THE KEY ELEMENTS OF US GAAP –SESSION 4

Wayne Bartlett, CPA

COURSE OUTLINE

SESSION 1: IntroCore principlesOverarching standards

SESSION 2: Statement of Financial PositionProperty, Plant and EquipmentOther AssetsContingencies and liabilities

SESSION 3: Income statementOther comprehensive incomeSpecific types of income and cost

SESSION 4: TaxationLeases and special asset situationsSpecial reporting and disclosures

SESSION 5: Consolidations and equity accounting

Fair value accounting

SESSION 6: Accounting for financial instruments

Final wrap-up

TAXATION, LEASES AND SPECIAL DISCLOSURES SESSION 4

SESSION 4: A BIT OF A MIXTURE…

Income Tax

Earnings per Share

Leasing

Related Party Disclosures

Foreign currency

Interim reporting

ASC 740 – INCOME TAX

There are three main elements to this:

ASC 740-20: intra-period tax allocation – the process of allocating income tax benefits or expenses to different components of comprehensive income

ASC 740-30: other considerations or special areas – related to investments in subsidiaries and corporate joint ventures

ASC 740-270: interim reporting – guidance on interim period income taxes

The general rule in GAAP is that financial statements are on an accrual basis and must therefore accrue for all tax due in all jurisdictions

MAJOR ISSUES

As in IFRS, the main tax issues are to:

1. Recognise taxes payable or refundable for the current year as a tax liability or asset as the case may be

2. Recognise a deferred tax liability or asset for the estimated future tax effects

The other main issue concerns the detailed application of tax and accounting rules in a number of areas, such as:

1. Claiming deductions

2. Deferring of income tax to future periods

3. Applying tax credits

4. Whether income is ‘ordinary’ or capital gain

5. Reporting income on income tax returns

6. Filing tax in a particular jurisdiction

ACCOUNTING FOR TAX

The main approach is based on the Statement of Financial Position. The amount of existing tax liabilities (or benefits) existing at that point in time needs to be clearly articulated in the SOFP.

Movements in the ‘balance sheet’ determine movements in earnings and not vice-versa

Deferred tax is particularly significant. Impacts can arise from a variety of factors e.g. deductible temporary differences or carried-forward tax losses and credits

The key issue with deferred tax is to assess how realisable it is in reality

TEMPORARY DIFFERENCES

A difference between a tax asset or liability computation which will result in taxable or deductible values in future years when the asset is recovered or the liability paid

Deferred income taxes provided for all temporary but not for permanent differences

Categories of possible temporary difference1. Revenue recognised for financial reporting before being recognised for tax 2. Revenue recognised for tax before recognition in financial statements3. Expenses deductible for income tax purposes prior to recognition in the financial

statements4. Expenses recognised in the financial statements prior to being deductible for tax

purposes

SOME SPECIFIC TEMPORARY DIFFERENCES

Accrued contingent liabilities: cannot be offset against tax until the liability is fixed and determinable

Depreciation: methods used may be different than those allowed by the IRS

Goodwill: under US tax law amortisation over 15 years is mandatory

Estimates e.g. warranties: not allowable until the periods in which the costs are actually incurred

Income received in advance: taxable when received, accounting may be in a different period

Charitable contributions that exceed the allowable tax limit

Uniform cost capitalisation (UNICAP): income tax rules require some organisations to recognise inventory costs that GAAP does not allow to be charged to inventory

PERMANENT DIFFERENCES

As the name suggests, these differences never reverse. They therefore affect current income tax payable but do not impact on deferred income taxes

Examples from a GAAP context:

Club membership fees, not allowable for federal income tax purposes

Lease costs on cars that the IRS deems to be luxury

Non-deductible goodwill

Penalties and fines e.g. parking tickets

Dividends received, depending on the ownership structure of the payer of the dividend and their relationship to the payee

LOSSES CARRIED FORWARD

Treated in the same way as temporary differences.

