakery estimates that losses under therecourse provision will total $15,000. When recording the journal entry to record the sale of the note prior toadoption of SFAS No. 166, the loss on the sale is debited for what amount?

a. $10,000.

b. $15,000.

c. $20,000.

d. $25,000.

9. Which of the following inventory costs is typically the only type incurred by a retailer?

a. Direct labor.

b. Direct materials.

c. Indirect costs.

d. Work in process.

10. The cost of an item of inventory is $30 and its selling price is $45. At the end of the year, its replacement costis $25. The net realizable value is $35. Due to firm sales commitments, the sales price has not changed. At whatamount is the inventory stated?

a. $25.

b. $30.

c. $35.

d. $45.


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8. A bakery has a note receivable of $150,000 due from a grocery store. The bakery sells the receivable to a bankfor $140,000, with the bakery retaining recourse for $20,000. The bakery estimates that losses under therecourse provision will total $15,000. When recording the journal entry to record the sale of the note prior toadoption of SFAS No. 166, the loss on the sale is debited for what amount? (Page 329)

a. $10,000. [This answer is incorrect. Although it may appear the loss is $10,000 ($140,000 received for a$150,000 note), the recourse obligation is factored into the loss amount recorded.]

b. $15,000. [This answer is incorrect. This is the amount of recourse obligation, not the amount of the loss.]

c. $20,000. [This answer is incorrect. Although the bakery may be liable for up to $20,000 if the grocery storedefaults on the note, the recourse retained is not included in the journal entry, or in the amount of the loss.]

d. $25,000. [This answer is correct. The loss is the amount of recourse obligation recorded ($15,000)plus the amount that would be the loss if there was no recourse obligation ($140,000 � $150,000).]

9. Which of the following inventory costs is typically the only type incurred by a retailer? (Page 332)

a. Direct labor. [This answer is incorrect. Direct labor, which includes payroll costs of personnel whose effortsdirectly result in manufacture of the product, are inventory costs of a manufacturing company.]

b. Direct materials. [This answer is correct. Direct materials are inventory costs for both manufacturersand retailers and wholesalers. Direct materials include invoice cost, freight�in, and tooling chargesfrom vendors.]

c. Indirect costs. [This answer is incorrect. Indirect costs, including factory facility costs, utilities, indirectmanufacturing labor and related costs, are inventory costs of manufacturers.]

d. Work in process. [This answer is incorrect. Work in process is a component of direct materials, and wouldtypically only be recorded in manufacturing companies.]

10. The cost of an item of inventory is $30 and its selling price is $45. At the end of the year, its replacement costis $25. The net realizable value is $35. Due to firm sales commitments, the sales price has not changed. At whatamount is the inventory stated? (Page 333)

a. $25. [This answer is incorrect. If the selling price drops to $30, the inventory would be carried at $25.]

b. $30. [This answer is correct. The lower of cost or market rule basically requires recognizing anunrealized loss when historical cost will not be recovered through the expected selling price.Generally, GAAP requires writing inventory down to current replacement cost (market value) exceptin the following instances: (1) market value should not be less than net realizable value reduced byan allowance for an approximately normal profit margin, and (2) market value should not exceed theinventory's net realizable value.]

c. $35. [This answer is incorrect. If the net realizable value drops below the replacement cost, then inventoryis stated at the net realizable value.]

d. $45. [This answer is incorrect. The sales commitments would not cause a company to state inventory atan amount greater than its cost.]


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Lesson 1 (PFSTG094)


1. A home appliance company has the following balances on December 31, 20X1, in its accounts with SecondBank: Operating account $150,000; certificate of deposit $50,000; cash restricted for mortgage payment$100,000 (does not offset a current liability); and money market account $10,000. The company also has anaccount at Fourth Bank with a book balance of ($25,000). The negative balance is due to the controller writingchecks in the amount of $40,000 on December 31, 20X1, but not mailing them until January 2, 20X2. Whatamount does the appliance company report as �Cash" on its December 31, 20X1 balance sheet?

a. $175,000.

b. $210,000.

c. $225,000.

d. $325,000.

2. Which type of account is typically included as a prepaid expense, and should be excluded from cash?

a. Restricted cash accounts.

b. Overdraft accounts.

c. Compensating balance accounts.

d. Escrow accounts.

3. Which of the following is considered a marketable security?

a. Warrants.

b. Money market accounts.

c. Repurchase agreements.

d. Certificates of deposit.

4. A television station owns common stock in several other communications companies. Assuming the equitymethod is not used to report these other companies, what basis does the television station use to report thevalue of the common stock owned in the companies, and how are unrealized gains and losses reported?

a. Amortized cost; unrealized gains and losses are not recognized.

b. Fair value; unrealized gains and losses are reported in earnings.

c. Fair value; unrealized gains and losses are reported in other comprehensive income.

d. Amortized cost; unrealized gains and losses are reported in earnings.


340

5. On January 1, 20X1, an entity purchased bonds with a face value of $100,000 at a premium of $110,000, andclassified the bonds as available�for�sale. On December 31, 20X1, when the bond's value is $115,000, the entityreclassifies the bonds as held�to�maturity. The bonds value increases to $120,000 on February 28, 20X2, andon March 31, 20X2, the entity's 20X1 financial statements are issued. What amount does the entity report asthe value of the bonds on the 20X1 financial statements?

a. $100,000.

b. $110,000.

c. $115,000.

d. $120,000.

6. A company purchases 12�month T bills for $1,000,000. At the end of the year, The Wall Street Journal reportsthe following information: Days to maturity40; Bid4.38; Ask 4.40; Yield4.49. What is the value of the Tbills?

a. $995,011.11.

b. $995,111.11.

c. $995,133.33.

d. $999,878.33

7. What information does GAAP require disclosure of, by major security type, for available�for�sale securities?

a. Gross unrecognized holding gains.

b. Aggregate fair value.

c. Net carrying amount.

d. Original cost of securities.

8. Assuming each of the following types of receivable has a material balance, which of the following will bepresented in the �Trade Receivables" caption?

a. Dividends receivable.

b. Tax refunds receivable.

c. Related party receivable.

d. Accounts receivable.

9. Which of the generally accepted methods of determining the sequence of costs to be charged to cost of salestracks the cost of each unit and charges the cost to cost of sales when the unit is sold?

a. Specific identification.

b. First�in, first�out.

c. Last�in, first�out.

d. Average cost.


341

10. Which method of estimating inventory is an acceptable method to use during interim periods, but not anacceptable method in annual statements?

a. Last�in, first�out.

b. Lower of cost or market.

c. Gross profit method.

d. Standard cost.


342


343

Lesson 2: Long�term Investments

INTRODUCTION

The long�term investments caption of the balance sheet may include the following types of holdings:

a. Noncurrent marketable equity and debt securities

b. Nonmarketable equity and debt securities

c. Property and equipment held for investment purposes

d. Cash value of life insurance


This lesson covers long�term investments and using the equity method to account for nonmarketable equity securi�ties.

Completion of this lesson will enable you to:� Determine the appropriate captions and valuation for long�term investments such as nonmarketable securities,

cash value of life insurance policies, and property held for investment.� Determine the accounting treatment for nonmarketable equity securities.� Determine the correct reporting for cash value life insurance policies.

Nonmarketable Equity Securitiesthe Equity Method

The accounting treatment of holdings of equity securities, whether marketable or nonmarketable, is influenced bythe percentage of voting stock held. (Using the equity method is not affected by whether the equity securities aremarketable or nonmarketable, but blocks of stock large enough to require the equity method are typically nonmar�ketable.) Generally, the relationships are as follows:

� Less Than 20%. Holdings of less than 20% of marketable voting stock are accounted for at fair value asprescribed by FASB ASC 320�10 (formerly SFAS No. 115). Holdings of less than 20% of nonmarketable

voting stock are accounted for at cost. Cost is reduced for permanent declines in value, and dividends aretreated as income when received.

� More Than 50%. A holding of more than 50% of the voting stock of another company constitutes controland normally requires presentation of consolidated financial statements.

� Between 20% and 50%. There is a presumption, according to FASB ASC 323�10�15�8 (formerly APBOpinion No. 18, The Equity Method of Accounting for Investments in Common Stock), that the holder(investor) of 20% to 50% of the voting stock of another company (investee) has the ability to exercisesignificant influence over the investee and should account for the investment using the equity method.

The appropriateness of using the equity method and the effect on the investor's financial statements are explainedin the following paragraphs.

Should the Equity Method Be Used? Holding 20% or more of voting stock does not create an absolute require�ment to use the equity method for an investment. The 20% line is usually a reasonable presumption for significantinfluence over a public company. However, for a nonpublic company, ownership of considerably more than 20%may be necessary, as a practical matter, to exercise significant influence.

GAAP notes that determination of whether there is significant influence requires an evaluation of all the facts andcircumstances. However, holdings of 20% or more are presumed to indicate significant influence absent predomi�


344

nant evidence to the contrary (emphasis added). FASB ASC 323�10�15�10 (formerly FASB Interpretation No. 35,�Criteria for Applying the Equity Method of Accounting for Investments in Common Stock") provides the followingtwo examples as possible indicators of lack of significant influence that are not unusual for nonpublic companies:

� Majority ownership of the investee is concentrated among a small group of shareholders who operate theinvestee without regard to the views of the investor.

� The investor needs or wants more financial information to apply the equity method than is available to theinvestee's other shareholders�.�.�.�, tries to obtain that information, and fails.

Situations such as those described above are not conclusive indications of lack of significant influence. All of theattendant facts and circumstances must be evaluated.

FASB ASC 323�10 (formerly APB Opinion No. 18) addresses applying the equity method to investments in votingcommon stock. FASB ASC 323�10�15�13 through 15�19 (formerly EITF Issue No. 02�14, �Whether an InvestorShould Apply the Equity Method of Accounting to Investments Other Than Common Stock") expanded theapplication of the equity method to investments that are in�substance common stock. An investment may beconsidered in�substance common stock if it has risk and reward characteristics that are substantially similar to theentity's common stock. An investment is considered to be in�substance common stock if all of the followingcharacteristics are substantially similar to the entity's common stock:

� Subordination features, such as liquidation preferences.

� Risks and rewards of ownership, such as participation in earnings, losses, and appreciation anddepreciation in value.

� Obligation to transfer value, such as a mandatory redemption provision.

� Future changes in its fair value is expected to vary directly with changes in the common stock's fair value.

If any of these characteristics are not met, the investment is not considered in�substance common stock and shouldnot be accounted for using the equity method.

Measurement Using the Equity Method. Under the equity method, the investment is initially recorded at costfollowing the requirements in FASB ASC 805�50�30 [formerly SFAS No. 141(R)], is increased by the investor'sproportionate share of the investee's net income, and is reduced by dividends and the investor's proportionateshare of the investee's net loss. However, the investment is not reduced below zero unless the investor is com�mitted to provide financial support to the investee. If there is a difference between the cost of the investment and theinvestor's proportionate equity in the investee's net assets at acquisition, the difference should first be related tospecific assets of the investee based on their fair market value. Any difference that cannot be related to specificassets is considered to be attributable to goodwill. The investor should adjust the investment account and invest�ment earnings by an amount that represents the additional depreciation or amortization related to the difference asif it were actually recorded by the investee. (As a practical matter, unless the difference is material, it usually isaccounted for as goodwill, instead of attempting to associate it with specific assets and recording the relateddepreciation.) The equity method is sometimes referred to as a �one�line consolidation" because stockholders'equity and net earnings of the investor generally should be the same whether the equity method is used or the twocompanies are consolidated. Thus, the amortization of the difference between cost and proportionate equity in netassets and other transactions and events follow essentially the same GAAP as consolidation, for example, inter�company profits should be eliminated.


345

An Example of Equity Calculations. Assume the following facts for ABC Company (an equity investee):

Net Book Value

Earnings Dividends 100% 40%

Acquisition $ 75,000 $ 30,000

End of Year:

1 $ 25,000 $ � 100,000 40,000

2 30,000 10,000 120,000 48,000

3 35,000 15,000 140,000 56,000

4 30,000 5,000 165,000 66,000

5 15,000 � 180,000 72,000

If CAS, Incorporated (CAS) buys 40% of the stock of ABC at book value, its statements would reflect the following:

Increasefor

Earnings

Decreasefor

Dividends Investment

Acquisition $ 30,000

End of Year:

1 $ 10,000 $ � 40,000

2 12,000 4,000 48,000

3 14,000 6,000 56,000

4 12,000 2,000 66,000

5 6,000 � 72,000

To illustrate the mechanics of applying the equity method, the following entries would be made by CAS for year 2:

Cash 4,000

Investment 4,000

To record receipt of dividend.

Investment 12,000

Equity in earnings of ABC 12,000

To record earnings on investment.

An Example with Intra�entity Profits. FASB ASC 323�10�35�7 (formerly Paragraph 19a of APB Opinion No. 18)requires eliminating all intra�entity profits or losses until realized by the investor or investee as if the investee wereconsolidated. (Note that if the investee is consolidated, GAAP requires the elimination of all intra�entity income orloss, even though the investor owns less than 100% of the stock.) Listed below is guidance on eliminatingintra�entity profits and losses under the equity method:

a. Only intra�entity profits or losses on assets held by the investor or investee are candidates for elimination.

b. Upstream sales, i.e., the investee sells to the investor:

(1) Eliminate all intra�entity profit or loss less the related tax effect from the investee's net income or lossbefore computing the equity pick�up. The tax effect is the difference between the investee's taxprovision computed with and without the intra�entity profit or loss.

(2) Compute the equity in the investee's earnings following the guidance previously discussed.


346

c. Downstream sales, i.e., the investor sells to the investee:

(1) The investor should eliminate from its net income all of the intra�entity profit or loss less the related taxeffect. The tax effect is the difference between the investor's tax provision computed with and withoutthe intra�entity profit or loss.

(2) Record the eliminated profit or loss in a deferred account, such as deferred revenue, and the tax effectof the eliminated profit or loss in a deferred tax account, such as deferred tax benefit.

(3) Compute the equity in the investee's earnings following the guidance previously discussed. Note thatthe intra�entity profit or loss does not affect computation of the equity pick�up.

The preceding guidance differs from the provisions of FASB ASC 323�10�35�9 and 35�10 (formerly AICPA Inter�pretation No. 1 of APB Opinion No.�18) about how to recognize intra�entity profit or loss from downstream saleswhen the investor holds less than a controlling financial interest. Essentially, recognition of a portion of theintra�entity profit or loss is permitted when when the sale is on an arm's�length basis. In that circumstance, thecontrolling financial interest is, in effect, treated as a third party, and intra�entity profit or loss is recognized inproportion to the controlling financial interest. Nevertheless, entities could choose to adopt a blanket policy ofdeferring all profit or loss on intra�entity sales because it complies with the provisions and also avoids the need tomake subjective evaluations of whether sales are on an arm's�length basis.

The examples in the following two paragraphs illustrate how to apply the preceding guidance in accounting forupstream and downstream sales. Both assume that the investor holds 40% of the investee's voting stock, aneffective tax rate of 30%, and anticipated ultimate distribution of investee earnings in the form of dividends subjectto the 80% exclusion. Company P's investment is presented in the first column using the equity method. Althoughthe conditions for consolidation are not met, consolidated results also are presented in the last column to illustratethat accounting conforms with GAAP by producing generally the same net income and equity interest for CompanyP under both the equity and consolidation methods. In each case, the only differences between the equity methodand consolidation are the deferred tax on the equity pick�up, which represents the benefit gained from consolida�tion by excluding all dividends rather than just 80%, and recording of noncontrolling interests for consolidationpurposes.

The following assumes the investee recognized intra�entity profit of $20,000 from a sale of inventory included in theinvestor's balance sheet (i.e., upstream sale):

COMPANYP

COMPANYS

ELIMINA�TIONS

CONSOLI�DATED

ASSETS

Investment $ 22,400 $ � (d) $ (22,400 ) $ �

Other 250,000 100,000 (a) (20,000 ) 330,000

$ 272,400 $ 100,000 $ (42,400 ) $ 330,000

LIABILITIES

Taxes

Current $ 75,000 $ 30,000 (b) $ (6,000 ) $ 99,000

Deferred 1,344 � (c) (1,344 ) �

EQUITY

Retained earnings 196,056 70,000 (68,656 ) 197,400

Noncontrolling interests � � (e) 33,600 33,600

$ 272,400 $ 100,000 $ (42,400 ) $ 330,000


347

CONSOLI�DATED

ELIMINA�TIONS

COMPANYS

COMPANYP

EARNINGS

Pretax $ 250,000 $ 100,000 (a) $ (20,000 ) $ 330,000

Equity in investee's earnings 22,400 � (d) (22,400 ) �

272,400 100,000 (42,400 ) 330,000

Taxes

Current 75,000 30,000 (b) (6,000 ) 99,000

Deferred 1,344 � (c) (1,344 ) �

76,344 30,000 (7,344 ) 99,000

196,056 70,000 (35,056 ) 231,000

Noncontrolling interests � � (e) (33,600 ) (33,600 )

Net income $ 196,056 $ 70,000 $ (68,656 ) $ 197,400

Equity in the investee's earnings in the amount of $22,400 is computed by eliminating $14,000 from Company S'snet income, i.e., $20,000 intra�entity profit less the related $6,000 tax effect, and multiplying the remaining $56,000by the investor's 40% interest. Deferred taxes related to the equity pick�up in the amount of $1,344 are computedby multiplying the portion of the equity pick�up that will eventually be taxed, i.e., 20% of $22,400 = $4,480, by the30% tax rate. The elimination entries to obtain consolidated results for the preceding example are explained asfollows:

a. To eliminate intra�entity profit of investee (Co. S)

b. To eliminate the tax effect of the intra�entity profit

c. To eliminate deferred taxes related to the taxable portion of equity pick�up as a result of excluding alldividends in consolidation rather than 80%

d. To eliminate the equity pick�up

e. To record minority interests ($56,000 � 60%)

The following assumes the investor recognized intra�entity profit of $20,000 from a sale of inventory included in theinvestee's balance sheet (i.e., downstream sale):

COMPANYP

COMPANYS

ELIMINA�TIONS

CONSOLI�DATED

ASSETS

Investment $ 28,000 $ � (f) $ (28,000 ) $ �

Deferred tax benefit 6,000 � (c) (6,000 ) �

Other 250,000 100,000 (a) (20,000 ) 330,000

$ 284,000 $ 100,000 $ (54,000 ) $ 330,000

LIABILITIES

Taxes

Current $ 75,000 $ 30,000 (b) $ (6,000 ) $ 99,000

Deferred 1,680 � (d) (1,680 ) �

Deferred revenue 20,000 � (e) (20,000 ) �

EQUITY

Retained earnings 187,320 70,000 (68,320 ) 189,000

Noncontrolling interests � � (g) 42,000 42,000

$ 284,000 $ 100,000 $ (54,000 ) $ 330,000


348

CONSOLI�DATED

ELIMINA�TIONS

COMPANYS

COMPANYP

EARNINGS

Pretax $ 250,000 $ 100,000 (a) $ (20,000 ) $ 330,000

Equity in investee's earnings 28,000 � (f) (28,000 ) �

Intra�entity (20,000 ) � (e) 20,000 �

258,000 100,000 (28,000 ) 330,000

Taxes

Current 75,000 30,000 (b) (6,000 ) 99,000

Deferred

Investee's earnings 1,680 � (d) (1,680 ) �

Intra�entity (6,000 ) � (c) 6,000 �

70,680 30,000 (1,680 ) 99,000

187,320 70,000 (26,320 ) 231,000

Noncontrolling interests � � (g) (42,000 ) (42,000 )

Net income $ 187,320 $ 70,000 $ (68,320 ) $ 189,000

Equity in the investee's earnings in the amount of $28,000 represents 40% of Company S's net income of $70,000.Note that the intra�entity profit, i.e., $20,000 less the related tax effect of $6,000, is eliminated from Company P's netincome and deferred through a deferred tax benefit and a deferred revenue account. Deferred taxes related to theequity pick�up in the amount of $1,680 are computed by multiplying the portion of the equity pick�up that willeventually be taxed, i.e., 20% of $28,000 = $5,600, by the 30% tax rate. The elimination entries to obtain consoli�dated results for the preceding example are explained as follows:

a. To eliminate intra�entity profit in inventory (Co. P)

b. To eliminate the tax effect of the intra�entity profit

c. To eliminate the deferred tax benefit recorded by Co. P on the equity method

d. To eliminate deferred taxes related to the taxable portion of equity pick�up as a result of excluding alldividends in consolidation rather than 80%

e. To eliminate the deferred revenue recorded by Co. P on the equity method

f. To eliminate the equity pick�up

g. To record noncontrolling interests ($70,000 � 60%)


349

SELF�STUDY QUIZ


11. A nonpublic company owns the following percentages of voting common stock. Which of these investmentsis accounted for at fair value?

a. 10% of stock owned in a telephone company.

b. 20% owned in an internet company.

c. 50% owned in a software company.

d. 100% owned in an advertising agency.

12. DEF Company owns 30% of the voting common stock of GHI Inc. The cost of the investment on January 1, 20X1was $30,000. During 20X1, GHI's earnings were $200,000 and dividends paid were $50,000. The market valueof GHI's common stock was $150,000 on December 31, 20X1. What is the balance of DEF's investment in GHIat the end of 20X1 if the equity method is used?

a. $45,000.

b. $75,000.

c. $90,000.

d. $105,000.

13. Up Co. owns 40% of Down Co. Down recognized a profit of $20,000 from the sale of fishing equipment recordedas inventory on Up's balance sheet. Down's net income, after taxes, is $70,000. Assuming the effective tax rateis 30%, if Up and Down prepare consolidated financial statements, what amount is eliminated as pretaxintra�entity profit?

a. $20,000.

b. $28,000.

c. $70,000.

14. Up Co. owns 40% of Down Co. Down recognized a profit of $20,000 from the sale of fishing equipment recordedas inventory on Up's balance sheet. Down's net income, after taxes, is $70,000. Assuming the effective tax rateis 30%, and the anticipated ultimate distribution of Down's earnings in the form of dividends is subject to the80% exclusion, if Up and Down prepare consolidated financial statements, what amount is eliminated fromdeferred taxes on the equity pick�up?

a. $1,344.

b. $3,360.

c. $5,376.

d. $6,000.


350

15. Big Co. owns 40% of Small Co. Big recognized a profit of $20,000 from the sale of books recorded as inventoryon Small's balance sheet. Small's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%,if Big and Small prepare consolidated financial statements, what amount of equity pick up is eliminated?

a. $1,680.

b. $5,600.

c. $28,000.

d. $70,000.

16. Big Co. owns 40% of Small Co. Big recognized a profit of $20,000 ($180,000 sales price, less $160,000 costof goods sold) from the sale of inventory included in Small's balance sheet. Small's net income, after taxes, is$70,000. Assuming the effective tax rate is 30%, if Big and Small prepare consolidated financial statements,which of the following statements is most accurate?

a. Since this is a downstream sale, intra�entity sales are not eliminated.

b. The equity pick�up is eliminated.

c. Net profit is reduced by $126,000.

d. The equity pick�up is $22,400.


351



11. A nonpublic company owns the following percentages of voting common stock. Which of these investmentsis accounted for at fair value? (Page 343)

a. 10% of stock owned in a telephone company. [This answer is correct. Holdings of less than 20% ofmarketable voting stock are accounted for at fair value as prescribed by FASB ASC 320�10 (formerlySFAS No. 115). Nonmarketable voting stock are accounted for at cost.]

b. 20% owned in an internet company. [This answer is incorrect. Although holding 20% or more of votingstock does not create an absolute requirement to use the equity method for an investment, the 20% lineis usually a reasonable presumption for significant influence over a public company.]

c. 50% owned in a software company. [This answer is incorrect. When 50% of the voting stock of anothercompany is owned there is a presumption that there is an ability to exercise significant influence over theinvestee. Therefore, the equity method is used.]

d. 100% owned in an advertising agency. [This answer is incorrect. When a company holds more than 50%of the voting stock of another company, the financial statements are consolidated.]

12. DEF Company owns 30% of the voting common stock of GHI Inc. The cost of the investment on January 1, 20X1was $30,000. During 20X1, GHI's earnings were $200,000 and dividends paid were $50,000. The market valueof GHI's common stock was $150,000 on December 31, 20X1. What is the balance of DEF's investment in GHIat the end of 20X1 if the equity method is used? (Page 344)

a. $45,000. [This answer is incorrect. This would be the value of the investment if the DEF accounted for theinvestment under GAAP and classifies the investment as available for sale.]

b. $75,000. [This answer is correct. Under the equity method, the investment is initially recorded atcost, is increased (decreased) by the investor's proportionate share of the investee's net income(loss), and is reduced by dividends ($30,000 + ($200,000 � 30%) � ($50,000 � 30%)).]

c. $90,000. [This answer is incorrect. The dividends are included in the measurement of the investment.Dividends are not recorded as income when the equity method is used to account for investments.]

d. $105,000. [This answer is incorrect. Dividends received do not increase the investment account.]

13. Up Co. owns 40% of Down Co. Down recognized a profit of $20,000 from the sale of fishing equipment recordedas inventory on Up's balance sheet. Down's net income, after taxes, is $70,000. Assuming the effective tax rateis 30%, if Up and Down prepare consolidated financial statements, what amount is eliminated as pretaxintra�entity profit? (Page 346)

a. $20,000. [This answer is correct. When eliminating the intra�entity profit, both revenue and inventoryare reduced by the amount of profit recognized from intra�entity sales.]

b. $28,000. [This answer is incorrect. The investor's share of the investee's net income (before any eliminationentries) is not the same as intra�entity profit.]

c. $70,000. [This answer is incorrect. The entire net income of the investee is not eliminated whenconsolidated statements are prepared, unless 100% of the investee's sales are upstream sales.]


352

14. Up Co. owns 40% of Down Co. Down recognized a profit of $20,000 from the sale of fishing equipment recordedas inventory on Up's balance sheet. Down's net income, after taxes, is $70,000. Assuming the effective tax rateis 30%, and the anticipated ultimate distribution of Down's earnings in the form of dividends is subject to the80% exclusion, if Up and Down prepare consolidated financial statements, what amount is eliminated fromdeferred taxes on the equity pick�up? (Page 346)

a. $1,344. [This answer is correct. Deferred taxes related to the equity pick�up are computed bymultiplying the portion of equity pick�up that will eventually be taxed (20% of $22,400), by the taxrate of 30%. The $22,400 is calculated by reducing Down's profit of $70,000 by the intra�entity profitof $20,000 less the tax effect of $6,000 ($20,000 � 30%) and multiplying by Up's interest ($70,000� ($20,000 � $6,000)) � 40%.]

b. $3,360. [This answer is incorrect. The equity pick�up that will eventually be taxed is Up's share of Down'snet income reduced by the intra�entity profit.]

c. $5,376. [This answer is incorrect. The equity pick�up is excluded by 80%.]

d. $6,000. [This answer is incorrect. The tax effect of the intra�entity profit is not the amount of deferred taxesrelated to the taxable portion of the equity pick�up.]

15. Big Co. owns 40% of Small Co. Big recognized a profit of $20,000 from the sale of books recorded as inventoryon Small's balance sheet. Small's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%,if Big and Small prepare consolidated financial statements, what amount of equity pick up is eliminated?(Page 347)

a. $1,680. [This answer is incorrect. This is the amount of deferred taxes related to the taxable portion of theequity pick up.]

b. $5,600. [This answer is incorrect. This is the amount of equity pick up that will eventually be taxed.]

c. $28,000. [This answer is correct. Because this is a downstream sale, the equity pick up is Big's shareof Small's net income.]

d. $70,000. [This answer is incorrect. This is the entire net income of Small. Big only picks up its share.]

16. Big Co. owns 40% of Small Co. Big recognized a profit of $20,000 ($180,000 sales price, less $160,000 costof goods sold) from the sale of inventory included in Small's balance sheet. Small's net income, after taxes, is$70,000. Assuming the effective tax rate is 30%, if Big and Small prepare consolidated financial statements,which of the following statements is most accurate? (Page 347)

a. Since this is a downstream sale, intra�entity sales are not eliminated. [This answer is incorrect. Intra�entityprofits are eliminated in both upstream and downstream sales when preparing consolidated financialstatements.]

b. The equity pick�up is eliminated. [This answer is correct. In both upstream and downstream salesthe equity pick�up is eliminated when consolidated statements are prepared. However, thecalculation of the equity pick�up differs between the two types of intra�entity sales.]

c. Net profit is reduced by $126,000. [This answer is incorrect. The amount eliminated from net profit is notthe gross sales amount less the tax effect.]

d. The equity pick�up is $22,400. [This answer is incorrect. This is the amount of equity pick if this were anupstream sale.]


353

Cash Value Life Insurance Policies

Cash value life insurance policies (which are sometimes called permanent life insurance) have an investmentelement with low to moderate risk and a rate of return that is often higher than other investments of similar risk,primarily because its value appreciates tax�free. The two most common forms of cash value policieswhole lifeand universal lifediffer primarily in that premiums are fixed under a whole life policy, but they may vary for auniversal life policy.

The investment element of a cash value policy is an asset under the definition in FASB Concepts Statement No. 6,Paragraph 25. According to FASB ASC 325�30�35�1 and 35�2 (formerly FASB Technical Bulletin No. 85�4, Account�ing for Purchases of Life Insurance), the asset should be reported at the amount that could be realized under theinsurance contract at the balance sheet date. That amount differs depending on whether the company buys thepolicy for itself, which this course refers to as a traditional arrangement, or to provide benefits for the insured undera split dollar arrangement. The amount of the asset equals the policy's cash surrender value in many traditionalarrangements and some split dollar arrangements.

While the amount of the asset to be reported can equal the policy's cash surrender value, there can be instanceswhere a different amount should be recognized. FASB ASC 325�30�55 (formerly EITF Issue No. 06�5, �Accountingfor Purchases of Life InsuranceDetermining the Amount That Could Be Realized in Accordance with FASBTechnical Bulletin No. 85�4") provides further guidance on this issue and addresses individual�life policies pur�chased for a number of employees and a group life policy that has multiple certificates.

This guidance indicates an entity should consider any additional amounts included in the terms of the insurancepolicy in assessing the amount that could be realized under the contract. The Issue also indicates an entity shouldgenerally assume that individual�life policies or certificates in a group policy are surrendered individually, ratherthan all at the same time, when determining the amount that could be realized. However, if a group of individual�lifepolicies or a group policy only permits the surrender of all the policies or certificates as a group, the amount thatcould be realized under the contract should be determined on a group basis. EITF Issue No. 06�5 also providesguidance on when it is appropriate to discount amounts that could be realized under insurance contracts.

Because of its investment element, cash value policies are attractive instruments for funding a variety of long�termcommitments, such as buy�out and nonqualified deferred compensation arrangements. When accounting for cashvalue policies, accountants should also consider whether they are funding commitments for which a liability shouldbe recognized.

Asset under a Traditional Arrangement. When the company buys the policy for itself, the amount that it couldrealize at the balance sheet dateand, accordingly, the asset to be recordedis generally the policy's cashsurrender value, which equals its cash value reduced by policy loans and surrender charges [however, see theprevious discussion of FASB ASC 325�30 (formerly EITF Issue No. 06�5)]. Cash value arises from two sources:

a. Premiums paid by the owner of the policy and those that are financed through loans against the policy

b. Dividends declared by the insurance carrier and allowed to accumulate, used to offset the cost ofpremiums, or used to buy additional insurance (Generally, dividends paid to the policy owner or allowedto accumulate are taxable, but dividends used to offset premiums or to buy additional insurance are nottaxable.)

GAAP does not address the balance sheet presentation of cash value of life insurance. Best practice recommenda�tions include the following:

a. Based on FASB ASC 210�10�45�4 (formerly ARB No. 43, Chapter 3, Paragraph 6), the asset is normallyclassified as noncurrent unless the cash value is reasonably expected to be realized within the next year.Accordingly, it typically should be presented with other investments.

b. Since the asset is measured as the amount of cash available through settlement at the balance sheet date,the caption �Cash surrender value of life insurance" is the most precise caption. However, best practicesindicate that the caption �Cash value of life insurance" also is acceptable.


354

c. Loans against a policy's cash value are used as a source of cash for the owner of the policy and to financepremiums and interest in excess of dividends. However, best practices indicate that the asset recognizedis the amount that could be realized from the policy, and, thus, loans are netted against the cash value inthe balance sheet. The amount of cash that could be realized normally is the only amount in which a readerof the financial statements is interested, especially when loans are part of the policy's design. If theaccountants believe that the amount of loans is of interest to the reader, they should be disclosed in thenotes to the financial statements or through a descriptive balance sheet caption such as �Cash surrendervalue of life insurance after policy loans of $7,500 in 20X2 and $6,000 in 20X1."

d. Unpaid interest on policy loans should be included with other accrued interest if management expects torepay it; otherwise, it should be included with policy loans. Since interest on policy loans normally is paidalong with premium payments or is recognized through the adjustment of cash surrender value, it issometimes classified as insurance expense. However, unless the amount is significant, it generally is notnecessary to reclassify the interest from insurance expense to interest expense nor to include interestexpense on the policy loan with the disclosure of interest expense and interest payments.

Asset under a Split Dollar Arrangement. Split dollar arrangements are a method of paying for insurance ratherthan a type of insurance (although such arrangements are sometimes referred to as split dollar insurance). Similarto traditional arrangements discussed previously, split dollar arrangements also use cash value policies, eitherwhole life or universal life. The two arrangements differ, however, in the cash consequences to the employer. In thetraditional arrangement, the employer pays all premiums and is entitled to all of the cash value and death proceeds.The economic substance of split dollar arrangements, however, is to provide a benefit to the employee at no costto the employer. Thus, in split dollar arrangements, the employer usually pays most of the premiums until the policyis self�sustaining and recovers those payments through loans against the policy's cash value or death proceeds.

In split dollar arrangements, the employer may own the insurance policy through an endorsement arrangement, orthere may be a collateral assignment of a policy not owned by the employer. The two forms are described asfollows:

a. Endorsement. Under endorsement arrangements, the employer owns the policy, pays the premiums, andis reimbursed by the employee for a portion of the premiums. The endorsement document filed with theinsurance carrier specifies how the cash value and death proceeds are allocated between the employerand the employee. Typically, no more than a small portion of the cash value is allocated to the employee.

b. Collateral Assignment. Under collateral assignments, an employee or a third party, such as an irrevocabletrust, owns the policy. The premium payments are, in form, financed through interest�free loans from theemployer that generally are repaid through the death proceeds. The collateral assignment document thatis filed with the insurance carrier effectively pledges the policy as security for the employer's loans.

Responsibility for premium payments and allocations of policy proceeds vary under split dollar arrangements. Forexample:

a. The employer may pay all of the premiums, annual premiums equal to the increase in cash value, or someother portion of premiums.

b. The cash value allocated to the employer normally does not exceed premiums paid; however, some splitdollar arrangements allocate all of it to the employer without regard to the amount of premiums paid.

c. Some arrangements, for which the term roll out often is used, transfer (or roll out) the policy to the employeeor a third party, such as a trust, in the future. In other arrangements, which are sometimes referred to asfrozen arrangements, the cash value allocated to the employer reaches its maximum at a specified date(usually sometime after seven years), but the employer cannot recover any of it until the insured dies andthe death proceeds are distributed.

Thus, under some split dollar arrangements, the amount that could be realized by the employer is limited topremiums paid. Under other arrangements, however, the employer could realize the cash value of the policy, whichmight be more or less than premiums paid.


355

Since the employer owns the policy under both traditional arrangements and endorsement split dollar arrange�ments, asset measurement considerations are the same, and FASB ASC 325�30�25�1; 325�30�35�1 and 35�2(formerly FASB Technical Bulletin 85�4) applies to both. Under a split dollar arrangement with a collateral assign�ment, however, the employer does not own the policy. FASB ASC 715�60�35�177 through 35�185; 715�60�55�177through 55�181 (formerly EITF Issue No. 06�10, �Accounting for Collateral Assignment Split�Dollar Life InsuranceArrangements") addresses accounting for the asset in a collateral assignment split�dollar life insurance arrange�ment. Under this guidance, an employer should measure and recognize an asset based on the nature andsubstance of the collateral assignment split�dollar arrangement. That is, because the employee or a third partyowns the policy, the employer should consider any future cash flows the employer is entitled to, as well as theemployee's recognition of the obligation and his/her ability to repay the employer. For example, if the employer mayonly recover the amount of the policy's cash surrender value at the balance sheet date, the employer should onlyrecognize an asset equal to the cash surrender value, even if the employer's loan to the employee to pay theinsurance policy premiums exceeds the cash surrender value.

Income Tax Considerations. Whether split dollar arrangements involve endorsements or collateral assignments,IRS Revenue Ruling 64�328 indicates that the substance of both is an investment to provide death or retirementbenefits to the employee at no cost to the employer. Accordingly, they are treated the same for income taxpurposes, and IRC Section 264 applies equally to both forms in determining deductions for interest on policy loans.Generally, policy loan interest is nondeductible (except that a limited amount of interest may be deducted on policyloans covering a �key person," i.e., an officer or 20% owner, to the extent that the aggregate amount of policy loanscovering that person does not exceed $50,000). Premiums paid by a company for any life insurance policy are notdeductible if the company is directly or indirectly a beneficiary under the policy.

Other Long�term Investments

Other long�term investments may be presented as part of the investment caption or included in other assets.

Cost Method Investments. Certain investments in equity securities (a) do not have readily determinable fair valuesand (b) do not qualify for consolidation or the equity method. Such investments are accounted for using the costmethod. Accounting literature provides only limited guidance on accounting for cost method investments. Ordi�narily, the investment is originally recorded at cost with dividends recorded as income in the period received.