The value of any net operating losses is computed and recorded

However, a ‘valuation allowance’ must be developed

A ‘valuation allowance’ means that management reviews the value of a tax asset and makes a judgement on whether it is more likely or not that the deferred tax asset will or will not be realised

EXAMPLE OF TAX ASSET CALCULATION

Deductible temporary differences and carry-forwards:

Inventory costs capitalised (IR Code 263A) $80,000

Bad debts foreseen $90,000

Net operating losses carried forward $120,000

Total allowable $290,000

x tax rate (say 34%, marginal tax rates are currently also 35% or 38% depending on income)

Tax asset = $98,600 ($290,000 x 34%)

MEASUREMENT OF DEFERRED TAX ASSETS AND LIABILITIES

Often use the expected average income tax rate to measure deferred tax assets and liabilities

Determine appropriate income tax rate, often the 34% current marginal rate is used though this may not be applicable in every circumstance

Compute deferred income tax:1. Identify all temporary differences2. Segregate differences into future taxable and deductible difference (need to be

separately assessed for valuation allowances)3. Accumulate information on tax loss carry-forwards4. Apply income tax rates to accumulated differences including carry-forward of losses

(federal, state, local, foreign etc.)

ACCOUNTING FOR THE UNKNOWN OR THE UNCLEAR…

There is a lot of judgement in tax calculations and unsurprisingly the IRS does not always see things in the same way as the taxpayer!

Initial recognition:

1. Management assesses whether it is ‘more likely than not’ that its tax position on each significant element will not be agreed by the taxing authority

2. Assess whether the position is clear in tax law and consider whether based on the facts, circumstances and information available it is ‘probable’ that the position will be acceptable to the taxing authority

SUBSEQUENT RECOGNITION

Changes can only be made based on the receipt of new information

Benefits become recognisable then in the period in which any one of the following is met:

1. The more likely than not test is met by the reporting date

2. The tax position is settled through examination, negotiation or litigation

3. The statute of limitations for the tax authority to examine and challenge the tax position has expired

EFFECT OF CHANGES IN TAX LAW ON DEFERRED INCOME TAX ASSETS AND LIABILITIES

All deferred tax assets and liabilities must be reviewed at every year-end

Changes in rates may impact on the calculations themselves

Note that this may impact not only on the final financial statements but also on interim reporting

There may also be changes to the tax law that impact on valuation allowances that have been made including, for example, those of an acquired entity’s deferred income tax asset (more detail can be found in ASC 805)

DIFFERENCES BETWEEN GAAP AND IFRS

In IFRS, a deferred tax asset/liability is measured when there is an intra-group transfer of assets involving separate jurisdictions. This is not the case with GAAP

In GAAP, the valuation adjustment is based on whether an item is more likely or not to be recognised. In IFRS it is the other way round, it is probable that it will be recognised

In GAAP, deferred tax assets and liabilities are shown as current and non-current depending on what assets/liabilities they are linked to. In IFRS, all deferred tax assets and liabilities are non-current

In GAAP, share-based payment deferred tax payments are based on the market value of the shares as they were at the time in which the related compensation was paid. In IFRS, they must then be reviewed every year against current market values of the shares. No such review is done in GAAP

ASC 260 - EARNINGS PER SHARE

Applies to all entities whose common or potential stock is traded publicly or who has made a filing/is about to do so

Indicator commonly used by investors to benchmark profitability

In it simplest form it is net income or loss divided by the weighted average number of shares of common stock

Other types of stock complicate the calculation e.g. convertible stock, options

Diluted EPS takes into account the possible dilution that could occur if other financial instruments that impact on common stock come into play

SIMPLE CAPITAL STRUCTURES

Simple capital structures: those with only common stock outstanding – therefore they only have ‘basic’ EPS

Basic EPS calculation is the income available to common stockholders (the numerator) divided by the weighted-average number of common shares outstanding during the period (the denominator)

Numerator: earnings must be reduced by those available for other types of shares (e.g. preference shares)

Denominator: some complications may arise e.g. because any shares reacquired must be excluded from the date of re-acquisition. Or, because new shares may be issued during the period

Stock dividends also need to be taken into account because they increase the number of shares in circulation. Note that stock dividends (or splits) must be retroactively applied for each period covered

EXAMPLE OF BASIC EPS Earnings $250,000

Extraordinary loss ($ 75,000)

Preference shares: 150,000 at par $1, dividend payable 8%, ($12,000)

Earnings $163,000

Denominator:

Ordinary shares at 1/1 120,000

New shares issued at 30/6 80,000

Shares re-acquired at 30/9 (20,000)

Weighted average shares in issue (120,000 + 40,000 – 5,000) 155,000

Therefore EPS $1.05

COMPLEX CAPITAL STRUCTURES

This is a capital structure which includes securities that could grant rights that could reduce the EPS (‘dilutive securities’)

The denominator should be increased to allow for the impact of such securities

The numerator also needs to be adjusted to take account of any impact on earnings if these securities are allowed for

A convertible security is one type of dilutive security. It has the right to receive dividends or interest and the right to potentially participate in earnings by becoming a common stockholder

Options or warrants derive their value from the right to obtain common stock at specified prices over a given period

TWO TYPES OF DILUTED EPS

Treasury stock method: used for most options or warrants. Diluted EPS is converted as if the options or warrants were exercised at the beginning of the period (unless their issuance was later) and that the funds were used to purchase the company’s common stock at the average market price for the period

If-converted method: used for convertible securities that are currently earning interest or dividends as preferential securities but could be converted to a share of in earnings as common stock. However, of course, such securities can only be counted as being one or the other but not both

IF-CONVERTED METHOD

Numerator: income is converted to reflect assumed or actual conversion:

Add back interest effect net of tax

Convertible preferred dividends are no longer deducted

Add back any other expenses attributable to convertible issues

Denominator: Weighted-average number of common stock shares outstanding is adjusted to take account of assumed or actual conversion of securities at the beginning of the period or of actual date of issuance should it be later

DIFFERENCES BETWEEN GAAP AND IFRS

IFRS does not recognise the concept of extraordinary items which are therefore not covered by the framework, in contrast to GAAP

If a contract may be settled in cash or securities then GAAP allows cash to be assumed if that is the normal practice of the business. With IFRS, in such cases it is assumed that the option of securities will be used in all circumstances and diluted EPS will be calculated using that presumption

ASC 840 – LEASES

Involves two parties, lessor and lessee, plus an asset/s

Main elements:

1. The borrower (lessee) can often obtain 100% financing

2. There may be tax benefits to both parties

3. The lessor receives not only capital payments but also interest and the possibility of some residual value at the end of the lease term

It has recently become critical to assess whether or not entities known as ‘variable interest entities’ exist and should be consolidated

VARIABLE INTEREST ENTITIES

See also ASC 810 on Consolidations

Technically described as an entity that does not have sufficient equity to sustain itself without additional support from someone else should it incur losses

Suspicions that VIEs have been set up in the past to keep items off a company’s statement of financial position. Therefore they were just really ‘shell’ organisations designed to enable entities to make their financial statements look more favourable than they would otherwise be

LEASING OR SELLING?

A lease: “the right to use property, plant or equipment (land and/or depreciable assets) usually for a stated period of time (ASC 840-10-35)

Note that short-term non-depreciable assets such as inventory are excluded from the definition and therefore cannot be leased

Scope exceptions apply e.g. for oil, gas, minerals, timber

Intangible leasing rights e.g. for films, manuscripts, patents, copyrights) are also not covered

“The right to use property”; includes the right to operate the asset or allow others to do so, the right to control physical access to an asset and a general rule that it is unlikely that parties other than the lessee will be able to obtain anything except a minor part of the output of the asset

LEASE CLASSIFICATION

Can be either operating or capital

ASC 840: if substantially all the risks and rewards of ownership are transferred to the lessee, then it is assumed that the lease is a capital one

Substantially all the rewards and benefits are deemed to be transferred if any one of the following applies:

1. Transfer of ownership to the lessee at the end of the lease term

2. The lease contains a bargain purchase option

3. The lease term is equal to 75% or more of the expected economic life of the asset and the beginning of the term does not fall in the last 25% of that life

4. The present value of the minimum lease payments at the beginning of the lease term is 90% or more of the fair value to the lessor less any investment tax credit retained by the lessor.