Impairment of Cost Method Investments. An investment is deemed impaired if its fair value is less than its cost. If acost method investment is other�than�temporarily impaired, its carrying amount is reduced to fair value through acharge to current period income. FASB ASC 320�10�35�17 through 35�35 (formerly FSP FAS 115�1 and FAS 124�1)provides guidance regarding the meaning of other�than�temporary impairment and its application to cost methodinvestments. GAAP provides guidance for (a) determining when an investment is impaired, (b) determining whetherthe impairment is other than temporary, and (c) measuring, recognizing, presenting, and disclosing an impairmentloss if the impairment is deemed other than temporary.

The fair value of an investment in equity securities accounted for using the cost method is not readily determinable.An investor that has estimated the fair value, for example, to disclose financial instrument information required byFASB ASC 825�10�50 (formerly SFAS No. 107, Disclosures about Fair Value of Financial Instruments) must deter�mine whether that fair value is less than cost and, if so, determine whether the decline in fair value below cost istemporary or other than temporary. Other than temporary does not mean permanent.

An entity that has evaluated a cost method investment for impairment in a prior period but concluded that thedecline in fair value below cost was temporary must continue to estimate the fair value of the investment andevaluate whether the decline in fair value is temporary or other than temporary until either

a. The investment experiences a recovery of fair value at least up to its cost, or

b. The entity recognizes an other�than�temporary impairment loss.

An entity that has not estimated the fair value of a cost method investment should evaluate whether an event orchange in circumstances has occurred during the period that may have a significant adverse effect on the fair value


356

of the investment. FASB ASC 320�10�35�27 (formerly FSP FAS 115�1�FAS 124�1) gives five examples of impairmentindicators:

a. A significant deterioration in the earnings performance, credit rating, asset quality, or business prospectsof the investee.

b. A significant adverse change in the regulatory, economic, or technological environment of the investee.

c. A significant adverse change in the general market conditions of either the geographic area or the industryin which the investee operates.

d. A bona fide offer to purchase (whether solicited or unsolicited), an offer by the investee to sell, or acompleted auction process for the same or similar security for an amount less than the cost of theinvestment.

e. Factors that raise significant concerns about the investee�s ability to continue as a going concern, such asnegative cash flows from operations, working capital deficiencies, or noncompliance with statutory capitalrequirements or debt covenants.

If an impairment indicator is present, the entity should estimate the fair value of the investment and, if the estimatedfair value is less than its cost, determine whether the decline in fair value below cost is temporary. The guidance onthe impairment of equity securities also applies to cost method investments.

Property and Equipment Held for Investment. This balance sheet caption typically includes the following:

a. Real estate acquired primarily for speculation

b. Property and equipment retired from operations

c. Real estate that is currently unused but that may be developed and sold or may be used for operatingfacilities

Property and equipment held for investment normally should be reported at cost. However, if a long�lived asset ispotentially impaired, the requirements of FASB ASC 360�10 (formerly SFAS No. 144, Accounting for the Impairment

or Disposal of Long�Lived Assets) should be followed. The balance sheet caption should provide a generaldescription of the assets, for example, �Real estate." If the caption is included with other assets, it should beexpanded to indicate that it is being held as an investment, for example, �Real estate held for investment." If thecaption is included with investments, it does not need expansion.


357

SELF�STUDY QUIZ


17. What amount of cash value life insurance policies is reported as an asset under a traditional arrangement?

a. Cash surrender value.

b. The cumulative amount of premiums paid.

c. Dividends declared and allowed to accumulate.

d. The amount of policy loans available.

18. Which of the following is true regarding recommendations made in this course for the presentation of cash valuelife insurance policies on the balance sheet?

a. The asset is normally classified as current.

b. �Investment in life insurance" is an appropriate caption.

c. Loans against a policy's cash value should be classified as a current liability.

d. Unpaid interest on policy loans may be included with accrued interest.

19. What are split dollar arrangements when referring to life insurance policies?

a. A type of insurance.

b. A payment method.

20. Light Co. owns 10% of the common stock of Bulb Co. Bulb's stock is considered nonmarketable. What amountdoes Light record as its investment in Bulb, and how are dividends treated?

a. Both amounts are eliminated in consolidation.

b. Investment is recorded at market value, and dividends are recorded as income.

c. Investment is recorded at cost, and dividends are recorded as income.

d. Investment is recorded at cost, increased (decreased) by net profits (losses) of Bulb, decreased bydividends received.


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17. What amount of cash value life insurance policies is reported as an asset under a traditional arrangement?(Page 353)

a. Cash surrender value. [This answer is correct. When the company buys the policy for itself, theamount that it could realize at the balance sheet date, and the asset to be recorded, is generally thepolicy's cash surrender value, which equals its cash value reduced by policy loans and surrendercharges.]

b. The cumulative amount of premiums paid. [This answer is incorrect. Premiums paid by the owner of thepolicy and those that are financed through loans against the policy, are a component of the amountrecorded as an asset.]

c. Dividends declared and allowed to accumulate. [This answer is incorrect. Dividends declared by theinsurance carrier and allowed to accumulate, used to offset the cost of premiums, or used to buy additionalinsurance, are a component of the amount recorded as an asset.]

d. The amount of policy loans available. [This answer is incorrect. Policy loans are a reduction in the amountrecorded as an asset.]

18. Which of the following is true regarding recommendations made in this course for the presentation of cash valuelife insurance policies on the balance sheet? (Page 353)

a. The asset is normally classified as current. [This answer is incorrect. Based on ARB No. 43, the asset isnormally classified as noncurrent unless the cash value is reasonably expected to be realized within thenext year.]

b. �Investment in life insurance" is an appropriate caption. [This answer is incorrect. Since the asset ismeasured as the amount of cash available through settlement at the balance sheet date, the caption �Cashsurrender value of life insurance" is the most precise caption.]

c. Loans against a policy's cash value should be classified as a current liability. [This answer is incorrect. Bestpractices indicate that the asset recognized is the amount that could be realized from the policy, and, thus,loans are netted against the cash value in the balance sheet.]

d. Unpaid interest on policy loans may be included with accrued interest. [This answer is correct.Unpaid interest on policy loans should be included with other accrued interest if managementexpects to repay it; otherwise, it should be included with policy loans.]

19. What are split dollar arrangements when referring to life insurance policies? (Page�354)

a. A type of insurance. [This answer is incorrect. Although this type of arrangement is sometimes referred toas split dollar insurance, a split dollar arrangement is not a type of insurance. The type of insurance wouldbe a cash value policy, either whole life or universal life.]

b. A payment method. [This answer is correct. Split dollar arrangements are a method of paying forinsurance rather than a type of insurance. The economic substance of split dollar arrangements isto provide a benefit to the employee at no cost to the employer. Thus, in split dollar arrangements,the employer usually pays most of the premiums until the policy is self�sustaining and recoversthose payments through loans against the policy's cash value or death proceeds.]


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20. Light Co. owns 10% of the common stock of Bulb Co. Bulb's stock is considered nonmarketable. What amountdoes Light record as its investment in Bulb, and how are dividends treated? (Page 355)

a. Both amounts are eliminated in consolidation. [This answer is incorrect. This investment does not qualifyfor consolidation because Light owns less than 50% of Bulb.]

b. Investment is recorded at market value, and dividends are recorded as income. [This answer is incorrect.Since there is no readily determinable market value, the asset cannot be recorded at a market value.]

c. Investment is recorded at cost, and dividends are recorded as income. [This answer is correct.Investments in equity securities that do not have a readily determinable market value and do notqualify for consolidation or the equity method are accounted for using the cost method.]

d. Investment is recorded at cost, increased (decreased) by net profits (losses) of Bulb, decreased bydividends received. [This answer is incorrect. This investment does not qualify for the equity method. Theequity method applies when 20%�50% of equity securities are owned.]


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Lesson 2 (PFSTG094)


11. A local restaurant chain owns the following percents of voting common stock. Which of these will be accountedfor using the equity method?

a. 5% of stock owned in a restaurant supply company.

b. 45% of stock owned in a fish market.

c. 55% of stock owned in a printing company.

d. 100% of stock owned in another restaurant.

12. Ocean Inc. owns 25% of the voting common stock of Lake Co. The initial cost of the investment on January 1,20X1 was $25,000. During 20X1, Lake had earnings of $150,000, and paid dividends totaling $20,000. Themarket value of Lake's common stock was $80,000 on December 31, 20X1. What amount does Ocean includeas its investment in Lake in its 20X1 financial statements?

a. $20,000.

b. $38,750.

c. $57,500.

d. $62,500.

13. Push Co. owns 40% of Pull Co. Pull recognized a profit of $20,000 from the sale of inventory included on Push'sbalance sheet. Pull's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%, if Push and Pullprepare consolidated financial statements, what amount is reported as �minority interests"?

a. $22,400.

b. $33,600.

c. $56,000.

d. $42,000.

14. Push Co. owns 40% of Pull Co. Pull recognized a profit of $20,000 from the sale of inventory included on Push'sbalance sheet. Pull's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%, and ananticipated ultimate distribution of Pull's earnings in the form of dividends subject to the 80% exclusion, if Pushand Pull prepare consolidated financial statements, what amount is eliminated from current taxes as the taxeffect of the intercompany profit?

a. $1,344.

b. $4,656.

c. $6,000.

d. $7,344.


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15. Thrill Co. owns 40% of Seeker Co. Thrill recognized a profit of $20,000 from the sale of inventory included onSeeker's balance sheet. Seeker's net income, after taxes, is $70,000. Assuming the effective tax rate is 30%,if Thrill and Seeker prepare consolidated financial statements, what amount is reported as �minority interests"?

a. $20,000.

b. $28,000.

c. $42,000.

d. $56,000.

16. Thrill Co. owns 40% of Seeker Co. Thrill recognized a profit of $20,000 ($100,000 sale less $80,000 cost ofgoods sold) from the sale of inventory included on Seeker's balance sheet. Seeker's net income, after taxes,is $70,000. Assuming the effective tax rate is 30%, if Thrill and Seeker prepare consolidated financialstatements, what amount is eliminated from pretax revenue?

a. $14,000.

b. $20,000.

c. $70,000.

d. $100,000.

17. Which of the following characteristics of cash value life insurance is true regarding whole life policies, but notuniversal life policies?

a. The premiums are fixed.

b. There is an investment element of low to moderate risk.

c. Value appreciates tax�free.

d. The rate of return is higher than other investments of similar risk.

18. Which type of life insurance policy is owned by the employee rather than the employer?

a. Traditional arrangements.

b. Split�dollar with collateral assignment.

c. Endorsement split�dollar arrangements.


19. Sun Co. owns 5% of the common stock of Moon Co. Moon Co. does not have a readily determinable fair valueof its stock. Sun's investment in Moon was $10,000 on January 1, 20X1. During 20X1, Moon incurred a loss of$5,000, but managed to pay dividends of $8,000. What amount does Sun include as its investment in Moonon its 20X1 balance sheet?

a. $9,350.

b. $9,600.

c. $9,750.

d. $10,000.


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20. Day Inc. has accounted for its share of ownership in Night Inc. using the cost method. After determining thatthe impairment of the investment in Night is other�than�temporary, Day reduces the investment in Night to itsfair value. Which of the following is affected by the entry to reduce the investment?

a. Common stock.

b. Other comprehensive income.

c. Prior period adjustment.

d. Current period income.


363

Lesson 3: Property and Equipment

INTRODUCTION

Property and equipment includes all assets used in a company's operations that have an estimated useful lifelonger than one year. The following is a listing of items commonly included:

� Land on which operating facilities are located

� Buildings used as operating facilities

� Machinery and other production equipment

� Office furniture and other administrative equipment

� Items leased from others under capital leases

� Items leased to others under operating leases

� Buildings being constructed for use as operating facilities

� Idle facilities

� Leasehold improvements

� Computer hardware and software

Items originally acquired as property and equipment but later used for other purposes, for example, items retiredand held for resale, should be removed from the property and equipment caption. The change is equivalent to achange in estimate, and prior�period statements should not be restated.

Accounting for property and equipment includes both routine and complex areas. This lesson discusses the basicsof balance sheet presentation and the following accounting topics related to property and equipment:

� Capital leases

� Contributed and exchanged assets

� Interest capitalization

� Leasehold improvements

� Questions related to depreciation

� Impairment of long�lived assets


Completion of this lesson will enable you to:� Identify the the balance sheet presentation options for property and equipment.� Determine the classification of and properly record assets acquired by capital lease, contribution or exchange.� Calculate depreciation.


364


Cost Basis. Under GAAP, acquired property and equipment is stated at acquisition cost, including all costsnecessary to bring the asset to its location in working condition such as the following:

� Sales tax

� Freight

� Installation costs

� Direct and indirect costs (including interest) incurred by an entity in constructing its own assets

Thus, stating property and equipment above cost is a departure from GAAP. (However, if depreciable assets arereported at appraisal values, depreciation must be computed on the appraisal values rather than on cost. Appraisalvalues may be disclosed in a note without causing those measurement problems.) If fully depreciated assets are nolonger on hand, the assets and related accumulated depreciation should be removed from the balance sheet.

Costs to remove, contain, neutralize, or prevent existing or future environmental contamination generally shouldnot be capitalized, however, FASB ASC 410�30�25�16 through 25�19 (formerly EITF Issue No. 90�8, �Capitalizationof Costs to Treat Environmental Contamination") states that those costs should be expensed when incurred unlessthe costs are recoverable and at least one of the following conditions is met:

a. The costs extend the life, increase the capacity, or improve the safety or efficiency of property owned bythe company. In addition, the costs improve the property as compared to its condition when constructedor acquired.

b. The costs mitigate or prevent environmental contamination that has not occurred but may otherwise resultfrom future operations or activities. In addition, the costs improve the property as compared to its conditionwhen constructed or acquired.

c. The costs prepare for sale property that is currently held for sale.

Costs incurred to treat or remove asbestos may be capitalized regardless of whether the building was acquired witha known asbestos problem or the problem was discovered in an existing building if the above criteria are met.

Choosing Balance Sheet Captions. Historically, the term �fixed assets" has been used to refer to these assets.The term is still acceptable, but many preparers now use more descriptive terms. Some preparers use the term�Property, plant, and equipment." Although the term is acceptable, it will not fit all situations and the terms�Property" and �plant" are redundant. Best practices indicate the following recommendations:

� Property and equipmentappropriate whenever the company has both real and personal property.

� Equipmentappropriate whenever the company has only personal property.

� Equipment and leasehold improvementsappropriate whenever the company has only personal propertyand leasehold improvements.

�Land" and �Buildings" are normally sufficient captions for the components of property. Improvements to land (forexample, landscaping and paving) and to buildings (for example, wings and porches) are capitalized as a cost ofthe item. The reader has no particular need to distinguish improvements, so there is no need to expand thecaptions whenever improvements are made, for example, �Buildings and improvements." Also, best practicesindicate that all cost components should be presented together even if they have not yet been depreciated, forexample, construction�in�progress. �Equipment" is a catch�all caption for all personal property. The following arecommon captions for its components:

� Machinery


365

� Vehicles

� Transportation equipment

� Furniture and fixtures

� Production equipment

Since depreciation is a method of allocating cost rather than a valuation allowance, the caption �Accumulateddepreciation" is preferable to �Allowance for depreciation." However, both are acceptable. Since leaseholdimprovements are included with depreciable assets, depreciation of leasehold improvements should simply beincluded in accumulated depreciation. There is no need to use a separate �accumulated amortization" account forleasehold improvements.

Secondary Captions Are Optional. Presentation in the balance sheets may be limited to a primary caption asfollows:

20X2 20X1

PROPERTY AND EQUIPMENT,less accumulated depreciation of$75,000 in 20X2 and $60,000 in 20X1 295,000 270,000

GAAP requires the balances of major classes of depreciable assets at the balance sheet date to be disclosed.Secondary captions may be presented either in a note or on the face of the balance sheets as follows:

20X2 20X1

PROPERTY AND EQUIPMENT

Land 50,000 50,000

Building 250,000 150,000

Production equipment 40,000 30,000

Vehicles and other equipment 30,000 25,000

Construction in progress � 75,000

370,000 330,000

Accumulated depreciation (75,000 ) (60,000 )

295,000 270,000


366


367

SELF�STUDY QUIZ


21. Which of the assets would be classified as property and equipment?

a. Buildings used as operating facilities.

b. Supplies on hand at the end of the year.

c. Equipment retired and held for resale.

22. A manufacturing company bought a piece of equipment for $105,000, of which $5,000 was sales tax. It costthe company $2,500 to install. During the year, the company spent $1,000 on maintenance for the equipment.The company expects a salvage value of $15,000 at the end of the useful life of the equipment. What amountis presented on the balance sheet for the equipment?

a. $90,000.

b. $100,000.

c. $106,000.

d. $107,500.

23. A computer repair store owns computers that it sells, as well as uses in its operations. The store also owns otheroffice equipment that it uses in operations. The store rents its office space. What is the best balance sheetcaption the store should use for its fixed assets?

a. Property and equipment.

b. Equipment and leasehold improvements.

c. Equipment.

d. Equipment and inventory.


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21. Which of the assets would be classified as property and equipment? (Page 363)

a. Buildings used as operating facilities. [This answer is correct. Buildings used as operating facilities,as well as buildings being constructed for use as operating facilities, are classified as property andequipment.]

b. Supplies on hand at the end of the year. [This answer is incorrect. Property and equipment includes allassets used in a company's operations that have an estimated useful life of one year or longer. Suppliesmost likely do not meet the one year or longer criteria. Supplies on hand at the end of they year would beclassified as a prepaid expense, if material.]

c. Equipment retired and held for resale. [This answer is incorrect. Items originally acquired as property andequipment but later used for other purposes, such as items retired and held for resale, should be removedfrom the property and equipment caption.]

22. A manufacturing company bought a piece of equipment for $105,000, of which $5,000 was sales tax. It costthe company $2,500 to install. During the year, the company spent $1,000 on maintenance for the equipment.The company expects a salvage value of $15,000 at the end of the useful life of the equipment. What amountis presented on the balance sheet for the equipment? (Page 364)

a. $90,000. [This answer is incorrect. The salvage value is used when calculating depreciation, not whencapitalizing the asset.]

b. $100,000. [This answer is incorrect. Sales tax is capitalized with the cost of the equipment.]

c. $106,000. [This answer is incorrect. The cost of maintenance is not capitalized.]

d. $107,500. [This answer is correct. Under GAAP, acquired property and equipment is stated atacquisition cost (cost basis), including all costs necessary to bring the asset to its location inworking condition such as sales tax, freight, and installation costs. The cost of routine maintenancewould be expensed. Salvage value reduces the depreciable basis, not the amount to be capitalized.]

23. A computer repair store owns computers that it sells, as well as uses in its operations. The store also owns otheroffice equipment that it uses in operations. The store rents its office space. What is the best balance sheetcaption the store should use for its fixed assets? (Page 364)

a. Property and equipment. [This answer is incorrect. The company does not own any real property;therefore, the term �property' is inappropriate.]

b. Equipment and leasehold improvements. [This answer is incorrect. Since the company rents its facilities,it is possible they may have leasehold improvements, but the question does not state the companycurrently has any.]

c. Equipment. [This answer is correct. The caption �equipment" is appropriate whenever the companyonly has personal property. If the company makes any leasehold improvements to the rentedproperty, they may change the caption to �equipment and leasehold improvements".]

d. Equipment and inventory. [This answer is incorrect. Computers that are considered inventory are currentassets and would be captioned as �inventory" on the balance sheet.]