5. If none of these terms are met then the lease will be treated as an operating lease

LESSEE ACCOUNTING

Operating lease: rental payments are charged as expense as the payments are paid/become payable. Lease payments are assumed to be made on a straight-line basis

Therefore no impact on statement of financial position

Capital lease: set up an asset on the statement of financial position and an equal and opposite liability – this should be equal to the present value of the minimum lease payments at the beginning of the lease term or the fair value of the asset (whichever is lower)

Minimum lease payments include the minimum rentals plus any guaranteed residual value made by the lessee and the penalty for any failure to renew the lease should one apply

Leases involving property should have land and buildings dealt with as separate elements

EXAMPLE OF LEASE

An entity has a lease agreement for some equipment over four years. The economic life of the asset is five years. Consider the facts of the following and how the lease should be treated.

The fair value of the equipment is $150,000

There is a rental of $55,000 per annum over the four years

The lessee guarantees a residual value of $15,000 at the end of the lease

The lessee’s incremental borrowing rate is 10%

PRESENT VALUES

Present Values are as follows assuming 10%:

Year 1 = 0.91

Year 2 = 0.83

Year 3 = 0.75

Year 4 = 0.68

Years 1-4 = 3.17

ANSWER

Fair value = $150,000

90% of fair value = $135,000

Present value of minimum lease payments = annual payments of $55,000 x 3.17 = $174,350 plus residual value of $15,000 x .68 = $10,200 = $184,550

Therefore the minimum payments are more than 90% of the fair value and this is a capital lease

The lease period (four years) is more than 75% of the economic life. On this ground it is also a capital lease.

LESSOR ACCOUNTING

In many ways, a mirror image of the treatment in the books of the lessee

Operating leases: payments received by lessor are treated as rent revenues in the period received/receivable. Again normally recorded on a straight-line basis

The asset is recorded on the statement of financial position as ‘investment in leased property’ (or similar wording appropriate to the type of asset). These will be depreciated in the same way as other similar asset owned by the entity

Initial direct costs (e.g. fees to third parties for originating the lease) are amortised over the lease term in line with recognition of the revenue

SALE AND LEASEBACK

Exists when property is sold and then immediately leased back in full or in part from the new owner (buyer-lessor)

Important to recognise two separate events.

Normally sales value is at or above current fair value of the asset. The payback is often higher repayments over the lease period.

The accounting treatment depends on the rights retained by the seller: minor (rentals less than 10% of fair value), more than minor but less than substantially all (10-90%), substantially all (over 90%).

Substantially all = capital lease

10-90% = if at least one of the criteria for capital lease met, then it is a capital lease, any excess profit on sale is deferred and amortised over the life of the lease

Less than 10% = account for elements separately. Any excess profit is recognised on the date of sale (excess profit = total minus present value of minimum payments over the lease term)

OTHER LEASING ISSUES

Accounting for sub-leases: original lessee acts as a sub-lessor. If original lease meets any of the main four conditions, then normally a new capital lease will be created

If original lease is an operating lease, then the new lease will also qualify as an operating lease

Lease escalations: escalating base rents (periodic increases to fixed monthly rentals) should be included in minimum lease payments

Changes in residual values: must be reviewed at least annually. Any decline needs to be considered to assess whether it is likely to be temporary or permanent. If deemed to be other than temporary then it must be revised. Any loss will be reflected in the period that it is first recognised. In no circumstances shall a gain be recognised

DIFFERENCES BETWEEN GAAP AND IFRS

ASC 840 contains four specific criteria for determining the type of lease, IFRS looks at the overall substance of the transaction

GAAP rules on leasing only apply to property, plant and equipment

When both land and buildings are included in a lease, GAAP states that two separate leases exist when the land value is at least 25% of the fair value. IFRS says they must be considered separately unless the value of the land is immaterial

Unlike IFRS, a lease of land is normally considered to be an operating lease unless title passes

Unlike IFRS, GAAP does not allow immediate recognition of a gain when a sale and leaseback arrangement takes place unless the leaseback is believed to be minor

ASC 850 - RELATED PARTY DISCLOSURES

Similar to IFRS in many respects.