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Capital Leases

FASB ASC 840 (formerly SFAS No. 13, Accounting for Leases) addresses accounting for leases both by lessors(those who rent to others) and lessees (those who rent from others). For lessees it requires classifying all leases aseither capital leases or operating leases. It distinguishes between the two by defining when a lease must beaccounted for as a capital lease and defining all other leases as operating leases.

Basic Requirements for Capital Lease Treatment. A capital lease is treated as a purchase that is financed overthe lease term. Capital lease treatment is required if the lease has at least one of the following characteristics:

a. It passes title to the lessee by the end of the lease term.

b. It contains a bargain purchase option.

c. The lease term is at least 75% of the asset's estimated economic life.

d. The present value of the minimum lease payments at the beginning of the lease term is at least 90% of theasset's fair value.

The 75% test and 90% test should not be considered if the lease term begins within the last 25% of the leasedasset's total estimated economic life. Leases for less than a 12�month period ordinarily would not be considered forcapital lease treatment.

Understanding the Basic Requirements. Normally, the most efficient way to gather the information to determinehow leases should be classified is to obtain a copy of the lease agreement. In applying the criteria above, problemsoften are encountered in defining lease term, estimated economic life, minimum lease payments, and fair value,and in making present value computations.

Lease term is defined as the fixed, noncancellable portion of the lease, plus all periods

a. covered by bargain renewal options.

b. for which failure to renew imposes enough of a penalty on the lessee that renewal is reasonably assured.

c. for which the lease can be renewed or extended at the option of the lessor.

d. covered by ordinary renewal options

(1) during which the lessee guarantees any of the lessor's debt that is directly or indirectly related to theleased asset. (It is assumed that the lessee will not terminate the lease if the lease payments are beingused by the lessor to pay debt the lessee has guaranteed.)

(2) during which a loan from the lessee to the lessor is outstanding. (This relates primarily tosale�leaseback transactions.)

(3) that precede the exercise date of a bargain purchase option. (It is assumed that the bargain purchaseoption will be exercised, so it is also assumed that all renewal options up to that date will be exercised.)

If the lease agreement includes a bargain purchase option, the lease term cannot extend past the date the optionbecomes exercisable, since it is assumed that the option will be exercised and the lease will end at that time. Inaddition, a lease term is considered noncancellable if it may be canceled only (a) on the occurrence of someremote contingency, (b) with the permission of the lessor, (c) if the lessee enters into a new lease with the samelessor, or (d) if cancellation imposes enough of a penalty on the lessee that continuation of the lease appearsreasonably assured. Some of the more common cancellation provisions are those that permit the lessee toterminate the lease under either of the following conditions:

� At any time during the lease term with a prescribed amount of notice, for example, one month's notice


370

� Up to a prescribed amount of time before the end of a period (Typically, such leases will automatically renewfor an additional year unless the lessee cancels in writing 60�90 days before the end of the year.)

Some leases provide for a noncancellable period followed by cancelable renewal periods (typically on a year�to�year basis). Only the noncancellable period should be considered when determining how to classify the lease.

Estimated economic life is similar to the GAAP concept of estimated useful life. Basically, it is the period an assetwould be economically useable, with normal repairs and maintenance, for the purpose intended at the inception ofthe lease, regardless of the lease term. For computers and other items subject to rapid obsolescence, estimatedeconomic life often is no longer than the original lease term.

Minimum lease payments include all rentals called for during the lease term plus any residual value guaranteed bythe lessee. Residual value is similar to the GAAP concept of salvage value. Guaranteed residual values arecommon in vehicle leases, which typically specify a value and require one of the following at the end of thenoncancellable lease term:

a. The lessee buys the vehicle for the specified amount.

b. The lessee returns the vehicle to the lessor and, provided its fair market value is at least the specifiedamount, the lessee has no further obligation.

c. If the fair market value is less than the specified amount, the lessee must pay the lessor the difference if thelessee decides not to buy the vehicle.

In addition to residual value guaranteed by the lessee, GAAP specifically includes and excludes the following fromminimum lease payments:

a. Includes any payment the lessee must make for not renewing or extending the lease, including arequirement to purchase the asset.

b. Excludes:

(1) any guarantee by the lessee of the lessor's debt.

(2) the portion of the rent payments representing executory costs (e.g., insurance, maintenance, andtaxes) and any related profit.

(3) any penalty for which the lease term has been extended.

(4) contingent rentals (i.e., those rentals that depend on factors other than the passage of time such asfuture sales volume, future inflation rate, or future property taxes).

If the lease contains a bargain purchase option, however, the previous criteria should be disregarded. In that case,minimum lease payments consist only of the rental payments to the date the option is exercisable (excludingexecutory costs and profit thereon) and the option amount.

An Example Applying Capital Lease Requirements. To illustrate capital lease computations, assume the follow�ing facts for a car lease with a rental company:

� noncancellable lease term48 months.

� Monthly rent payments$371.

� Guaranteed residual value$5,200.

� Cost of vehicle per lease agreement$15,062. (Since the lessor is not a manufacturer or dealer, this is usedfor fair value computations.)


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� Lessee pays all executory costs directly; therefore, none are included in the monthly rent payments.

� The option to purchase the car for $5,200 does not constitute a bargain purchase option.

� The lease provides for renewal on a year�to�year basis at the same rental, but this does not constitute abargain renewal option.

� Estimated economic lifesix years.

Minimum lease payments include the following:

Monthly rentals (48 � $371) $ 17,808

Guaranteed residual value 5,200

$ 23,008

The implicit rate is the rate that causes the present value of the minimum lease payments to equal the $15,062 cost.Using a trial and error method, the implicit rate is 18% (or 1.5% per month) as illustrated by the following:

Present value of 48 payments of $371 discounted at 1.5% $ 12,630

Present value of a payment of $5,200 due at the end of 48months discounted at 1.5% 2,545

Rounding difference (113 )

$ 15,062

If the lessee could have financed the acquisition through a bank at a 15% rate (1.25% per month), the present valuewould have been:

Present value of 48 payments of $371 discounted at 1.25% $ 13,331

Present value of a payment of $5,200 due at the end of 48months discounted at 1.25% 2,864

$ 16,195

Note that the lease does not pass title, does not contain a bargain purchase option, and the noncancellable leaseterm is less than 75% of the estimated economic life (4/6 = 67%). However, the lease meets the 90% test asillustrated by the following:

Present value of minimum lease payments using theincremental borrowing rate since it is less than theimplicit rate $ 16,195

90% of the lessor's cost of $15,062 $ 13,556

Since the present value of minimum lease payments exceeds the 90% computation, the lease is a capital lease.

Calculating the Asset and Liability for the Example. In determining the amount to be capitalized, the lesseewould use the lower of:

Present value of minimum lease payments using theincremental borrowing rate $ 16,195

Cost to lessor (fair value) $ 15,062

Since the cost (fair value) is less than the present value of the minimum lease payments using the incrementalborrowing rate, the asset and liability are recorded at cost, and the liability is amortized monthly using the implicitrate as illustrated by the following:


372

Total LeasePayment

InterestExpense

Reduction ofLease

ObligationTotal

Liability

Inception $ 15,175

End of first 12 months $ 4,452 $ 2,582 $ 1,870 13,305

End of second 12 months 4,452 2,217 2,235 11,070

End of third 12 months 4,452 1,779 2,673 8,397

End of fourth 12 months 4,452 1,255 3,197 5,200

The liability at inception of $15,175 is set at an amount that enables amortization at the implicit rate. (The $113difference is immaterial.) The same amount is used to record the asset.

GAAP prescribes the following depreciation policies for assets under capital leases:

� If the lease passes title or has a bargain purchase optionlessee's normal depreciation method over theestimated economic life

� If the lease does not pass title or have a bargain purchase optionlessee's normal depreciation methodover the lease term

Accordingly, because this lease does not pass title and does not have a bargain purchase option, it would bedepreciated over four years rather than six years. If the lessee normally uses the straight�line method, annualdepreciation would be $2,494 [($15,175 � $5,200 residual = $9,975) � 4 = $2,494] and accounting for the assetwould be as follows:

Asset CostAccumulatedDepreciation

Cost LessDepreciation

Inception $ 15,175 $ � $ 15,175

End of first 12 months 15,175 2,494 $ 12,681

End of second 12 months 15,175 4,988 10,187

End of third 12 months 15,175 7,482 7,693

End of fourth 12 months 15,175 9,975 5,200

Note that at the end of the lease, both the asset and liability equal the guaranteed residual value. If the car has avalue of $5,200 and is returned, the following entry would be made:

Liability 5,200

Accumulated depreciation 9,975

Asset cost 15,175

If the car has a value of $4,500 and the lessee returns it and pays the $700 difference, the following entry would bemade:

Liability 5,200


Rent expense 700

Asset cost 15,175

Cash 700

If the car has a value of $4,500 and the lessee buys it for $5,200, the following entry would be made:

Liability 5,200

Cash 5,200

Note that book value should not be written down to fair value. The $5,200 book value should be depreciated overthe remaining two years of its estimated economic life unless a change in the estimated life is warranted.


373

Modification of Lease Terms. FASB ASC 840�30�35�18 through 35�20; 840�40�15�6 [formerly Paragraph 14(a) ofSFAS No. 13] addresses how a lessee should account for certain modifications to a capital lease agreement. If themodifications result in a new agreement classified as an operating lease, the transaction should be accounted foras a sale�leaseback transaction.


374


375

SELF�STUDY QUIZ


24. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months, and theestimated economic life is also 5 years. Monthly rental payments are $200, and the guaranteed residual valueis $5,000. The present value of the minimum lease payments is $8,000. The cost of the vehicle per the leaseagreement is $10,000. The vehicle does not pass title at the end of the lease term. Does the lease qualify forcapital lease treatment, and why or why not?

a. Yesit meets the present value test.

b. Yesit meets the lease term test.

c. Nothere is no bargain purchase option present.

d. Noit does not pass title at the end of the lease term.

25. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months. Monthlyrental payments are $200, and the guaranteed residual value is $5,000. Which of the following represents theminimum lease payments?

a. $5,000.

b. $12,000.

c. $17,000.

d. $37,000.

26. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months, and theestimated economic life is also 5 years. Monthly rental payments are $200, and the guaranteed residual valueis $5,000. The present value of the minimum lease payments is $8,000. The cost of the vehicle per the leaseagreement is $10,000. What amount does the computer repair store capitalize as an asset?

a. $8,000.

b. $10,000.

c. $12,000.

d. $17,000.


376



24. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months, and theestimated economic life is also 5 years. Monthly rental payments are $200, and the guaranteed residual valueis $5,000. The present value of the minimum lease payments is $8,000. The cost of the vehicle per the leaseagreement is $10,000. The vehicle does not pass title at the end of the lease term. Does the lease qualify forcapital lease treatment, and why or why not? (Page 369)

a. Yesit meets the present value test. [This answer is incorrect. In order to meet the present value test, thepresent value of the minimum lease payments at the beginning of the lease term must be at least 90% ofthe assets fair value. In this case the fair value is the cost of the vehicle per the lease agreement. $10,000� 90% = $9,000.]

b. Yesit meets the lease term test. [This answer is correct. The vehicle qualifies for capital leasetreatment because the lease term is at least 75% of the vehicle's estimated economic life (60months/60 months = 100%). The lease only needs to meet one of four tests in order to qualify forcapital lease treatment.]

c. Nothere is no bargain purchase option present. [This answer is incorrect. If a bargain purchase optionwas present, the lease would qualify for capital lease treatment. But the lease is not automatically anoperating lease just because a bargain purchase option is not present.]

d. Noit does not pass title at the end of the lease term. [This answer is incorrect. The asset does not needto pass title to the lessee by the end of the lease term in order to qualify for capital lease treatment.]

25. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months. Monthlyrental payments are $200, and the guaranteed residual value is $5,000. Which of the following represents theminimum lease payments? (Page 370)

a. $5,000. [This answer is incorrect. The guaranteed residual value is a component of the minimum leasepayments, but it is not the only amount.]

b. $12,000. [This answer is incorrect. The minimum lease payments include any guaranteed residual value.]

c. $17,000. [This answer is correct. The minimum lease payments include the amount of all rentalscalled for during the lease (60 months � $200 = $12,000), plus any guaranteed residual valueguaranteed by the lessee ($5,000).]

d. $37,000. [This answer is incorrect. The guaranteed residual value is not multiplied over the lease term inyears.]

26. The computer repair store decides to lease a vehicle. The noncancellable lease term is 60 months, and theestimated economic life is also 5 years. Monthly rental payments are $200, and the guaranteed residual valueis $5,000. The present value of the minimum lease payments is $8,000. The cost of the vehicle per the leaseagreement is $10,000. What amount does the computer repair store capitalize as an asset? (Page 371)

a. $8,000. [This answer is correct. In determining the amount to be capitalized, the lessee uses thelower of the present value of minimum lease payments ($8,000) or the cost to the lessor (fair value)($10,000).]

b. $10,000. [This answer is incorrect. Under this scenario, the cost to the lessor (fair value) is not the correctcapitalization amount.]


377

c. $12,000. [This answer is incorrect. The amount of rental payments is not one of the options whencapitalizing a leased asset.]

d. $17,000. [This answer is incorrect. The minimum lease payments are not considered when determiningthe amount to be capitalized.]


378

Contributed and Exchanged Assets

Obtaining property and equipment by contribution is a nonmonetary transaction. FASB ASC 845�10 (formerly APBOpinion No.�29, Accounting for Nonmonetary Transactions) [Note: FASB ASC 845�10 (formerly APB Opinion No.29) does not apply to companies under common control.] requires recording contributed property and equipmentat fair value at the date of the contribution. [Note: FASB ASC 958�605 (formerly SFAS No. 116, Accounting for

Contributions Received and Contributions Made) requires that contributions be recognized when an unconditionalpromise to give is made. Thus, if an unconditional promise to give exists, the contribution would be recorded as areceivable before it is actually received.] In some cases, income tax regulations require recording those items at theprevious owner's basis. Accordingly, the basis of the items for financial statement reporting may differ from their taxbasis, resulting in a temporary difference.

This guidance also addresses accounting for exchanges of nonmonetary assets, such as property and equipment.An exchange of nonmonetary assets should be recorded based on the fair value of the assets involved, and a gainor loss should be recognized on the transaction, unless any of the following three conditions exists:

a. Neither the fair value of the asset received nor the asset surrendered can be reasonably determined.

b. The exchange transaction facilitates sales to customers.

c. The exchange transaction lacks commercial substance. An exchange lacks commercial substance if thefuture cash flows of the entity are not expected to change significantly as a result of the exchange.

If any of those conditions exist, the exchange transaction should be measured based on the recorded amount ofthe asset surrendered and not on the fair values of the assets exchanged. However, the recorded amount should bereduced if there is an indicated impairment of value. To be considered an exchange subject to the provisions ofFASB ASC 845�10 (formerly APB Opinion No. 29), the transferor of a nonmonetary asset must have no substantialcontinuing involvement with the transferred assets. In other words, the transferor must have transferred the usualrisks and rewards of ownership of the asset.

An exchange of nonmonetary assets should generally be measured using the fair value of the assets involved in theexchange. If a company receives an asset in a nonmonetary exchange, the company should record the cost of theasset acquired using the fair value of the asset surrendered. However, if the fair value of the asset received is moreclearly evident, it should be used to record the asset received. Furthermore, GAAP states if one of the parties to thenonmonetary exchange transaction could have chosen to receive cash in lieu of the nonmonetary assets, theamount of cash that could have been received may be evidence of the fair value of the nonmonetary assetsexchanged.

An Example of an Exchange of Assets Measured at Fair Value. Assume that a company exchanges machinerywith a net book value of $10,000 for a parcel of land with a fair value of $20,000 and that because of the specializednature of the machinery, there is no readily determinable fair value for sale in its present condition. The exchangewould be recorded using the following entry:

Investment in land 20,000

Machinerynet 10,000

Gain on exchange 10,000

If the preceding example were revised to exchange the land for the machinery, and the land had a cost of $12,000,the following entry would be made to record the exchange:

Machinery 20,000

Land 12,000

Gain on exchange 8,000


379

An Example of an Exchange Measured at Recorded Amounts Involving Monetary Consideration. If a com�pany exchanges property and equipment through a transaction that would otherwise be measured at recordedamounts and the transaction involves monetary consideration, the following rules apply:

a. The company receiving the monetary consideration should recognize a portion of the gain in the ratio ofcash received to total consideration received, i.e., cash plus fair value of asset received;

b. The company paying monetary consideration should not recognize any gain, i.e., the new asset shouldbe recorded at the book value of the asset surrendered plus any payments; and

c. Any losses on the exchange should be recognized.

See later discussion for guidance that applies in certain cases.

To illustrate, assume that ABC Co. acquires a truck for $25,000 (book value $21,000) from DEF Mfg. for a trade�inof a truck with a book value of $20,000 (cost $30,000 and accumulated depreciation of $10,000) plus an additionalcash payment of $2,000. Assuming the fair value of the old truck is $23,000, the entries to record the trade wouldbe as follows:

ABC Co.

New truck [$20,000 book value of old truck + $2,000 cashpayment]

22,000


Old truck 30,000

Cash 2,000

DEF Mfg.

Cash 2,000

New truck [$23,000 less $3,680 deferred gain ($4,000 �$320)]

19,320

Old trucknet 21,000

Gain � $2, 000

$2, 000� $23, 000� ($25, 000� $21, 000 � $4, 000)� 320

If ABC Co. had paid cash of $6,000 (assuming a trade�in allowance on the old truck of only $19,000 was allowed),it would have made the following entry:

New truck 25,000


Loss ($20,000 book value of old truck less $19,000 fair valueof old truck)

1,000

Old truck 30,000

Cash 6,000

Additional Guidance on Accounting for Exchanges of Nonmonetary Assets. In FASB ASC 845�10 (formerlyEITF Issue No. 01�2, �Interpretations of APB Opinion No. 29"), the EITF reached the following conclusions regard�ing exchanges of nonmonetary assets:

� If an exchange of nonmonetary assets involves monetary consideration (boot) of 25% or more of the fairvalue of the exchange, the transaction should be considered a monetary transaction, and fair valueaccounting would be required for both parties. If boot is less than 25%, the guidance in the example stillapplies. (FASB ASC 845�10�25�6)


380

� If a company acquires control of a subsidiary through an exchange of securities, the exchange should beaccounted for as a business combination following the guidance of FASB ASC 845�10�15�4 (formerly SFASNo. 141).

DepreciationGeneral

Accounting Terminology Bulletin No. 1 defines depreciation as a means of spreading the cost of an asset over theperiods benefited. It also emphasizes that depreciation is not a valuation method. Since depreciation is a methodof allocating cost rather than a valuation allowance, the caption �Accumulated depreciation" is preferable to�Allowance for depreciation." However, both are acceptable. Since leasehold improvements are included withdepreciable assets, depreciation of leasehold improvements should simply be included in the �accumulateddepreciation" caption. There is no need to use a separate �accumulated amortization" caption for leaseholdimprovements. (See earlier discussion.) Recognizing depreciation under GAAP involves a determination of each ofthe following:

a. Estimated useful life

b. Pattern of decline in value

c. Salvage value

d. Depreciation method

Estimated Useful Life. The depreciation period for GAAP is normally the estimated useful life. (Exceptions occurfor certain capital leases and leasehold improvements.) It is the time the company intends to use the asset, and itwill vary depending on factors such as the company's maintenance policy and obsolescence of the asset. Forexample, some companies buy trucks with the intention of having minimal maintenance costs and trading thembefore repairs become a problem. Others buy them with the intention of holding them for a long time andconsequently pay greater attention to maintenance. The estimated useful life for trucks would vary for each of thoseapproaches. As another example, computer technology advances so rapidly that regardless of the maintenancephilosophy, the hardware quickly becomes obsolete. To remain competitive, companies have found that for asmaller investment they can acquire computer systems that have expanded capacities, and therefore, it is nolonger feasible to keep the old system. Accordingly, the companies typically depreciate the costs of their systemover a relatively short period. Useful lives may be estimated for individual acquisitions, or ranges may be estab�lished for types of assets that the company regularly acquires, such as vehicles.

Pattern of Decline in Value. Even though depreciation is not a valuation process, the depreciation method usedshould typically reflect the decline in value. Therefore, using an accelerated method would conceptually beappropriate only if an asset's value declines faster in the early years than in the later years. Methods are usuallyselected for components of depreciable assets and all assets within that component are depreciated using thesame method. For example, assume that a company's depreciable assets consist of a building, productionmachinery, and office equipment. It could use a different depreciation method for each component, for example,150% declining balance for the building, sum�of�the�years' digits for the production machinery, and straight�line forthe office equipment. However, all items within a component would normally be depreciated using the samemethod, for example, all office equipment would be depreciated using the straight�line method.

Salvage Value. Some assets have value at the end of their useful life that the company can realize through sale ortrade�in. By depreciating to salvage value, a company is actually spreading the net cost (acquisition cost lesssalvage value) over the period it uses the assets. If it depreciates the asset to zero, there will be a gain when thesalvage value is realized. However, the gain really only represents a �catch�up" adjustment of prior depreciationexpense. Salvage value often fluctuates with market conditions. For example, during recessionary periods, themarket for used vehicles increases and their salvage values increase. However, for computers and other deprecia�ble assets subject to rapid obsolescence, there may be no market for older assets. Also, for many depreciableassets, salvage value is minor, particularly if there is no market for used assets, such as machinery, and thecompany tends to keep them until they are scrapped. If salvage value is minor, there is no need to complicate theaccounting by considering it in the computation.


381

Depreciation Methods. Generally accepted accounting principles recognize basically two approaches to allocat�ing the cost of an asset over periods benefited:

� Straight�line. The cost less salvage value is allocated evenly over the estimated useful life.

� Accelerated. The cost is allocated disproportionately over the useful life so that the early years are chargedwith most of the cost.

There are a number of permissible allocation formulas for accelerated methods. They are sometimes calleddecreasing charge methods and include sum�of�the�years' digits and double declining balance. For example,double declining balance is a depreciation rate that is twice the straight�line rate, which means that if an asset hasan estimated useful life of five years, the straight�line rate would be 20% per year (1/5) and the double decliningbalance rate would be 40%. Comparative computations for depreciation methods are illustrated in the nextparagraph.

Planned Change in Depreciation Method. Since declining balance methods do not depreciate to zero, somecompanies adopt a policy of using a declining balance method until it drops below what straight�line would havebeen and then switch to straight�line. The book value of the asset when the change is made is depreciated on astraight�line basis over the remaining useful life. To illustrate, assume that a machine is bought for $15,000, has anestimated useful life of five years, and will have only a minor salvage value. The following compares the doubledeclining balance method (DDB) with the straight�line method (SL).

DDB SL

Depreciation Book Value Depreciation Book Value

Acquisition $ 15,000 $ 15,000

End of Year:

1 $ 6,000 9,000 $ 3,000 12,000

2 3,600 5,400 3,000 9,000

3 2,160 3,240 3,000 6,000

4 1,296 1,944 3,000 3,000

5 778 1,166 3,000 �

$ 13,834 $ 15,000

Note that the straight�line rate is 20% and the double declining balance rate is 40%.

The company may, therefore, establish a policy that for this type of asset, it will use DDB for the first two years, thenswitch to SL. Depreciation based on that policy would be as follows:

Depreciation Book Value

Acquisition $ 15,000

End of Year:

1 $ 6,000 9,000

2 3,600 5,400

3 1,800 3,600

4 1,800 1,800

5 1,800 �

$ 15,000

The preceding policy is acceptable for GAAP and actually reflects the economic decline in value of many assets.FASB ASC 250�10�45�20 (formerly SFAS No. 154, Accounting Changes and Error Corrections) specifically statesthat the consistent application of a policy to change to the straight�line method at a specific point in the service lifeof an asset does not constitute a change in accounting principle, and, therefore, accounting change disclosurerequirements do not apply.


382

Change in Salvage Value and Estimated Useful Life. Changes in salvage value and estimated useful life arenormally changes in estimates caused by things such as changing market conditions and better information. FASBASC 250�10�45�7 through 45�20 (formerly SFAS No. 154) discusses changes in estimates and distinguishes themfrom a correction of an error arising from misuse of facts available at the time of acquisition. A change in estimateis either recorded entirely in current earnings or current and future periods if the change affects both.

For example, assume that a repair shop buys a press for $12,000 and estimates that it will have a useful life of fiveyears. However, at the end of the fourth year, management believes it can use the press for four more years. Usingthe original estimate, annual depreciation is $2,400 ($12,000 divided by 5), but using the revised estimate, annualdepreciation should have been $1,500 ($12,000 divided by 8). As a result, there is an overstatement of depreciationof $900 ($2,400 � $1,500) for each of the first four years (for a total of $3,600), which should be spread overdepreciation of years five through eight. The undepreciated cost at the time of the change in estimate of $2,400($12,000 � $9,600) should be allocated to the remaining four years at $600 per year as follows. Note: The�catch�up" method, which would reduce depreciation by $3,600 in the year of change, is a departure from GAAP.

Year Depreciation

1 $ 2,400

2 2,400

3 2,400

4 2,400

5 600

6 600

7 600

8 600

$ 12,000

Adoption of a New Depreciation Method. Many factors affect the depreciation method selected, and thosefactors may change. Consequently, a new depreciation method may be adopted in response to those changes.GAAP refers to a change in method of depreciation for long�lived, nonfinancial assets as a change in accountingestimate effected by a change in accounting principle. Such changes are accounted for as changes in estimates.Changes in estimates are accounted for in the period of change if the change only affects that period or in theperiod of change and future periods if the change affects both. A change in depreciation method is only permittedif the new method can be justified on the basis that it is preferable.


383

SELF�STUDY QUIZ


27. The computer repair store decides to lease a vehicle. The noncancellable lease term is 36 months, and theestimated economic life is 4 years. The recovery period under MACRS is 5 years. Monthly rental payments are$200, and the guaranteed residual value is $2,000. The present value of the minimum lease payments is $8,000.The cost of the vehicle per the lease agreement is $7,000. Title does not pass to the lessee at the end of leaseterm, and there is no bargain purchase option. How many years, if any, is the vehicle depreciated over for GAAPpurposes?

a. 0it is an operating lease.

b. 3.

c. 4.

d. 5.

28. Ham Inc. acquires a piece of machinery for $50,000 from Beans Inc. for a trade�in of machinery with a bookvalue of $30,000, plus cash of $5,000. The fair value of the machinery traded�in by Ham was $45,000, and thebook value of the machinery acquired by Ham was $40,000 on Bean's books. What amount does Bean recordas its new piece of machinery?

a. $35,000.

b. $36,000.

c. $40,000.

d. $44,000.

29. An accounting firm purchases new laptops for its employees. The total cost of the laptops is $15,000, and theestimated useful life is 3 years. The firm believes that at most, the salvage value will be $600 at the end of 3 years,but may be less. The laptops qualify for the Section 179 deduction. Using straight�line depreciation, what is thedepreciation expense in the acquisition year?

a. $4,800.

b. $5,000.

c. $10,000.

d. $15,000.

30. An accounting firm purchases new laptops for its employees. The total cost of the laptops is $15,000, and theestimated useful life is 3 years. At the beginning of the second year, the firm estimates that the laptops can beused for 4 more years (for a total of 5 years). What will the depreciation be for year 2 if the straight�line methodis used?

a. $2,000.

b. $2,500.

c. $3,000.

d. $5,000.


384



27. The computer repair store decides to lease a vehicle. The noncancellable lease term is 36 months, and theestimated economic life is 4 years. The recovery period under MACRS is 5 years. Monthly rental payments are$200, and the guaranteed residual value is $2,000. The present value of the minimum lease payments is $8,000.The cost of the vehicle per the lease agreement is $7,000. Title does not pass to the lessee at the end of leaseterm, and there is no bargain purchase option. How many years, if any, is the vehicle depreciated over for GAAPpurposes? (Page 372)

a. 0it is an operating lease. [This answer is incorrect. Even though there is no bargain purchase option ortitle passing at the end of the lease term, the lease is a capital lease because it meets the lease term test(3/4 = 75%) and the present value of the minimum lease payments is greater the asset's fair value (therequirement is 90% or more).]

b. 3. [This answer is correct. Since the lease does not pass title or contain a bargain purchase option,the vehicle is depreciated over the lease term of 36 months.]

c. 4. [This answer is incorrect. If the lease passed title or contained a bargain purchase option, the vehiclewould be depreciated over the estimated economic life.]

d. 5. [This answer is incorrect. The recovery period provided by the IRS is not considered when creating aGAAP policy for depreciation.]

28. Ham Inc. acquires a piece of machinery for $50,000 from Beans Inc. for a trade�in of machinery with a bookvalue of $30,000, plus cash of $5,000. The fair value of the machinery traded�in by Ham was $45,000, and thebook value of the machinery acquired by Ham was $40,000 on Bean's books. What amount does Bean recordas its new piece of machinery? (Page 379)

a. $35,000. [This answer is incorrect. This is the amount Ham will record as its new asset.]

b. $36,000. [This answer is incorrect. The amount of recognized gain is not subtracted from the fair value ofthe asset received.]

c. $40,000. [This answer is incorrect. This is the book value of the old piece of machinery on Bean's books.This is the net amount credited from the machinery account.]

d. $44,000. [This answer is correct. Bean records the new machinery as the fair value of the machineryreceived ($45,000), less the deferred gain of $1,000 ($5,000/($5,000 + $45,000)) � ($50,000 �$40,000)].

29. An accounting firm purchases new laptops for its employees. The total cost of the laptops is $15,000, and theestimated useful life is 3 years. The firm believes that at most, the salvage value will be $600 at the end of 3 years,but may be less. The laptops qualify for the Section 179 deduction. Using straight�line depreciation, what is thedepreciation expense in the acquisition year? (Page 380)

a. $4,800. [This answer is incorrect. In this case, the salvage value is not taken into consideration since it isminor, and there may not be a market for the laptops at the end of the third year.]

b. $5,000. [This answer is correct. The salvage value is not factored into the calculation ofdepreciation; therefore straight�line depreciation is calculated as $15,000/3 = $5,000.]

c. $10,000. [This answer is incorrect. This would be the depreciation amount in the acquisition year if thedouble declining balance was used.]

d. $15,000. [This answer is incorrect. The depreciation recorded on the books is not the same as thedepreciation taken for federal income tax purposes.]


385

30. An accounting firm purchases new laptops for its employees. The total cost of the laptops is $15,000, and theestimated useful life is 3 years. At the beginning of the second year, the firm estimates that the laptops can beused for 4 more years (for a total of 5 years). What will the depreciation be for year 2 if the straight�line methodis used? (Page 382)

a. $2,000. [This answer is incorrect. This would be the amount depreciated if the undepreciated cost of theasset at the end of year 1 was depreciated over another 5 years, not 4 years.]

b. $2,500. [This answer is correct. The undepreciated amount of the laptops, $10,000 ($15,000 �$5,000), is depreciated over the remaining useful life of the laptops ($10,000/4 years = $2,500).]

c. $3,000. [This answer is incorrect. This is the amount that would have been depreciated if the laptops wereoriginally given an estimated useful life of 5 years. A change in the estimated useful life is not a correctionof an error.]

d. $5,000. [This answer is incorrect. This is the amount of depreciation in the year of acquisition. The firm isallowed to change its estimated useful life, therefore, the amount of depreciation taken in the second yearwill change.]


386


Lesson 3 (PFSTG094)


21. Which of the following assets would be classified as �property and equipment," rather than �property andequipment held for investment"?

a. Land on which operating facilities are located.

b. Real estate acquired primarily for speculation.

c. Property and equipment retired from operations.

d. Unused real estate to be developed for operating facilities.

22. A film production company bought the latest camera on the market for $17,500 on January 1, 20X1. Sales taxon the camera was an additional $875, and freight charges were $200. The production company believes thecamera has a $5,000 salvage value at the end of its useful life. On December 31, 20X1, the camera has a marketvalue of $19,000. What amount does the company present on its balance sheet as its basis in the camera?

a. $13,575.

b. $17,500.

c. $18,575.

d. $19,000.

23. A manufacturing facility owns the land and building it occupies. It also owns several pieces of large and smallequipment. What is the best caption the company should use on its balance sheet to present the fixed assets?

a. Property, plant, and equipment.

b. Equipment and leasehold improvements.

c. Property and equipment.

d. Land, building, improvements, and equipment.

24. The manufacturing facility leases a large piece of equipment. The fixed, noncancellable portion of the lease is5 years. The lease can be extended at the option of the lessor for an additional 2 years, with a bargain renewaloption at the end of a third year extension, if the lease is extended for the 2 years. The estimated economic lifeis 10 years. What is the lease term of this equipment?

a. 5 years.

b. 7 years.

c. 8 years.

d. 10 years.


387

25. The manufacturing facility leases a large piece of equipment. The fixed, noncancellable portion of the lease is5 years. The lease can be extended at the option of the lessor for an additional 2 years. The estimated economiclife is 10 years. The present value of the minimum lease payments is $85,000 and the asset's fair value is$100,000. There is no bargain option at the end of the lease term. The equipment's title passes to the lesseeat the end of the lease term. Does the equipment qualify for capital lease treatment, and why or why not?

a. Yesit passes title at the end of the lease term.

b. Yesit meets the present value test.

c. Noit does not meet the lease term test.

d. Nothere is no bargain option at the end of the lease term.

26. The manufacturing facility leases a large piece of equipment. The fixed, noncancellable portion of the lease is5 years. The lease can be extended at the option of the lessor for an additional 2 years. The estimated economiclife is 10 years. The present value of the minimum lease payments is $85,000 and the asset's fair value is$100,000. The minimum lease payments are $110,000. There is no bargain option at the end of the lease term.The equipment's title passes to the lessee at the end of the lease term. What amount, if any, does the facilitycapitalize as an asset?

a. $0it is an operating lease.

b. $85,000.

c. $100,000.

d. $110,000.

27. The manufacturing facility leases a large piece of equipment. The fixed, noncancellable portion of the lease is5 years. The lease can be extended at the option of the lessor for an additional 2 years. The estimated economiclife is 10 years. The recovery period under MACRS is 5 years. The present value of the minimum lease paymentsis $85,000 and the asset's fair value is $100,000. The minimum lease payments are $110,000. There is nobargain option at the end of the lease term. The equipment's title passes to the lessee at the end of the leaseterm. For GAAP purposes, over how many years is the equipment depreciated (if any)?

a. 0it is an operating lease.

b. 5.

c. 7.

d. 10.

28. Bob recently started his own accounting firm. Bob contributed the computer and related peripherals he waspreviously using for personal purposes to the company. The computer and peripherals cost Bob $5,000. If Boboriginally purchased the equipment for business use, its book value (cost less depreciation) would be $4,000.The fair value of the equipment on the day of conversion to business use was $3,500. What amount does Bob'sfirm record as its contributed equipment?

a. $0.

b. $3,500.

c. $4,000.

d. $5,000.


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29. A company has a policy of calculating depreciation using the double declining balance for office equipmentpurchased, and switching to the straight�line method when the depreciation drops below what straight�linewould have been, over a five year period. During the year, the company acquired $20,000 in office equipment.What is the depreciation in year 2?

a. $2,400.

b. $4,000.

c. $4,800.

d. $8,000.

30. A company has a policy of calculating depreciation using the double declining balance for office equipmentpurchased, and switching to the straight�line method when the depreciation drops below what straight�linewould have been, over a five year period. During the year, the company acquired $20,000 in office equipment.What is the depreciation in year 3?

a. $1,728.

b. $2,400.

c. $2,880.

d. $4,000.


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

INTRODUCTION

This balance sheet caption includes noncurrent assets that are not covered in this lesson. Although there is aconceptual difference between intangible assets and deferred costs, most readers are not particularly interested inthem because they are not a source of cash. Instead they are viewed as a cost of business, which is �frozen" in thebalance sheet and amortized over future periods.


Completion of this lesson will enable you to:� Identify the appropriate accounting for goodwill and other intangibles.� Determine when an asset is impaired.� Determine when to apply FASB ASC 360�10 (formerly SFAS No. 144) to long�lived assets.

Goodwill and Other Intangible Assets

FASB ASC 805 [formerly SFAS No. 141(R), Business Combinations] provides guidelines for goodwill and otherintangible assets acquired in a business combination at acquisition. FASB ASC 350 (formerly SFAS No. 142,Goodwill and Other Intangible Assets) addresses intangible assets acquired individually or with a group of otherassets (excluding those acquired in a business combination) at acquisition. In addition, it provides guidance forgoodwill and other intangible assets subsequent to acquisition. Goodwill and other intangible assets generallyinclude the following:

a. Goodwill

b. Patents

c. Trademarks

d. Customer lists

e. Company name

f. Franchise fees

g. Covenants not to compete

Balance Sheet Captions. Intangible assets (excluding goodwill) may be aggregated and presented in the balancesheet as a single line item or the components of intangible assets may be separately presented in the balancesheet. However, the aggregate balance of goodwill must be presented as a separate line item on the balance sheet.The presentation of goodwill and other intangible assets may appear as follows:

20X2 20X1

INTANGIBLE ASSETS

Goodwill 100,000 110,000

Noncompetition agreement 70,000 75,000

Trademark 50,000 60,000

220,000 245,000

Acquisition of Goodwill. Nonpublic companies acquire goodwill through a business combination. Generally, in abusiness combination, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest are


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recognized at their fair values. The excess of (a) the fair value of the consideration transferred and the fair value ofany noncontrolling interest over (b) the fair value of the identifiable net assets acquired is considered to be goodwill.

GAAP requires an acquired intangible asset to be recognized as a separate asset, apart from goodwill, if it arisesfrom legal or contractual rights. If it does not, it should be recognized separately from goodwill only if the asset isseparable (i.e., capable of being separated from the entity and sold, transferred, licensed, rented, or exchanged byitself or in combination with a related contract, asset, or liability).