Required to disclose material related-party transactions other than compensation arrangements, expense allowances and other items that occur in the ordinary course of business [this is the major difference from IFRS]

Related parties include affiliates, investors accounted for using the equity method, principal owners, management and immediate family members

Transactions must be disclosed even if there is no accounting for them e.g. because they were for nil value

If the financial position or results could change significantly because of control of a related party then the nature of the relationship must be disclosed even if there were no transactions between the parties

ASC 270: INTERIM REPORTING

Provides guidance on financial reporting for periods of less than one year

GAAP does not mandate interim reporting but SEC requires quarterly summarised interim data (form 10-Q: within 45 days of quarter end). The content of this is much less than what is required for annual financial reporting by GAAP

Two approaches:

Integral approach: interim period is considered an integral part of the annual reporting period. Annual operating expenses are to be estimated and allocated to interim reports. Correction for misestimation takes place in subsequent interim periods [this is the major difference between GAAP and IFRs – IAS 34 and IFRIC 10 which does not use the integral approach other than for tax]

Discrete approach: each interim period is considered a discrete accounting period. Estimations and allocations therefore made using the same assumptions as used for annual reporting

Seasonality: many business have seasonal variations. Disclosure of these is required (ASC 270-10-45-11). There is also a need to present comparatives for the proceeding 12 months up to the end of the interim period

SOME SPECIFIC ELEMENTS

Revenues: recognised as earned during interim periods using the same methodologies as apply to annual financial statements. Cut-off procedures to be applied at the end of each interim period in the same way as at year-end in annual reporting.

Product and direct costs: normally associated with the revenue they produce. However there are four integral view exceptions (see 270-10-45):

1. Gross profit may be used to estimate cost of goods sold and inventory

2. If inventory consists of LIFO base layers, anticipated cost of replacing any liquidated

inventory is included in cost of sales for the interim period

3. An inventory market decline reasonably expected by year-end need not be included in

interim results

4. If using standard costing for inventory valuation, any purchase price and volume variances

may be excluded from interim results if expected to be absorbed by year-end

OTHER COSTS AND EXPENSES

Most costs and expenses are expensed in the period in which they are incurred under the integral approach

But if an expense clearly benefits more than one period then it is allocated to several periods, based on e.g. estimates of time expired, benefits received or activity related to each specific period

These methodologies are basically in line with year-end approaches. However allocation must not be arbitrary and some general rules are applied:

1. Costs that benefit two or more periods are assigned through the use of deferrals or accruals

2. Quantity discounts based on annual sales are allocated by proportioning interim period to

annual sales

3. Property taxes and similar are deferred/accrued to ensure a full charge to the interim period

4. Advertising costs may be deferred if it can clearly be shown that they will benefit future

periods

5. Costs that are only decided upon at year-end, such as bonuses, are assigned to interim periods

in a reasonable and consistent manner if they can be reliably estimated

INCOME TAXES

At each interim date, the entity makes its best estimate of income tax using the rate expected to apply to the full fiscal year

This should reflect federal, state, local and foreign income tax rates, credits etc.

Changes in tax rate are reflected only in the interim periods in which they become effective

As income taxes apply to annual income and not just individual interim periods, an integral approach is necessary

CONTINGENCIES

Generally contingencies are treated in the same way as they would be with annual financial statements

The materiality of the contingency is assessed with reference to the expected annual results

Disclosures relating to material contingencies and uncertainties are to appear both in interim and annual financial statements

If any new information comes to light that affects both current and financial years, then:1. The portion related to the current interim period is restated in this period

2. Prior interim periods are restated to take account of the new information

3. The amount relating to prior years is restated and recognised in the first interim period of the current year.