Assessing the Impairment of Goodwill. FASB ASC 350 (formerly SFAS No. 142) requires that goodwill be testedfor impairment at least annually rather than being amortized. Impairment is to be assessed at the reporting unitlevel, which is defined as an operating segment or a component one level below an operating segment. Acomponent is considered a reporting unit if it is a business with discrete financial information and operating resultsthat are regularly reviewed by segment management. Two or more components should be combined into a singlereporting unit if they have similar economic characteristics. FASB ASC 280�10 (formerly SFAS No. 131, Disclosuresabout Segments of an Enterprise and Related Information) should be used to identify the reporting units of acompany.

Testing goodwill for impairment is a two�step process. The first step is to determine whether impairment exists. Thatis accomplished by comparing the fair value and the carrying value (including goodwill) of a reporting unit.Impairment exists if the carrying value exceeds the fair value of the reporting unit. Conversely, if the fair valueexceeds the carrying value, the goodwill is not considered impaired and the second step of the impairment processis not applicable.

The second step of the impairment process is the measurement of the amount of the impairment loss. The loss iscalculated by comparing the carrying value of the goodwill to its implied fair value. The loss is the amount by whichthe carrying value exceeds the implied fair value. However, the loss cannot exceed the carrying value of thegoodwill and recognized impairment losses may not be subsequently reversed. The implied fair value of goodwillcan be estimated similar to the methodology used to measure the amount of goodwill resulting from a businesscombination. The following steps are required:

� Determine the fair value of a reporting unit.

� Assign that fair value to all of the assets and liabilities of that reporting unit. Amounts should also beassigned to unrecognized intangible assets, if any.

� Compare the fair value of the reporting unit to the amounts assigned to its assets and liabilities. Any excessof fair value is considered the implied fair value of the goodwill.

� Compare the implied fair value of the goodwill to its carrying value. The impairment loss is the amount bywhich the carrying value exceeds the implied fair value.

Frequency of Testing Goodwill for Impairment. GAAP requires that goodwill be tested for impairment at leastonce a year. Impairment testing may need to be performed more frequently if events or circumstances change suchthat it is more likely than not that the fair value of a reporting unit has been reduced below its carrying value. Suchcircumstances may include the allocation of goodwill to a business to be disposed of, significant adverse changesin an entity's business or legal environment, regulatory actions or assessments, impairment testing of a significantgroup of assets within a reporting unit, or the assessment of a goodwill impairment loss in a subsidiary that is acomponent of a reporting unit. Furthermore, companies should test goodwill for impairment at the same time everyyear. However, all reporting units are not required to test for impairment at the same time as the others.

An entity is not required to make a detailed determination of the fair value of a reporting unit each year. A prior year'svaluation may be carried forward to a subsequent year if the following conditions are met in their entirety:

� The reporting unit's assets and liabilities have not changed significantly since the prior fair valuedetermination was made.

� The fair value of the reporting unit substantially exceeded the carrying amount at the time the prior fair valuedetermination was made.


391

� The entity can conclude, based on an analysis of recent events and circumstances, that the likelihood isremote that a revised fair value calculation would produce an amount lower than the current carrying valueof the reporting unit.

Amortization of Intangible Assets Other Than Goodwill. Intangible assets other than goodwill that have anindefinite useful life should not be amortized, but rather should be subject to an impairment test similar to thatperformed for goodwill. Intangible assets that have a finite useful life should be amortized over the asset'sestimated useful life. FASB ASC 350�30�35�1 through 35�5 (formerly SFAS No. 142) provides guidance for estimat�ing the useful life of an intangible asset. Amortization should be calculated using the straight�line method unlessanother method better reflects the pattern of consumption of the economic benefits of the intangible asset.

Assessing the Impairment of Intangible Assets Other Than Goodwill. Intangible assets other than goodwill thathave an indefinite useful life should be tested for impairment by comparing the fair value to the carrying amount ofthe intangible asset. Note: FASB ASC 350�30�35�21 through 35�28 (formerly EITF Issue No. 02�7, �Unit of Account�ing for Testing Impairment of Indefinite�Lived Intangible Assets") indicates that in certain cases it is appropriate togroup separately recorded intangible assets together when assessing impairment. To qualify for aggregation, theunderlying assets must be inseparable from one another and be operated as a single unit. This guidance specifiesa number of conditions that indicate whether it is appropriate to combine intangible assets and also includes otherrestrictions on combining intangible assets to assess impairment.) If the assessment indicates that the carryingamount exceeds the fair value of the intangible asset, the excess should be recognized as an impairment loss. If thefair value exceeds the carrying amount, impairment is deemed not to exist. Impairment should be tested at leastannually or more frequently if certain circumstances indicate that the asset may be impaired. Such circumstancesmay include a significant decline in the market value of the asset, significant adverse changes in an entity'sbusiness or legal environment, regulatory actions or assessments, or other factors that could adversely impact thevalue of the intangible asset. Once an impairment loss has been recognized, GAAP prohibits the subsequentreversal of that loss.

Covenants Not to Compete Negotiated in Connection with the Acquisition of a Business or Treasury Stock.The following summarizes accounting for the acquisition of a business or treasury stock:

� Business Combination. In a business combination, one company either acquires a controlling financialinterest in another company, generally either by acquiring equity or substantially all of the entity's assets.In an asset acquisition, some or all of the liabilities may also be assumed. Generally the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest are recognized at their fair values. Theexcess of (a) the fair value of the consideration transferred and any noncontrolling interest over (b) the fairvalue of the identifiable net assets acquired is considered to be goodwill.

� Treasury Stock Acquisition. In a treasury stock acquisition, a company acquires the stock of a stockholder.The consideration for the acquisition of treasury stock is allocated between the stock and rights, privileges,or agreements in addition to the stock. The amount allocated to stock generally is charged to stockholders'equity, but whether the other consideration is capitalized or charged to earnings depends on the specificrights, privileges, or agreements obtained.

When the seller could be a significant competitive threat, the buyer typically requires the seller to agree not tocompete for a prescribed period. That is a common situation when the acquisition involves a small to medium�sizedbusiness when one or more of the sellers has been critical to the success of the business. A single price may bespecified for the acquisition, including the covenant, or consideration for the covenant may be separate, eitherpayable at closing or in installments. The best practices indicate accounting for the covenant depends on whetherit has economic substance, and that generally depends on whether the seller could be a significant competitivethreat:

� If the covenant has no economic substance, payments should be accounted for as additional considerationfor the treasury stock acquired or the net assets acquired in a business combination.

� If the covenant has economic substance, a value should be recorded only if there is a prepayment, eitherby an upfront payment or by including the covenant in the total consideration for the treasury stock orbusiness combination.


392

Accounting for a Prepayment. The best practices indicate that a buyer will pay in advance for a covenant only ifhe does not believe the seller is a competitive threat, because collecting a refund of the payment if the seller doescompete may be difficult. The seller may provide financing when a single price is specified in a treasury stockacquisition or a business combination. However, the underlying note generally specifies interest and a singleprincipal amount. Typically, payments under the note are fixed and are unaffected by whether the seller violates thecovenant. Similarly, a payment due at closing and designated as consideration for a covenant usually does notprovide for a refund in the event the seller violates the covenant. Accordingly, best practices indicate that aprepayment should normally be accounted for as follows:

� Single Price for Treasury Stock. If treasury stock is being purchased and the price includes a covenant notto compete, all of the consideration should be accounted for as the cost of acquiring the treasury stock.

� Single Price for a Business Combination. If stock or assets are acquired in a business combination and theprice includes a covenant not to compete, all of the identifiable assets and liabilities should be recognizedat their fair values.

� Upfront Payment. Generally, an upfront payment only is required in a business combination. The paymentshould be recognized at its fair value in accounting for the business combination.

Accounting for Installment Payments under a Covenant. The following provides a best conclusion on theaccounting for covenants that require installment payments:

� The Covenant Has Economic Substance. If the covenant has economic substance, the payments are forfuture performance, and, best practices indicate that the contractual obligation for those payments isincurred based on the passage of time. Accordingly, no liability should be recorded for the future payments,and the payments should be charged to future operations as they become due.

� The Covenant Does Not Have Economic Substance. If the covenant does not have economic substance,best practices indicate that payments under the agreement are in substance additional payments for thetreasury stock or assets acquired in a business combination. Accordingly, the transaction obligating thebuyer for the additional payments (that is, the purchase of the stock or assets) has occurred, and theconditions for recording a liability are met.

Other Assets

Organization Costs. These represent costs incurred in establishing a legal entity. They normally consist of legalfees incurred for drafting the formation documents, such as bylaws and articles of incorporation. FASB ASC720�15�15; 720�15�25�1; 720�15�55 (formerly SOP 98�5, Reporting on the Costs of Start�Up Activities) requiresorganization costs to be expensed as incurred. For income tax purposes, organization costs may be capitalized oramortized over a five�year period. If organization costs are capitalized for tax purposes but expensed for financialreporting, deferred taxes should be provided.

Costs of Acquiring or Terminating a Lease. Buying and selling operating leases occurs in practice in situationssuch as the following:

� Sale of a Lease. ABC sold its office building to DEF. Since ABC already has a lease with CAS that providesa steady stream of income, DEF may be willing to pay a lump sum amount to acquire the rights to the leasewith CAS rather than finding and negotiating a new lease. Essentially, the lump sum payment representsthe cost of acquiring the right to an income stream. Accordingly, the new lessor (DEF) incurs costs inacquiring the rental property and also acquiring an existing income stream.

� Purchase of a Business. In a purchase of a business with favorable leases either as a lessor or a lessee,a portion of the purchase price may be allocated to the leases following the preceding reasoning.

Federal Tax Deposit to Retain Fiscal Year. For income tax reporting, there is a presumption that the reporting yearfor a partnership or S corporation should be the same as for its owners (generally the calendar year). A partnershipor S corporation can report on a fiscal year basis only if it can show that the fiscal year is its natural business year


393

or if it pays a deposit. (Note: Due to the difficulty in receiving IRS approval for a fiscal year that conforms to anentity's natural business year, many partnerships and S corporations wanting to adopt a year end other thanDecember 31 make a Section�444 election to use a fiscal year and make required deposits under Section 7519. Ifthe Section 444 election is made, there are restrictions on the fiscal year that can be used, however. Partnershipsor S corporations making the Section 444 election are limited to year ends of September 30, October 31, orNovember 30.) That applies to new entities as well as entities that previously reported on another basis (forexample, a C corporation that reported on a fiscal year basis and elects to file as an S corporation). (A personalservice corporation is subject to the same requirements except that a deposit is not required.)

The deposit generally represents the tax the owners would have paid for the deferral period. To illustrate, assumea C corporation that filed on a fiscal year basis elects S status effective October 1, 20X0. If the corporation changesto a calendar year, the S corporation will be required to file a tax return for the three months ending December 31,20X0, with the taxable income included in the stockholders' taxable income for 20X0. But if it retains its fiscal year,the stockholders will recognize no taxable income from the S�corporation in 20X0, and instead will include taxableincome for the year ending September 30, 20X1, in their 20X1 return. Retaining the fiscal year effectively deferstaxable income of three months, and the deposit reflects the tax benefit to the owners of that deferral. Generally, thedeposit is calculated as the product of the highest individual tax rate plus 1%, the percentage of the deferral periodto a total year, and the entity's taxable income for the prior year. Adjustments are made if the return for that periodwas for less than a year.

Although the balance of the deposit may fluctuate depending on taxable income and other factors (for example,payments to stockholders), a balance is generally required until the entity either liquidates, changes to the requiredreporting year (generally the calendar year), or terminates its S election. The deposit is generally viewed as aninterest�free loan of the tax benefits of adopting a fiscal year. Accordingly, best practices indicate that it should bereported as a noncurrent asset using a caption such as �Federal tax deposit to retain fiscal year."

The deposit is adjusted annually on May 15 of the calendar year following the calendar year in which the fiscal yearbegins. For example, an additional deposit or refund for the fiscal year ended June 30, 20X1, would be settled onMay 15, 20X1, since the fiscal year begins in calendar year 20X0. Likewise, an adjustment for the fiscal year endedMarch 31, 20X1, would be settled on May 15, 20X1. As a result, for fiscal years ending January through April, thedeposit adjustment each year will not be made until the following fiscal year. Best practices indicate, however, thatthe adjustment should be reflected in the financial statements of the fiscal year to which it relates. To illustrate,assume that an additional deposit is required for the year ended April 30, 20X1 (due May 15, 20X1). The adjustmentshould be reflected in the April 30, 20X1, financial statements through a charge to the deposit account and a creditto accrued liabilities. Similarly, if a refund is due, it should be recorded as a current asset.


394


395

SELF�STUDY QUIZ


31. Which one of the following choices indicates an impairment of goodwill exists?

a. Unit A's carrying value is $100,000 and its fair value is $300,000.

b. Unit B's carrying value is $200,000 and its fair value is $200,000.

c. Unit C's carrying value is $300,000 and its fair value is $200,000.

32. Which of the following is true regarding goodwill?

a. Goodwill generated internally can be capitalized.

b. Goodwill should be tested for impairment annually.

c. Goodwill can be aggregated and presented in the balance sheet with other intangible assets.

d. Goodwill should be tested for impairment at the same time for all reporting units.

33. A company filed for a patent for its new invention. The costs to file the patent were $20,000. The term of thepatent is 20 years, but the company believes that other companies will have similar products on the market in5 years. What amount, if any, is the company's first year of amortization on the patent? (Hint: Assumestraight�line method).

a. $0it is not amortized.

b. $1,000.

c. $4,000.

d. $8,000.

34. How is a covenant not to compete with no economic substance treated in a treasury stock acquisition?

a. As additional net assets acquired.

b. As an intangible asset.

c. As an expense.

d. As additional consideration for the treasury stock.

35. A C corporation with a fiscal year of May 31 elects S status and retains the fiscal year. On May 31, 20X1 itsbalance in the �Federal tax deposit to retain fiscal year" account is $4,500. On May 15, 20X2, the S corporationcalculated that the deposit should decrease by $500. Which of the following is the correct journal entry to recordthis federal tax deposit adjustment?

a. DebitCash; CreditFederal tax deposit to retain fiscal year.

b. DebitFederal tax deposit to retain fiscal year; CreditAccrued liabilities.

c. DebitFederal tax receivable; CreditFederal tax deposit to retain fiscal year.

d. DebitIncome tax expense; CreditFederal tax deposit to retain fiscal year.


396



31. Which one of the following choices indicates an impairment of goodwill exists? (Page�390)

a. Unit A's carrying value is $100,000 and its fair value is $300,000. [This answer is incorrect. When the fairvalue of the unit exceeds the carrying value, the goodwill is not considered impaired and the second stepof the impairment process is not applicable.]

b. Unit B's carrying value is $200,000 and its fair value is $200,000. [This answer is incorrect. Since thecarrying value and the fair value of the unit is the same amount, goodwill is not impaired.]

c. Unit C's carrying value is $300,000 and its fair value is $200,000. [This answer is correct. Impairmentof goodwill exists if the carrying value exceeds the fair value of the reporting unit. This is the firststep in testing goodwill for impairment. The second step is measuring the amount of impairmentloss.]

32. Which of the following is true regarding goodwill? (Page 390)

a. Goodwill generated internally can be capitalized. [This answer is incorrect. Internally generated goodwillis never capitalized. Goodwill acquired in a business acquisition is the only capitalized goodwill.]

b. Goodwill should be tested for impairment annually. [This answer is correct. GAAP requires thatgoodwill be tested for impairment at least once a year. Impairment testing may need to be performedmore frequently if events or circumstances change such that it is more likely than not that the fairvalue of a reporting unit has been reduced below its carrying value.]

c. Goodwill can be aggregated and presented in the balance sheet with other intangible assets. [This answeris incorrect. Intangible assets, excluding goodwill, may be aggregated and presented in the balance sheetas a single line item or the components of intangible assets may be separately presented in the balancesheet.]

d. Goodwill should be tested for impairment at the same time for all reporting units. [This answer is incorrect.Companies should test goodwill for impairment at the same time during the year, but reporting units arenot required to test for impairment at the same time as the others.]

33. A company filed for a patent for its new invention. The costs to file the patent were $20,000. The term of thepatent is 20 years, but the company believes that other companies will have similar products on the market in5 years. What amount, if any, is the company's first year of amortization on the patent? (Hint: Assumestraight�line method). (Page 391)

a. $0it is not amortized. [This answer is incorrect. The patent has a finite life, and therefore, should beamortized.]

b. $1,000. [This answer is incorrect. The patent has a legal life of 20 years, but its actual useful life is a shorterperiod.]

c. $4,000. [This answer is correct. The company should use 5 years as its useful life since it expectsothers to enter the market with similar products. Amortization should be calculated over thestraight�line method, unless another method better reflects the pattern of consumption of theeconomic benefits of the patent.]

d. $8,000. [This answer is incorrect. This would be the amount of amortization if the double declining balancemethod were used.]


397

34. How is a covenant not to compete with no economic substance treated in a treasury stock acquisition?(Page 391)

a. As additional net assets acquired. [This answer is incorrect. This would be the treatment if the covenantnot to compete was negotiated in a business combination.]

b. As an intangible asset. [This answer is incorrect. An intangible asset is only recorded if there is economicsubstance.]

c. As an expense. [This answer is incorrect. Whether the covenant not to compete is negotiated in a businesscombination or treasury stock acquisition, or whether the covenant has economic substance or not, it isnot treated as an expense.]

d. As additional consideration for the treasury stock. [This answer is correct. If the covenant has noeconomic substance, payments should be accounted for as additional consideration for thetreasury stock acquired or net assets acquired in a business combination.]

35. A C corporation with a fiscal year of May 31 elects S status and retains the fiscal year. On May 31, 20X1 itsbalance in the �Federal tax deposit to retain fiscal year" account is $4,500. On May 15, 20X2, the S corporationcalculated that the deposit should decrease by $500. Which of the following is the correct journal entry to recordthis federal tax deposit adjustment? (Page 393)

a. DebitCash; CreditFederal tax deposit to retain fiscal year. [This answer is incorrect. Cash is notincreased until actually received from the Treasury.]

b. DebitFederal tax deposit to retain fiscal year; CreditAccrued liabilities. [This answer is incorrect. Thiswould be the correct entry if the Federal tax deposit needed to be increased.]

c. DebitFederal tax receivable; CreditFederal tax deposit to retain fiscal year. [This answer iscorrect. A current asset should be recorded if a refund is due to the company. The deposit is viewedas an interest free loan of the tax benefits of adopting a fiscal year; therefore, the entries are runthrough the balance sheet, not as income statement items.]

d. DebitIncome tax expense; CreditFederal tax deposit to retain fiscal year. [This answer is incorrect. Thedeposit is viewed as an interest free loan of the tax benefits of adopting a fiscal year; therefore, the entriesare run through the balance sheet, not as an income statement item.]


398

IMPAIRMENT OR DISPOSAL OF LONG�LIVED ASSETS

Applicability

Occasionally, changes in operating conditions raise doubts about a company's ability to fully recover the carryingvalue of a particular long�lived asset. FASB ASC 360�10 (formerly SFAS No. 144, Accounting for the Impairment orDisposal of Long�Lived Assets) provides guidance on the recognition and measurement of an impairment loss.

Assets Specifically Excluded from the Provisions of FASB ASC 360�10 (formerly SFAS No. 144)

The provisions of FASB ASC 360�10 (formerly SFAS No.�144) do not apply to the following long�lived assets:

a. Goodwill

b. Intangible assets with indefinite useful lives not subject to amortization

c. Servicing assets

d. Financial instruments, including equity security investments accounted for under the cost or equity method

e. Deferred policy acquisition costs

f. Deferred tax assets

g. Unproved oil and gas properties accounted for by the successful�efforts method of accounting

h. Assets accounted for under FASB ASC 928 (formerly SFAS No. 50, Financial Reporting in the Record andMusic Industry); FASB ASC 920 (formerly SFAS No. 63, Financial Reporting by Broadcasters); FASB ASC985�20 (formerly SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or

Otherwise Marketed); and FASB ASC 980�360 (formerly SFAS No. 90, Regulated EnterprisesAccountingfor Abandonments and Disallowances of Plant Costs).

Overview of the Accounting Requirements

Accounting for long�lived assets depends on whether the assets will be (a) held and used, (b) held for sale, or (c)held for disposal other than by sale. Generally, the following is required for each classification:

� Long�lived Assets to Be Held and Used. An impairment loss should be recognized to the extent the asset'scarrying amount is not recoverable and exceeds its fair value. Accounting for long�lived assets to be heldand used is discussed later in this lesson.

� Long�lived Assets Held for Disposal, Other Than by Sale (e.g., Abandonment). An impairment loss shouldbe measured and recognized the same as for assets to be held and used. However, GAAP providesadditional requirements relative to depreciating long�lived assets held for disposal by abandonment andestimating future cash flows for long�lived assets to be distributed to owners or through an exchangemeasured using the recorded amount of the nonmonetary asset surrendered. Accounting for long�livedassets held for disposal, other than by sale, is discussed later in this lesson.

� Long�lived Assets Held for Sale. Should be reported at the lower of the carrying amount of the long�livedasset or its fair value less selling costs. An impairment loss should be recognized for any initial orsubsequent adjustment to the carrying amount of the long�lived asset to fair value less cost to sell. Along�lived asset is not subject to depreciation while held for sale. Accounting for long�lived assets to be soldis discussed later in this lesson.


399

Determining the Classification of a Long�lived Asset

GAAP provides different accounting requirements depending on whether a long�lived asset is to be held and used,held for disposal by sale, or held for disposal by a method other than sale. However, the need to classify long�livedassets into these three categories depends on the facts and circumstances as follows:

� GAAP requires disclosure of long�lived assets held for sale, regardless of whether they are impaired.Therefore, management should always identify the long�lived assets that the company intends to disposeof through a sale and value the assets accordingly.

� For long�lived assets that are not being held for sale, classifying them as held for disposal other than bysale or held and used is not necessary unless there is an indication that the assets may be impaired. Seethe following discussion of potential impairment.

When Is an Impairment Assessment Necessary?

An entity is required to consider the need to recognize a loss from the impairment of a long�lived asset held andused or held for disposal other than by sale whenever events or changes in circumstances indicate the carryingamount of the asset may not be recoverable. Therefore, entities are not required to routinely assess all of theirlong�lived assets for impairment. The following examples of events or circumstances that may indicate that anasset's carrying amount is not recoverable are provided:

a. The market value of the asset significantly decreases

b. A significant adverse change in the physical condition of the asset or an adverse change in the way theasset is being used

c. A significant adverse change in legal factors or the business climate that could affect the value of the asset(e.g., actions or assessments by regulators)

d. Incurring costs to acquire or construct an asset that are significantly higher than originally planned

e. Current period operating or cash flow losses along with a history of such losses from using the assetaccompanied by projections or forecasts that reflect continuing losses related to use of the asset

f. A current expectation that the possibility that the asset will be sold or disposed of significantly prior to theend of its estimated useful life is more likely than not

The list of examples is not all�inclusive. Other factors might raise doubts about the recoverability of an asset, and,if they do, the accountant should assess the asset for impairment. For small businesses, it is likely that operatinglosses resulting from using the assets will often be the first indicator that an asset may be impaired. Anotherrecurring indicator might be a change in the way an asset is being used. The following are examples of situationsthat may indicate an asset is impaired:

� A manufacturing company supplies parts to oil field service companies in the United States. Due to anexcess supply of oil from Middle Eastern countries, oil prices have dramatically declined, and 50% of theactive, domestic oil wells have been shutdown. The manufacturing company's orders are negligible, andit is currently projecting a loss for at least the next two years.

� Buy City Electronics built a retail store on Main Street three years ago. Due to high growth in the county,the state is constructing a major thoroughfare approximately two miles north of Main Street. Once the newroad is constructed, Buy City expects to lose a significant amount of the revenues currently generated fromdrive�by customers. However, the Company does not believe it can justify relocating its store at the presenttime.

Accounting for Long�lived Assets Held and Used or Held for Disposal Other Than by Sale

An entity must be able to estimate both the expected cash flows (on an undiscounted basis) and the fair value of along�lived asset to calculate an impairment loss. GAAP provides guidance on estimating the future cash flows from


400

a long�lived asset and its fair value. Essentially, if the estimated undiscounted cash flows from a long�lived asset(whether held and used or held for disposal other than by sale) are at least equal to the asset's carrying amount, noadjustment is required and no impairment loss is recognized. Generally accepted accounting principles view anasset's carrying amount as the recorded amount less related valuation allowances. However, if the carrying amountexceeds the estimated undiscounted cash flows, the entity should recognize an impairment loss through a chargeto earnings and a reduction of the asset's carrying amount for any excess of the carrying amount over fair value.GAAP does not address whether the reduction should be accomplished through a credit to the asset account or toa valuation allowance. As a practical matter, crediting a valuation allowance may be the best approach for mostsmall and midsize entities. That will enable management to readily identify the temporary difference that arisesbecause impairment losses are not deductible in computing taxable income until they are realized.

Upon recognizing an impairment loss, the adjusted carrying amount becomes the asset's new cost basis. It shouldnot be adjusted for subsequent increases in fair value. However, it continues to be subject to the impairmentrequirements and future tests for recoverability should be based on comparisons with the new cost basis.

Additionally, the new cost basis of a long�lived asset (whether classified as held and used or held for disposal otherthan by sale) should be depreciated over the estimated remaining useful life of the asset. As a practical matter, theevents or changes in current circumstances that led to the impairment may have affected the remaining useful life.If the entity plans to abandon the asset, the method used to depreciate it should result in a carrying amount at thedate of abandonment equal to the expected salvage value, if any.

When a long�lived asset is distributed to owners in a spin�off or disposed of in an exchange measured using therecorded amount of the nonmonetary asset surrendered, an excess of the carrying amount over the fair value of theasset should be charged to earnings. However, a gain should not be recognized for any excess of fair value at thatdate.

Accounting for Long�lived Assets Held for Sale

GAAP establishes a number of criteria that must be met before a long�lived asset can be classified as held for sale.All of the following conditions are required for classification as held for sale:

a. Management with the proper authority has committed to a plan to sell the asset.

b. The asset, in its present condition, is immediately available for sale (subject only to the usual and customarysales terms for similar assets).

c. The entity has initiated an active program to find a buyer and the asset is being actively marketed at areasonable price considering its current fair value.

d. Sale of the asset is probable and expected to be completed within one year (except as discussed in thenext paragraph).

e. It is unlikely that the plan of sale will significantly change or be abandoned prior to completion.

The period required to complete the sale of a long�lived asset may extend beyond the one year requirement statedin the paragraph above. due to events or circumstances beyond an entity's control. In the following situations, anexception is provided to the one�year requirement discussed in paragraph above:

a. At the date the entity commits to a plan to sell an asset, it reasonably expects that a party other than a buyerwill impose conditions on the transfer of the asset that will extend the period required to complete the saleand

(1) A firm purchase commitment must be obtained before necessary actions can be initiated to respondto those conditions

(2) It is probable that the entity will obtain a firm purchase commitment within one year


401

b. A firm purchase commitment is obtained by the entity but a buyer or other party unexpectedly imposesconditions on transfer of the asset that will extend the period required to complete the sale and

(1) Necessary actions have been or will be timely initiated to respond to the conditions

(2) The delaying factors are expected to be favorably resolved

c. During the initial one�year period, circumstances that were previously considered unlikely arise and, as aresult, the asset is not sold by the end of that period and

(1) The entity initiated actions necessary to respond to the change in circumstances during the initialone�year period

(2) Given the change in circumstances, the asset is being actively marketed at a reasonable price

(3) All the other conditions previously discussed are met

If the criteria for classification as held for sale are met after the balance sheet date but before the financialstatements are issued or available to be issued, the long�lived asset should be classified as held and used at thebalance sheet date but disclosures should be provided. In addition, if the criteria are initially met but conditionschange in a subsequent period so that one or more are no longer met, the asset should be reclassified as held andused in that period. FASB ASC 360�10 (formerly SFAS No. 144) generally requires an adjustment of the asset'scarrying amount during the period the conditions change.

If a company acquires a long�lived asset and management intends to hold the asset for sale, it should be classifiedas held for sale at the acquisition date only in the following situations:

a. The one�year requirement stated previously is met, unless one of the exceptions discussed in thepreceding paragraph applies.

b. Any other criteria stated previously that are not met at acquisition are probable of being met within a shortperiod following the acquisition, usually within three months.


402


403

SELF�STUDY QUIZ


36. A manufacturing company has a piece of equipment that it uses daily in its operations. One night, themaintenance crew used the wrong cleaning solution to clean the inside of the equipment. The equipment stillworks, but it can only produce about half of what it did prior to the change in condition. The company still planson using the equipment until it can find a suitable replacement. Which of the following is true regarding theimpairment of the asset, assuming the company can estimate both the expected cash flows and the fair valueof the equipment?

a. The asset should no longer be depreciated.

b. The adjusted carrying amount is the asset's new cost basis.

c. The loss is included in other comprehensive income.

d. It does not qualify for treatment under FASB ASC 360�10 (formerly SFAS No. 144).

37. Company X wants to classify a long�lived piece of equipment as held for sale. Which of the following meets theconditions required for classification as held for sale?

a. X advertises the equipment as for sale on its website, priced as �$1,000,000 no exceptions." The fair valueof the equipment is $500,000.

b. X expects that the equipment will be sold in 2�3 years.

c. The asset will need several modifications to be ready for the next owner.

d. It is unlikely that the plan of sale will significantly change prior to completion.


404



36. A manufacturing company has a piece of equipment that it uses daily in its operations. One night, themaintenance crew used the wrong cleaning solution to clean the inside of the equipment. The equipment stillworks, but it can only produce about half of what it did prior to the change in condition. The company still planson using the equipment until it can find a suitable replacement. Which of the following is true regarding theimpairment of the asset, assuming the company can estimate both the expected cash flows and the fair valueof the equipment? (Page 399)

a. The asset should no longer be depreciated. [This answer is incorrect. The new cost basis of a long�livedasset should be depreciated over the estimated remaining useful life of the asset.]

b. The adjusted carrying amount is the asset's new cost basis. [This answer is correct. Uponrecognizing an impairment loss, the adjusted carrying amount becomes the asset's new cost basis.It should not be adjusted for subsequent increases in fair value. However, it continues to be subjectto the requirements of GAAP.]

c. The loss is included in other comprehensive income. [This answer is incorrect. When an impairment lossis recognized, the loss is charged to current year earnings.]

d. It does not qualify for treatment under FASB ASC 360�10 (formerly SFAS No. 144). [This answer is incorrect.GAAP applies to assets (a) held and used, (b) held for sale, and (c) held for disposal other than by sale,except for certain assets specifically excluded from the provision.]

37. Company X wants to classify a long�lived piece of equipment as held for sale. Which of the following meets theconditions required for classification as held for sale? (Page 400)

a. X advertises the equipment as for sale on its website, priced as �$1,000,000 no exceptions." The fair valueof the equipment is $500,000. [This answer is incorrect. One of the conditions that must be met is that theentity has initiated a program to find a buyer and the asset is being actively marketed at a reasonable priceconsidering its current fair value.]

b. X expects that the equipment will be sold in 2�3 years. [This answer is incorrect. One of the conditions thatmust be met is that the sale of the asset is probable and expected to be completed within one year.]

c. The asset will need several modifications to be ready for the next owner. [This answer is incorrect. One ofthe conditions that must be met is that the asset, in its present condition, is immediately available for sale.]

d. It is unlikely that the plan of sale will significantly change prior to completion. [This answer is correct.GAAP requires 5 criteria that must be met before a long�lived asset can be classified as held for sale.One of the conditions is that it is unlikely that the plan of sale will significantly change or beabandoned prior to completion.]


405

Assessing an Asset Held for Sale for Impairment

As discussed previously, FASB ASC 360�10 (formerly SFAS No.�144) requires that the carrying amount of along�lived asset held for sale not exceed its fair value less the estimated direct costs to sell the asset. In addition toestimating the asset's fair value, the entity should estimate the incremental direct costs to transact a sale. Thatestimate should include only the costs that would result directly from and are essential to a sale transaction and thatwould not be incurred if the entity did not sell the asset. Examples are broker commissions, legal and title transferfees, and closing costs. For this purpose, selling costs exclude expected future losses associated with the opera�tion of the asset while it is classified as held for sale. Furthermore, selling costs should be discounted if the sale isexpected to occur beyond one year. An impairment loss should be recognized to the extent the carrying amountexceeds the estimated fair value of the long�lived asset less selling costs. An entity may recognize a gain forsubsequent increases in the fair value less selling costs of a long�lived asset, but only to the extent of the cumulativeimpairment loss previously recognized. As discussed previously, GAAP does not address whether a reduction incarrying amount should be accomplished through a credit to the asset account or to a valuation allowance. As apractical matter, best practices indicate that crediting a valuation allowance may be the best approach for mostsmall and midsize entities. Once an asset has been classified as held for sale, the entity should cease depreciatingthe asset.

FASB ASC 310�40�40�10 [formerly FASB Staff Position (FSP) No. FAS 144�1, �Determination of Cost Basis forForeclosed Assets under FASB Statement No. 15 and the Measurement of Cumulative Losses Previously Recog�nized under Paragraph 37 of FASB Statement No. 144"] clarifies that any valuation allowance for a loan collatera�lized by a long�lived asset should not be carried over as a separate element of the cost basis for purposes ofaccounting for the long�lived asset subsequent to foreclosure. In other words, FASB ASC 360�10 (formerly SFASNo. 144) does not allow the lender to look back to lending impairments measured and recognized under FASB ASC450 (formerly SFAS No. 5), FASB ASC 310; 470 (formerly SFAS No. 15), or FASB ASC 310 (formerly SFAS No. 114)for purposes of measuring the cumulative loss previously recognized. Therefore, if an impairment loss is recog�nized and the fair value of the long�lived asset less selling costs subsequently increases, the amount of the gain thatmay be recognized is limited to the cumulative losses previously recognized and measured under GAAP. Loanimpairment losses are not included in the calculation of cumulative losses.

Decision to Sell Subsequently Withdrawn

If, subsequent to classification as held for sale, an entity decides not to sell the long�lived asset, the entity shouldreclassify the asset as held and used. During the reporting period in which the decision not to sell was made, theentity should adjust, through a charge to earnings, the carrying amount of the asset to the lower of

a. The asset's carrying amount before it was classified as held for sale, adjusted for any depreciation thatwould have been recognized had the asset been continuously classified as held and used.

b. Fair value at the date of the decision not to sell.


406


407

SELF�STUDY QUIZ


38. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $110,000. The sale of the asset looks promising, and T estimates that the selling costs will be$5,000. What amount of gain can T recognize on the subsequent increase in fair value?

a. $0.

b. $5,000.

c. $20,000.

d. $25,000.

39. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $90,000. The sale of the asset looks promising, and T estimates that the selling costs will be $5,000.What amount of gain can T recognize on the subsequent increase in fair value?

a. $0.

b. $5,000.

c. $10,000.

d. $20,000.

40. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $110,000 and T decides to put the asset back into operations. During the time the asset wasclassified as held for sale, T would have recognized $10,000 of depreciation had the asset been continuouslyclassified as held and used. What amount does T now record as the asset's carrying amount when it isreclassified as held and used?

a. $80,000.

b. $90,000.

c. $100,000.

d. $110,000.


408



38. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $110,000. The sale of the asset looks promising, and T estimates that the selling costs will be$5,000. What amount of gain can T recognize on the subsequent increase in fair value? (Page 405)

a. $0. [This answer is incorrect. An entity may recognize a gain for subsequent increases in the fair value lessselling costs of a long�lived asset held for sale.]

b. $5,000. [This answer is incorrect. This is the amount of gain that will be realized if the asset sells for$110,000, incurs $5,000 of selling costs, with a basis of $100,000.]

c. $20,000. [This answer is correct. An entity may recognize a gain for subsequent increases in the fairvalue less selling costs of a long�lived asset held for sale, but only to the extent of the cumulativeimpairment loss previously recognized.]

d. $25,000. [This answer is incorrect. Selling costs must be included when calculating the gain.]

39. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $90,000. The sale of the asset looks promising, and T estimates that the selling costs will be $5,000.What amount of gain can T recognize on the subsequent increase in fair value? (Page 405)

a. $0. [This answer is incorrect. The fair value does not have to be greater than the carrying amount of theasset before it was classified as held for sale in order to recognize a gain. The only requirement is that animpairment loss was previously recognized on the asset before a gain can recognized.]

b. $5,000. [This answer is correct. The gain recognized if the difference in fair value of the asset($90,000) is reduced by the selling costs ($5,000) less the new carrying amount of $80,000 ($100,000� $20,000). Since a $20,000 loss has previously been recognized, the company can recognize a$5,000 gain.]

c. $10,000. [This answer is incorrect. The selling costs are included when calculating the gain.]

d. $20,000. [This answer is incorrect. If the company recognized a $20,000 gain, the asset would be recordedin an amount greater than its fair value. The company is limited to recognizing $20,000 of gain since it hasrecognized only $20,000 of loss previously, but the actual gain is less than this amount.]

40. T Co. classifies an asset with a book value of $100,000 as held for sale. At the time of the classification, Trecognized a loss of $20,000 due to declining market values. Three months later, the fair value of the assetincreases to $110,000 and T decides to put the asset back into operations. During the time the asset wasclassified as held for sale, T would have recognized $10,000 of depreciation had the asset been continuouslyclassified as held and used. What amount does T now record as the asset's carrying amount when it isreclassified as held and used? (Page 405)

a. $80,000. [This answer is incorrect. This is the fair value of the asset when it was classified as held for sale.]

b. $90,000. [This answer is correct. During the reporting period in which the decision not to sell wasmade, the entity should adjust, through a charge to earnings, the carrying amount of the asset tothe lower of (a) the asset's carrying amount before it was classified as held for sale, adjusted for anydepreciation that would have been recognized had the asset been continuously classified as heldand used, or (b) the fair value at the date of the decision not to sell.]


409

c. $100,000. [This answer is incorrect. The carrying amount of the asset is not the same as the carrying valuebefore it was classified as held for sale.]

d. $110,000. [This answer is incorrect. The fair value of the asset at the time it is returned to operations is not propercarrying amount.]


410


Lesson 4 (PFSTG094)


31. Which of the following group of intangible assets may be aggregated and presented in the balance sheet asa single line item?

a. Goodwill, patents, covenants not to compete.

b. Goodwill, trademarks, and customer lists.

c. Trademarks, customer lists, and covenants not to compete.

d. Goodwill, patents, and trademarks.

32. A company purchased a trademark for $30,000 on January 1, 20X1. Before the issuance of FASB ASC350�30�35�1 (formerly SFAS No. 142), the company amortized intangible assets, such as trademarks, over 10years. For tax purposes, the trademark will be amortized over a 15�year period. What is the company's 20X1amortization relating to the trademark for GAAP purposes?

a. $0it is not amortized.

b. $2,000.

c. $3,000.

d. $6,000.

33. A company purchased a covenant not to compete in a purchase method business combination. The covenantrequires installment payments, and is thought to have economic substance. Which of the following statementsregarding this transaction is most accurate?

a. Payments are recorded as an intangible asset as they become due.

b. Future payments are recorded as additional treasury stock.

c. Payments are recorded as additional net assets acquired.

d. No liability is recorded for future payments.

34. A new company incurred $15,000 of organization costs. What is the net amount of organization costscapitalized on the company's balance sheet at the end of the first year?

a. $0.

b. $8,000.

c. $12,000.

d. $15,000.


411

35. An S corporation with a fiscal year of April 30 has a balance of $5,000 in its �Federal tax deposit" account. Thecorporation has determined that it owes an additional deposit of $1,000 for the year ended April 30, 20X1, dueMay 15, 20X1. What is the balance of the federal tax deposit account on the balance sheet?

a. $0.

b. $4,000.

c. $5,000.

d. $6,000.

36. FASB ASC 360�10�15�5 (formerly SFAS No. 144) applies to which of the following assets?

a. Equipment held for sale.

b. Goodwill.

c. Deferred tax assets.

d. Servicing assets.

37. Which of the following statements is most accurate regarding assets that are held for sale when applyingGAAP?

a. These assets must routinely be assessed for impairment.

b. Any loss on impairment is presented on the other comprehensive income statement.

c. At least one of the five conditions must be met to classify assets as held for sale.

d. The assets should no longer be depreciated.

38. J Co. classifies an asset with a book value of $150,000 as held for sale. At the time of the classification, Jrecognized a loss of $60,000 due to declining market values. Five months later, the fair value of the assetincreases to $170,000. J estimates that the selling costs will be $10,000. What amount of gain can J recognizeon the subsequent increase in fair value?

a. $0.

b. $10,000.

c. $60,000.

d. $70,000.

39. J Co. classifies an asset with a book value of $150,000 as held for sale. At the time of the classification, Jrecognized a loss of $60,000 due to declining market values. Five months later, the fair value of the assetincreases to $110,000. J estimates that the selling costs will be $10,000. What amount of gain can J recognizeon the subsequent increase in fair value?

a. $0.

b. $10,000.

c. $20,000.

d. $60,000.


412

40. J Co. classifies an asset with a book value of $150,000 as held for sale. At the time of the classification, Jrecognized a loss of $60,000 due to declining market values. Five months later, the fair value of the assetincreases to $170,000 and J decides not to sell the asset and put it back into operations. During the time it washeld for sale, J would have recognized $10,000 of depreciation on the asset if it was continuously classified asheld and used. What amount does J now record as the asset's carrying amount when it is reclassified as heldand used?

a. $90,000.

b. $140,000.

c. $150,000.

d. $170,000.


413

GLOSSARY

Average cost method: A method used to determine the cost of a security sold or the amount reclassified out ofaccumulated other comprehensive income into earnings.

Cash value life insurance: Cash value life insurance policies (which are sometimes called permanent life insurance)have an investment element with low to moderate risk and a rate of return that is often higher than other investmentsof similar risk, primarily because its value appreciates tax�free. The two most common forms of cash valuepolicieswhole life and universal lifediffer primarily in that premiums are fixed under a whole life policy, but theymay vary for a universal life policy.

Certificate of deposit: Certificates of deposit are not marketable securities. Certificates of deposit may be includedwith cash and need not be separately disclosed.

Cost method: Certain investments in equity securities (a) do not have readily determinable fair values and (b) donot qualify for consolidation or the equity method. Such investments are accounted for using the cost method.

Depreciation: Depreciation is a method of allocating cost rather than a valuation allowance.

Equity method: Under the equity method, the investment is initially recorded at cost, is increased by the investor'sproportionate share of the investee's net income, and is reduced by dividends and the investor's proportionate shareof the investee's net loss.

First�in, first�out method: Inventory or sold is considered to be the oldest inventory available for sale; conversely,ending inventory is considered to be the latest inventory purchased.

Goodwill: If there is a difference between the cost of the investment and the investor's proportionate equity in theinvestee's net assets at acquisition, the difference should first be related to specific assets of the investee based ontheir fair market value. Any difference that cannot be related to specific assets is considered to be attributable togoodwill.

Gross profit method: The gross profit method is the most common method of estimating inventories at interim dateswhen physical inventories are not taken.

Intangible asset: Goodwill and other intangible assets generally include the following: Goodwill, Patents,Trademarks, Customer lists, Company name, Franchise fees, Covenants not to compete.

Last�in, first�out method: Inventory sold is considered to be the latest inventory purchased; conversely, endinginventory is considered to be the oldest inventory available for sale.

Long�lived asset: Accounting for long�lived assets under FASB ASC 360�10 (formerly SFAS No. 144) depends onwhether the assets will be (a) held and used, (b) held for sale, or (c) held for disposal other than by sale.

Lower of cost or market: Inventories are stated at the lower of cost or market value.

Marketable security: The balance sheet caption �marketable securities" includes equity securities and debtsecurities.

Money market accounts: Money market accounts offered by banks, savings and loan associations, and brokeragehouses are typically subject to only minimal withdrawal restrictions. Therefore, they are more in the nature ofinterest�bearing checking accounts and should be included in the cash caption.

Organization costs: These represent costs incurred in establishing a legal entity. They normally consist of legal feesincurred for drafting the formation documents, such as bylaws and articles of incorporation.

Overdraft accounts: Entities frequently have cash accounts with more than one financial institution. Generally, foreach financial institution, all cash account balances should be totaled to determine whether the entity has a netpositive or negative balance.


414

Repurchase agreements: Repurchase agreements are short�term investments typically sold by banks asalternatives to certificates of deposit. Transfers to and from the fund are made daily to cover checks clearing inoperating accounts. Accordingly, repurchase agreements should be presented in the financial statements in amanner similar to money market accounts.

Restricted cash: Cash restricted for special purposes should be segregated from cash available for generaloperations and, normally, should be excluded from current assets.

Specific identification method: If goods on hand can be identified as pertaining to specific purchases, they maybe inventoried at the actual cost of each specific item. This method requires the keeping of records by whichindividual items can be identified and their costs determined.

Trade receivables: Trade receivables include open accounts, notes, and installment contracts representing claimsfor goods and services sold in the ordinary course of business.


415

INDEX

A

ACCOUNTING CHANGE� Change in depreciation method 381, 382. . . . . . . . . . . . . . . . . . . . � Change in estimate 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Prospective application 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

AGENCY TRANSACTIONS� Escrow accounts 306. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

AMORTIZATION� Cost in excess of equity in net assets of investee

(goodwill) 344. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Intangible assets 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ASSETS� Components of current assets 303. . . . . . . . . . . . . . . . . . . . . . . . . � Offsetting against liabilities 304. . . . . . . . . . . . . . . . . . . . . . . . . . . .

B

BALANCE SHEET� Offsetting assets and liabilities 304. . . . . . . . . . . . . . . . . . . . . . . . .

BUSINESS COMBINATIONS� Allocation of purchase price 389. . . . . . . . . . . . . . . . . . . . . . . . . . . � Covenants not to compete 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Lease acquisition costs 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Organization costs 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

C

CAPTIONS� Accumulated depreciation 365, 380. . . . . . . . . . . . . . . . . . . . . . . . . � Allowance for doubtful accounts 327. . . . . . . . . . . . . . . . . . . . . . . . � Cash and cash equivalents 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash value of life insurance 353. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Intangibles and other deferred costs 389. . . . . . . . . . . . . . . . . . . . � Inventories 332. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Organization costs 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment 364, 365. . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment held for investment 356. . . . . . . . . . . . . � Receivables 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CASH� Balance sheet presentation 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 303, 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash and cash equivalents 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Certificates of deposit 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Compensating balances 305. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current asset 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Demand deposit 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Escrow accounts 306. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Held checks 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Money market accounts 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Operating accounts 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Overdrafts 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Repurchase agreements 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Restricted 305. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CASH VALUE OF LIFE INSURANCE� Balance sheet presentation 353. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 353. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Loans against cash value 353. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COMPREHENSIVE INCOME� Equity method investees 344. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COST METHOD INVESTMENTS� Impairment 355. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CUTOFF� Held checks 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

D

DEFERRED CHARGES� Lease acquisition costs 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Organization costs 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DEPRECIATION� Accumulated 365. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Capital leases 372. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 365, 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in estimated useful life 382. . . . . . . . . . . . . . . . . . . . . . . . . � Change in method

�� Planned 381. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Prospective 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Retroactive 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Change in method planned 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Change in salvage value 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Definition 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated useful life 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Methods 381. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Pattern of decline in value 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Salvage value 380, 382. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Selection of method 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

DISCLOSURES� Inventories 332, 333, 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment 365. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Receivables 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

E

ENVIRONMENTAL REMEDIATION COSTS� Asbestos removal costs 364. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Capitalization of costs 364. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

EXPENSES� Organization costs 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Start�up costs 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

I

IMPAIRMENT OF ASSETS� Long�lived assets 398. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INCOME TAXES� Tax deposit to retain fiscal year 392. . . . . . . . . . . . . . . . . . . . . . . . . � Temporary differences, examples of

�� Receivables 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INDUSTRY PRACTICE� Inventories 331. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTANGIBLE ASSETS� Amortization 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Balance sheet presentation 389. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 389. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 389. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Covenants not to compete 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Goodwill

�� Acquisition 389. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Impairment 390. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Impairment 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTEREST� Imputing 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INTERIM PERIODS� Inventories

�� Gross profit method 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� LIFO approximations 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� LIFO liquidations 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


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�� Market declines 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Standard cost system 335. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INVENTORIES� Average cost 333. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 332. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 332. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Costs 332. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current asset 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 332, 333, 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � FIFO defined 333. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Gross profit method 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Interim financial statements

�� Gross profit method 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� LIFO approximations 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� LIFO liquidations 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Market declines 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Standard cost system 335. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� LIFO�� Interim financial statements 334. . . . . . . . . . . . . . . . . . . . . . . . .

� Lower of cost or market 333, 334. . . . . . . . . . . . . . . . . . . . . . . . . . . � Net realizable value 333. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Obsolescence 333. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Physical counts 334. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Specific identification method 333. . . . . . . . . . . . . . . . . . . . . . . . . . � Standard cost 335. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INVESTMENTS� Captions 353. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash value life insurance policies 353. . . . . . . . . . . . . . . . . . . . . . . � Common stockequity method

�� Accounting treatment 343, 344. . . . . . . . . . . . . . . . . . . . . . . . . . �� Difference between cost and equity in net assets 344. . . . . . �� Intra�entity profits 345. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Negative balances 344. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Significant influence 343. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Components 343. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cost method investments 355. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Impairment 355. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Nonmarketable securities 343. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Property and equipment held for investment 356. . . . . . . . . . . . .

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LEASES� Acquisition costs 392. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Bargain purchase options 370. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Capital 369. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Criteria for classification as capital lease 369. . . . . . . . . . . . . . . . . � Depreciation 372. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated economic life 370. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Executory costs 370. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Fair value 372. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Guaranteed residual value 370, 372. . . . . . . . . . . . . . . . . . . . . . . . . � Land 369. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Minimum lease payments 370. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Modification of capital lease terms 373. . . . . . . . . . . . . . . . . . . . . . � Noncancellable lease 369. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Operating leases 369. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Sales tax 370. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term 369. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

LIABILITIES� Buy�out agreements 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cash overdrafts 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Loans against cash value of life insurance 353. . . . . . . . . . . . . . . � Long�term debt� Noncompete agreements 391. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Offsetting against assets 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Short�term debt� Transfers of receivables 328, 329. . . . . . . . . . . . . . . . . . . . . . . . . . .

M

MARKETABLE SECURITIES� Accounting for 309, 310. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Balance sheet presentation 321. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Categorizing securities 311. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 309. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current asset 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Debt securities 309. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Defined 309. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Equity securities 309. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Impairment 315. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Preferred stock 309. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Subsequent changes in fair value 314. . . . . . . . . . . . . . . . . . . . . . . � Transfer between categories 312. . . . . . . . . . . . . . . . . . . . . . . . . . . � Treasury securities 316. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Unrealized holding gains/losses 321. . . . . . . . . . . . . . . . . . . . . . . .

MATERIALITY� Escrow accounts 306. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Overdrafts 304. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Salvage value 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

N

NONMONETARY TRANSACTIONS� Authoritative literature 378, 379. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanges measured at recorded amounts involving

monetary considerations 379. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanges of assets measured at fair value 378. . . . . . . . . . . . . . � Exchanges of different types of assets 379. . . . . . . . . . . . . . . . . .

P

PARTNERSHIPS� Federal tax deposit to retain fiscal year 392. . . . . . . . . . . . . . . . . .

PREPAID EXPENSES� Current assets 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Supplies 331. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PROPERTY AND EQUIPMENT� Appraisal values 364. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Captions 364, 365. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 363. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Contributed assets 378. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Cost basis 364. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Decline in value 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 365. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Estimated useful life 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanges 378. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Fully depreciated 364. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Idle facilities 363. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Long�term investment 343, 356. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Salvage value 380. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Trade�in 379. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

R

RECEIVABLES� Captions 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Components 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Current assets 303. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Disclosures 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Nontrade 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Related party 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Trade 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Transfers 328. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

RELATED PARTY TRANSACTIONS� Receivables 327. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


417

S

S CORPORATION� Federal tax deposit to retain fiscal year 392. . . . . . . . . . . . . . . . . .

V

VALUATION ALLOWANCES� Impairment of long�lived assets 399, 405. . . . . . . . . . . . . . . . . . . .


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TESTING INSTRUCTIONS FOR EXAMINATION FOR CPE CREDIT

Companion to PPC's Guide to Preparing Financial StatementsCourse 1PreparingFinancial Statements: Liabilities and Stockholders' Equity (PFSTG091)

1. Following these instructions is information regarding the location of the CPE CREDIT EXAMINATIONQUESTIONS and an EXAMINATION FOR CPE CREDIT ANSWER SHEET. You may use the answer sheet tocomplete the examination consisting of multiple choice questions.

ONLINE GRADING. Log onto our Online Grading Center at OnlineGrading.Thomson.com to receive instantCPE credit. Click the purchase link and a list of exams will appear. Search for an exam using wildcards. Paymentfor the exam is accepted over a secure site using your credit card. Once you purchase an exam, you may takethe exam three times. On the third unsuccessful attempt, the system will request another payment. Once yousuccessfully score 70% on an exam, you may print your completion certificate from the site. The site will retainyour exam completion history. If you lose your certificate, you may return to the site and reprint your certificate.

PRINT GRADING. If you prefer, you may mail or fax your completed answer sheet to the address or numberbelow. In the print product, the answer sheets are bound with the course materials. Answer sheets may beprinted from electronic products. The answer sheets are identified with the course acronym. Please ensure youuse the correct answer sheet. Indicate the best answer to the exam questions by completely filling in the circlefor the correct answer. The bubbled answer should correspond with the correct answer letter at the top of thecircle's column and with the question number.



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

Please allow a minimum of three weeks for grading.

Note:�The answer sheet has four bubbles for each question. However, not every examination question hasfour valid answer choices. If there are only two or three valid answer choices, �Do not select this answer choice"will appear next to the invalid answer choices on the examination.

2. If you change your answer, remove your previous mark completely. Any stray marks on the answer sheet maybe misinterpreted.

3. Copies of the answer sheet are acceptable. However, each answer sheet must be accompanied by a paymentof $79. Discounts apply for 3 or more courses submitted for grading at the same time by a single participant.If you complete three courses, the price for grading all three is $225 (a 5% discount on all three courses). If youcomplete four courses, the price for grading all four is $284 (a 10% discount on all four courses). Finally, if youcomplete five courses, the price for grading all five is $336 (a 15% discount on all five courses or more).

4. To receive CPE credit, completed answer sheets must be postmarked by November 30, 2010. CPE credit willbe given for examination scores of 70% or higher. An express grading service is available for an additional$24.95 per examination. Course results will be faxed to you by 5 p.m. CST of the business day following receiptof your examination for CPE Credit Answer Sheet.

5. Only the Examination for CPE Credit Answer Sheet should be submitted for grading. DO NOT SEND YOURSELF�STUDY COURSE MATERIALS. Be sure to keep a completed copy for your records.

6. Please direct any questions or comments to our Customer Service department at (800) 323�8724.


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To enhance your learning experience, examination questions are located immediately following each lesson. Eachset of examination questions can be located on the page numbers listed below. The course is designed so theparticipant reads the course materials, answers a series of self�study questions, and evaluates progress bycomparing answers to both the correct and incorrect answers and the reasons for each. At the end of each lesson,the participant then answers the examination questions and records answers to the examination questions oneither the printed EXAMINATION FOR CPE CREDIT ANSWER SHEET or by logging onto the Online GradingSystem. The EXAMINATION FOR CPE CREDIT ANSWER SHEET and SELF�STUDY COURSE EVALUATIONFORM for each course are located at the end of all course materials.

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CPE Examination Questions (Lesson 1) 72. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



Companion to PPC's Guide to Preparing Financial StatementsPFST09

421

EXAMINATION FOR CPE CREDIT ANSWER SHEET

Companion to PPC's Guide to Preparing Financial StatementsCourse 1Preparing FinancialStatements: Liabilities and Stockholders' Equity (PFSTG091)

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Companion to PPC's Guide to Preparing Financial Statements PFST09

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Companion to PPC's Guide to Preparing Financial StatementsCourse 2Accounting for Certain Tax Transactions (PFSTG092)















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Companion to PPC's Guide to Preparing Financial StatementsCourse 3The Statement of Income (PFSTG093)















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Companion to PPC's Guide To Preparing Financial StatementsCourse 3The Statement of Income (PFSTG093)

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Companion to PPC's Guide to Preparing Financial StatementsCourse 4Preparing Financial Statements: Assets (PFSTG094)















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Companion to PPC's Guide To Preparing Financial StatementsCourse 4Preparing Financial Statements: Assets (PFSTG094)

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Course Title:��Companion to PPC's Guide To Preparing Financial StatementsCourse 4Preparing Financial Statements: Assets



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